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 940 different Large Cap Blend mutual funds and at least 5896 mutual funds across all styles. Do investors need that many choices? How different can the mutual funds be?

Those 940 Large Cap Blend mutual funds are very different. With anywhere from 14 to 1022 holdings, many of these Large Cap Blend mutual funds have very different portfolios, creating different investment implications.

The same is true for the mutual funds in any other style, as each offers a very different mix of good and bad stocks. Some styles have lots of good stocks and offer quality funds. The opposite is true for some styles, while others lie in between these extremes with a fair mix of good and bad stocks. For example, the Large Cap Blend style, per my 2Q Style Rankings Report ranks first out of 10 styles when it comes to providing investors with quality mutual funds. Small Cap Value ranks last. Details on the Best & Worst Mutual Funds in each style 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 style should not all be that different. I think the large number of Large Cap Blend (or any other) style 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 1022 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 Style Mutual Funds

Screen shot 2014-05-07 at 10.07.59 AMSources:   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 Style Mutual Funds with the Best Holdings

Figure 1 shows my top rated mutual fund for each style. 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 Specialized Funds: Vanguard Dividend Growth Fund (VDIGX) is the top-rated Large Cap Value mutual fund and the overall top-rated fund of the 5896 style mutual funds that I cover. Only four investment styles contain any Attractive (i.e. 4-star) or better rated mutual funds. The best every other style can offer is a Neutral or 3-star mutual fund.

Sometimes, you get what you pay for.

It is troubling to see one of the best style mutual funds, Manning & Napier Fund, Inc: Dividend Focus Series (MNDFX) has just $185 million in assets despite its Attractive (4-star) rating. On the other hand, Neutral rated Massachusetts Investors Growth Stock Fund (MIGNX) has $6,262 million in assets. MIGNX has lower total annual costs than MNDFX (0.51% and 0.66% 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 MIGNX if they knew that it has such a poor portfolio of stocks. It is cheaper than MNDFX, 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 Royce Fund: Royce Micro-Cap Discovery Fund (RYDFX) with just $6 million in assets. Sadly, other Small Cap Value mutual funds with more assets and inferior portfolios charge more than RYDFX In other words; Small Cap Value mutual fund investors are paying extra fees for no reason.

Financial Investors Trust: Stonebridge Small-Cap Growth Fund (SBSGX) is one of the worst mutual funds in the Small Cap Growth style. It gets my Very Dangerous rating based off the fact that barely 9% of its assets are allocated to Attractive-or-better rated stocks, while 67% is allocated to Dangerous-or-worse stocks. SBSGX also has total annual costs of 6.49%, higher than RYDFX’s 2.45%. One would think that SBSGX would have fewer assets than RYDFX, but instead it has over $20 million. Investors are paying extra fees for poor holdings.

The worst mutual fund in Figure 1 is Royce Fund: Royce Micro-Cap Discovery Fund (RYDFX), which gets a Neutral (3-star) rating. One would think mutual fund providers could do better for this style.

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

CIGNA Corporation (CI) is one of favorite holdings in FSMVX and earns my Very Attractive rating.  Over the past decade, CI has grown after-tax profits (NOPAT) by 13% compounded annually. CI currently earns an impressive return on invested capital (ROIC) of 12% and has generated positive economic earnings in nine of the past 10 years. With the stock being down around 5% this year, CI is very undervalued. At its current price of ~$83/share, CI has a price to economic book value (PEBV) ratio of 1.1. This ratio implies the market expects CI’s NOPAT to only grow by 10% from the current level for the remaining life of the corporation. This low expectation is awfully pessimistic for a company that has grown profits by double digits annually for a decade.

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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