Year-to-date the Energy sector is down nearly 9% while the S&P 500 is up 5%. This performance makes the Energy sector the worst performing sector in 2017, as measured by the State Street Select Sector SPDRs. Investors searching for value may now be drawn to the Energy sector, but buyer beware. Without analysis of the holdings in each mutual fund, one may be buying a fund filled with bad stocks. ICON Energy Fund (ICEAX, ICEEX, ICENX) is one of the Energy funds investors should avoid as all three share classes earn our Very Dangerous rating. In fact, this fund is one of the most expensive Energy funds with over $100 million in assets. All told, its high fees and overvalued holdings land it in the Danger Zone this week.

Look Past Expense Ratios: This Fund Is More Expensive Than It Seems

Per Figure 1, ICON Energy Fund’s expense ratios (particularly ICEAX) understate the true costs of investing in this fund. With total annual costs (TAC) of 4.38%, ICEAX is more expensive than 98% of the 7000+ mutual funds under coverage.

For comparison, the average TAC of the 116 Energy mutual funds under coverage is 2.65% and the weighted average is lower at 2.08%. The benchmark, State Street Energy Select Sector SPDR (XLE), charges total annual costs of just 0.15%.

Figure 1: ICON Energy Fund’s Understated Costs

icon energy fund newconstructs_iconenergyfund_tacvsexpenseratio_2017-03-27

icon energy fund

 

Sources: New Constructs, LLC and company filings 

To justify its higher fees, the ICON Energy Fund must outperform XLE by the following over three years:

  1. ICEAX must outperform by 4.22% annually.
  2. ICEEX must outperform by 2.86% annually.
  3. ICENX must outperform by 1.66% annually.

An in-depth analysis of ICEAX’s TAC is on page 2 here.

Worst yet, ICON Energy Fund investors are paying these fees for significantly overvalued stocks, as we’ll show below.

ICEAX’s Allocation Makes Outperformance Unlikely

The only justification for mutual funds to have higher fees than ETFs is “active” management that leads to out-performance. In Figure 2, the details behind our Predictive Overall Fund Rating for ICEAX show the managers of the fund have not selected good stocks in terms of earnings quality and valuation.

Figure 2: ICON Energy Fund (ICEAX) Rating Breakdown

 newconstructs_iceax_ratingbreakdown_2017-03-27

Sources: New Constructs, LLC and company filings

The findings from our discounted cash flow valuation of the fund reveal the market implied growth appreciation period (GAP) is 17 years for the S&P 500 – compared to 58 years for ICEAX.

This high valuation of the fund’s holdings is more troublesome considering the return on invested capital (ROIC) of the S&P is 17% compared to 1% for the ICON Energy Fund. In other words, despite being less profitable, the market expects the stocks held by ICEAX to grow economic earnings for 41 years longer than those held by the S&P 500.

Furthermore, the price-to-economic book value (PEBV) ratio for the S&P 500, which includes some of the world’s most successful companies, is 2.1. The PEBV ratio for ICEAX is 6.0. This ratio means that the market expects the profits for the S&P 500 to increase 210% from their current levels versus 600% for ICEAX.

Lastly, seven of the fund’s top 10 holdings receive our Dangerous-or-worse rating and make up 38% of its portfolio. At the end of the day, the high profit growth expectations baked into the valuations of stocks held by ICON Energy Fund lowers the upside potential and increases risks of a blow up.

Historical Underperformance Should Continue

Year-to-date, ICEAX is down 8% while XLE is down almost 9%. This slight outperformance is more an outlier rather than what should be expected from ICEAX going forward. In fact, over the last year, ICEAX and XLE are both up 12%. Given that 81% of assets are allocated to stocks with Dangerous-or-worse ratings, long-term outperformance seems unlikely.

Investors looking to buy ICEAX must not only expect the significant profit growth highlighted earlier, but also ignore the fund’s history of underperformance. Over the past five years, ICEAX is down 37%, ICEEX is down 38%, and ICENX is down 36%. Meanwhile, XLE is down just 4% over the same time. Figure 3 shows the growth of 10k since ICEAX’s inception in 2010.

We think it overly optimistic to invest in the belief that these mutual funds will ever outperform their much cheaper ETF benchmark over significant time frames given the issues outlined above.

Figure 3: ICON Energy Fund Vs. XLE: Growth of 10K

newconstructs_iconenergyfund_growthof10k_2017-03-27

Sources:   New Constructs, LLC and company filings.

The Importance of Holdings Based Fund Analysis

The analysis above shows that investors might want to withdraw most or all of the $335 million in the ICON Energy Fund and put the money into better investments. There are no funds that get an Attractive-or-better rating within the Energy sector. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees.

This article originally published on March 27, 2017.

Disclosure: David Trainer, Kyle Guske II, and Kyle Martone receive no compensation to write about any specific stock, style, or theme.