Why are there so many mutual funds? The answer is: because mutual fund providers are making lots of money selling them. The 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 is the easiest issue 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. In addition, low asset levels tend to mean lower volume in the mutual fund and large 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 at or below average fees, invest only in mutual funds with total annual costs below 2.34%, which is the average total annual cost of the 704 U.S. equity mutual funds we cover.
Figure 1 shows the most and least expensive sector mutual funds in the US equity universe based on total annual costs. Rydex provides four of the most expensive mutual funds while Vanguard mutual funds are among the cheapest.
Figure 1: 5 Least and Most Expensive Sector Mutual Funds
Sources: New Constructs, LLC and company filings
However, investors need not pay high fees for good holdings. Oak Associates Red Oak Technology Fund (ROGSX) is our highest-rated sector mutual fund and earns our Very Attractive rating. It also has total annual costs of 1.38%.
On the other hand, Fidelity Salem Spartan Real Estate Fund holds poor stocks and 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, 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
Sources: New Constructs, LLC and company filings
Vanguard appears more often than any other provider in Figure 2, which means that they offer the most mutual funds with the worst holdings.
Our overall ratings on mutual funds are based primarily on our stock ratings of their holdings. New Constructs covers over 3000 stocks and is known for the due diligence done on each stock we cover.
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.
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.
Photo Credit: Paul Vladuchick (Flickr)