How To Avoid The Worst Sector Mutual Funds 2Q16 by Kyle Guske II, New Constructs
Question: Why are there so many mutual funds?
Answer: mutual fund providers tend to make lots of money on each fund so they create more products to sell.
Hedge fund managers are among the wealthiest people in society, and many of them choose to give back through their own foundations. David Abrams of Abrams Capital is one hedge fund manager who has his own foundation. We can get an idea about his favorite hedge funds by seeing which funds his foundation invested in. Read More
The large number of mutual funds has little to do with serving your best interests. Below are three red flags you can use to avoid the worst mutual funds:
- Inadequate Liquidity
This issue is the easiest to avoid, and our advice is simple. Avoid all mutual funds with less than $100 million in assets. Low levels of liquidity can lead to a discrepancy between the price of the mutual fund and the underlying value of the securities it holds. Plus, low asset levels tend to mean lower volume in the mutual fund and larger bid-ask spreads.
- High Fees
Mutual funds should be cheap, but not all of them are. The first step here is to know what is cheap and expensive.
To ensure you are paying average or below average fees, invest only in mutual funds with total annual costs below 2.25%, which is the average total annual costs of the 643 U.S. equity Sector mutual funds we cover. The weighted average is lower at 1.38%, which highlights how investors tend to put their money in mutual funds with low fees.
Figure 1 shows that Saratoga Financial Services Portfolio (SFPAX) is the most expensive sector mutual fund and Fidelity Spartan Real Estate Index (FSRNX) is the least expensive. Saratoga (SFPAX, SBMBX, and SFPCX) provides three of the most expensive mutual funds while Vanguard mutual fund (VITAX, VFAIX, VHCIX, and VMIAX) are among the cheapest.
Figure 1: 5 Least and Most Expensive Sector Mutual Funds
Worst Sector Mutual Funds
Investors need not pay high fees for quality holdings. Davis Financial Fund (DVFYX) earns our Very Attractive rating and has low total annual costs of only 0.79%.
On the other hand, Vanguard Utilities Index Fund (VUIAX) holds poor stocks yet charges low total annual costs of 0.12%. No matter how cheap a mutual fund, if it holds bad stocks, its performance will be bad. The quality of a mutual fund’s holdings matters more than its price.
- Poor Holdings
Avoiding poor holdings is by far the hardest part of avoiding bad mutual funds, but it is also the most important because a mutual fund’s performance is determined more by its holdings than its costs. Figure 2 shows the mutual funds within each sector with the worst holdings or portfolio management ratings.
Figure 2: Sector Mutual Funds with the Worst Holdings
Fidelity (FBMPX and FSTCX) and Prudential (PHLQX and PRUZX) appear more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings.
BlackRock All-Cap Energy & Resources Fund (BACIX) is the worst rated mutual fund in Figure 2. REMS Real Estate Value-Opportunity Fund (HLRRX), Prudential Jennison Utility Fund (PRUZX), Prudential Health Sciences Fund (PHLQX), Fidelity Telecommunications Portfolio (FSTCX), and RS Technology Fund (RIFYX) also earn a Very Dangerous predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs too.
Our overall ratings on mutual funds are based primarily on our stock ratings of their holdings.
The Danger Within
Buying a mutual fund without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, research on mutual fund holdings is necessary due diligence because a mutual fund’s performance is only as good as its holdings’ performance. Don’t just take our word for it, see what Barron’s says on this matter.
PERFORMANCE OF MUTUAL FUND’s HOLDINGs = PERFORMANCE OF MUTUAL FUND
Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, or theme.