Finding the best mutual funds is an increasingly difficult task in a world with so many to choose from.

You Cannot Trust Mutual Fund Labels

There are at least 213 different Financial mutual funds and at least 601 mutual funds across all sectors. Do investors need that many choices? How different can the mutual funds be?

Those 213 Financial mutual funds are very different. With anywhere from 21 to 549 holdings, many of these Financial mutual funds have drastically different portfolios, creating drastically different investment implications.

The same is true for the mutual funds in any other sector, as each offers a very different mix of good and bad stocks. Some sectors have lots of good stocks and offer quality funds. Some do not. For example, the Financial sector, per my 2Q Sector Rankings Report ranks ninth out of 10 sectors when it comes to providing investors with quality mutual funds. Consumer Staples ranks first. Utilities ranks last. Details on the Best & Worst Mutual Funds in each sector are here.

The bottom line is: mutual fund labels do not tell you the kind of stocks you are getting in any given mutual fund.

Paralysis By Analysis

I firmly believe mutual funds for a given sector should not all be that different. I think the large number of Financial (or any other) sector of mutual funds hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many mutual funds. Analyzing mutual funds, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each mutual fund. As stated above, that can be as many as 549 stocks, and sometimes even more, for one mutual fund.

Any investor worth his salt recognizes that analyzing the holdings of a mutual fund is critical to finding the best mutual fund.

Figure 1: Best Sector Mutual Funds

Screen shot 2014-05-05 at 3.22.41 PMSources:   New Constructs, LLC and company filings

The Danger Within

Why do investors need to know the holdings of mutual funds before they buy? They need to know to be sure they do not buy a fund that might blow up. Buying a fund without analyzing its holdings is like buying a stock without analyzing its business and finances. As Barron’s says, investors should know the Danger Within. No matter how cheap, if it holds bad stocks, the mutual fund’s performance will be bad.


Finding the Sector Mutual Funds with the Best Holdings

Figure 1 shows my top rated mutual fund for each sector. Importantly, my ratings on Mutual Funds are based primarily on my stock ratings of their holdings. My firm covers over 3000 stocks and is known for the due diligence we do for each stock we cover. Accordingly, our coverage of mutual funds leverages the diligence we do on each stock by rating mutual funds based on the aggregated ratings of the stocks each mutual fund holds.

Vanguard World Funds: Vanguard Consumer Staples Index Fund (VCSAX) is the top-rated Consumer Staples mutual fund and the overall top-rated fund of the 608 sector mutual funds that I cover. Unfortunately, there are no sectors that have Attractive-or-better rated funds. The best each sector has to offer is Neutral-rated or worse.

Sometimes, you get what you pay for.

It is troubling to see one of the best sector mutual funds, Fidelity Select Portfolios: Wireless Portfolio (FWRLX) have just $287 million in assets despite its Neutral rating. On the other hand, Dangerous-rated Fidelity Devonshire Trust: Fidelity Telecom & Utilities Fund (FIUIX) has $1,019 million in assets. FIUIX has lower total annual costs than FWRLX (1.18% and 1.21% respectively), but low costs cannot drive positive performance. Quality holdings are the ultimate driver of performance.

I cannot help but wonder if investors would leave FIUIX if they knew that it has such a poor portfolio of stocks. It is cheaper than FWRLX, but, as previously stated, low fees cannot growth wealth, only good stocks can.

Sometimes, you DON’T get what you pay for.

The smallest mutual fund in Figure 1 is Fidelity Select Portfolios: Wireless Portfolio (FWRLX) with just $287 million in assets. Sadly, other Telecom Service mutual funds with more assets and inferior portfolios charge more than FWRLX. In other words, Telecom Service mutual fund investors are paying extra fees for no reason.

Fidelity Select Portfolios: Chemicals Portfolio (FSCHX) is one of the worst mutual funds in the Materials sector. It gets my Dangerous rating based off the fact that barely 6% of its assets are allocated to Attractive-or-better rated stocks, while 34% is allocated to Dangerous-or-worse stocks. FSCHX also has total annual costs of 1.05%. Investors are paying extra fees for poor holdings.

The worst mutual fund in Figure 1 is Fidelity Devonshire Trust: Fidelity Telecom & Utilities Fund (FIUIX), which gets a Dangerous (2-star) rating. One would think mutual fund providers could do better for this sector.

I recommend investors only buy mutual funds with more than $100 million in assets. You can find more liquid alternatives for the other funds on my mutual fund screener.

Covering All The Bases, Including Costs

My mutual fund rating also takes into account the total annual costs, which represents the all-in cost of being in the mutual fund. This analysis is complex for mutual funds, as one has to consider not only expense ratios, but also front-end load and transaction fees. A high front-end load not only costs investors at the beginning, it also reduces the growth investors can experience later on. While costs play a smaller role than holdings, my ratings penalize those funds with abnormally high costs.

Top Stocks Make Up Top Mutual Funds

Altria Group (MO) is one of favorite holdings in DVFYX and earns my Attractive rating. Since MO spun off Phillip Morris (PM) in 2008, it has grown after-tax profits (NOPAT) by 9% compounded annually and increased its return on invested capital (ROIC) from 13% to 19%. Even though smoking in the U.S. has been declining, MO has been able to keep growing profits by diversifying into smokeless tobacco products as well as wine. At its current price of ~$40/share, MO has a price to economic book value (PEBV) ratio of 1. This ratio implies that the market expects MO to never grow NOPAT for the remainder of its corporate life. Given MO’s recent track record of profit growth, it should be able to exceed these low expectations, and, so, the stock has upside.

Kyle Guske II contributed to this post.

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

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