How To Avoid the Worst Style Mutual Funds 2Q16

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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.

The large number of mutual funds has little to do with serving investors’ best interests. Below are three red flags investors can use to avoid the worst mutual funds:

  1. Inadequate Liquidity

This issue 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. Plus, low asset levels tend to mean lower volume in the mutual fund and larger bid-ask spreads.

  1. 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 1.93%, which is the average total annual cost of the 6089 U.S. equity Style mutual funds we cover. The weighted average is lower at 1.26%, which highlights how investors tend to put their money in mutual funds with low fees.

Figure 1 shows that Calvert U.S. Large Cap Growth Responsible Index (CGJYX) is the most expensive style mutual fund and Vanguard Total Stock Market Index (VSMPX) is the least expensive. American Growth Fund (AMREX, AMRHX, and AMRAX) provides three of the most expensive mutual funds while Vanguard mutual fund (VSMPX, VIIIX, and VITPX) are among the cheapest.

Figure 1: 5 Least and Most Expensive Style Mutual Funds

NewConstructs_LeastMostExpensive_StyleMFs_2Q16

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings. Smead Value Fund (SVFYX) earns our Very Attractive rating and has low total annual costs of only 0.97%.

On the other hand, Vanguard Extended Market Index Fund (VEMPX) holds poor stocks yet has low total annual costs of 0.08%. 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.

  1. 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 style with the worst holdings or portfolio management ratings.

Figure 2: Style Mutual Funds with the Worst Holdings

NewConstructs_AvoidWorstStyleMFs_2Q16

Sources: New Constructs, LLC and company filings

No one provider appears more often than any other providers in Figure 2.

Sims Total Return Fund (SIMFX) is the worst rated mutual fund in Figure 2. Seven other mutual funds (HDPCX, COREX, RYRHX, TDGNX, PUMYX, DEFIX, and KAUFX) 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, style, or theme.

Click here to download a PDF of this report.

Photo Credit: Jose Luis Hernandez (Flickr)

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