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 222 different Financials mutual funds and at least 618 mutual funds across all sectors. Do investors need that many choices? How different can the mutual funds be?

Those 222 Financials mutual funds are very different. With anywhere from 21 to 550 holdings, many of these Financials 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. The opposite is true for some sectors, while others lie in between these extremes with a fair mix of good and bad stocks. For example, the Industrials sector, per my 1Q Sector Rankings Report, ranks fifth 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 financials (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 550 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 2014-02-18 at 9.31.07 AM

Sources:   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 Consumer Staples Index Fund (VCSAX) is the top-rated Consumer Staples mutual fund and the overall top-rated fund of the 618 sector mutual funds that I cover. VCSAX is the only sector mutual fund to receive an Attractive-or-better rating, as no other mutual funds allocate enough assets to Attractive-or-better-rated stocks to earn a rating greater than Neutral.

Sometimes, you get what you pay for.

It is troubling to see one of the best sector mutual funds, ICON Consumer Staples Fund (ICLEX) have just $38 million in assets despite its Neutral rating. On the other hand, Very Dangerous-rated AIM Investment Securities Funds: Invesco Real Estate Fund (IARYX) has over $2 billion in assets. IARYX has lower total annual costs than ICLEX (1.24% and 1.88% 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 IARYX if they knew that it has such a poor portfolio of stocks. It is cheaper than ICLEX, 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 WorldCommodity Fund (WCOMX) with just $2 million in assets. Sadly, other Energy mutual funds with more assets and inferior portfolios charge more than WCOMX. In other words, Energy mutual fund investors are paying extra fees for no reason.

ICON Energy Fund (ICEAX) is one of the worst mutual funds in the Energy sector. It gets my Dangerous rating based off the fact that barely 13% of its assets are allocated to Attractive-or-better rated stocks, while 25% is allocated to Dangerous-or-worse stocks. ICEAX also has total annual costs of 4.22%, higher than WCOMX’s 2.04%. One would think that ICEAX would have fewer assets than WCOMX, but instead it has over $707mm. Investors are paying extra fees for poor holdings.

The worst mutual fund in Figure 1 is American Century Quantitative Equity Utilities Fund (BULIX), 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 free 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

Amgen Inc (AMGN) is one of my favorite stocks held by SWHFX and earns my Very Attractive rating. AMGN has grown after-tax profit (NOPAT) by 14% compounded annually over the past decade. Currently, AMGN earns a return on invested capital (ROIC) of 18%, and it has earned a double digit ROIC in 9 out of the past 10 years. Despite AMGN’s strong track record of growth and profitability, the market has low expectations for the company’s future. At its current valuation of ~$122/share, AMGN has a price to economic book value ratio of only 1.1, which implies that the company will never grow NOPAT by more than 10% from its current level. Given AMGN’s track record of profit growth, such a pessimistic expectation seems unwarranted. High profitability combined with low market expectations makes AMGN Very Attractive.

Jared Melnyk contributed to this post.

Disclosure: David Trainer and Jared Melnyk receive no compensation to write about any specific stock, sector, or theme.

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