How to Avoid the Worst Sector Mutual Funds 1Q23

Question: Why are there so many mutual funds?

Answer: Mutual fund management is profitable, so Wall Street creates more products to sell.

The large number of mutual funds has little to do with serving your best interests as an investor. More reliable & proprietary fundamental data, proven in The Journal of Financial Economics, drives our research and analysis of fund holdings and provides investors with a new source of alpha. We leverage this data to identify two red flags you can use to avoid the worst mutual funds:

1. High Fees

Mutual funds should be cheap, but not all of them are. The first step is to benchmark what cheap means.

To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs (TAC) below 1.87%, the average total annual costs of the 627 U.S. equity Sector mutual funds we cover. The weighted average TAC is lower at 1.11%, which highlights how investors tend to put their money in mutual funds with low fees.

Figure 1 shows Saratoga Financial Services Portfolio (SFPAX) is the most expensive sector mutual fund and Fidelity Real Estate Index Fund (FSRNX) is the least expensive. Saratoga (SFPAX, SMBMX, SHPAX, STPAX, SFPCX) provides all five of the most expensive mutual funds while Vanguard (VRTPX, VHCIX, VUIAX) mutual funds are among the cheapest.

Figure 1: 5 Most and Least Expensive Sector Mutual Funds

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings.^[1] Vanguard Health Care Index Fund (VHCIX) is the best ranked sector mutual fund in Figure 1. VHCIX’s Neutral Portfolio Management rating and 0.12% total annual cost earns it an Attractive rating.^[2] BlackRock Natural Resources Trust (MAGRX) is the best ranked sector mutual fund overall. MAGRX’s Attractive Portfolio Management rating and 1.14% total annual cost earns it a Very Attractive rating.

Despite having low total annual costs of 0.10%, Fidelity Real Estate Index Fund (FSRNX) holds poor stocks and receives our Very Unattractive rating. 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.

2. Poor Holdings

A mutual fund’s holdings have more weight in determining overall performance than its costs. Therefore, avoiding poor holdings is the most important (and hardest) part of avoiding mutual funds. 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 (VMIAX, VCDAX, VUIAX) and Fidelity (FRXMX, FIKEX, FONMX) appear more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings.

Davis Real Estate Fund (DREYX) is the worst rated mutual fund in Figure 2 based on our predictive overall rating. Firsthand Technology Opportunities Fund (TEFQX), Fidelity Disruptive Medicine Fund (FRXMX), and Vanguard Utilities Index Fund (VUIAX) also earn a Very Unattractive predictive overall rating, which means not only do they hold poor stocks, but they also charge high total annual costs.

Our overall ratings on mutual funds reflects our stock ratings of their holdings and a measure of the total annual costs of investing in the fund.

The Danger Within

Buying a mutual fund without analyzing its holdings is like buying a stock without analyzing its business and finances. To put it differently, research on mutual fund holdings is necessary due diligence because a mutual fund’s performance is only as good as its holdings. Don’t just take our word for it, see what Barron’s says on this matter.

PERFORMANCE OF MUTUAL FUND’s HOLDINGS – FEES = PERFORMANCE OF MUTUAL FUND

Analyzing each holding within funds is no small task. Our Robo-Analyst technology enables us to perform this diligence with scale and provide the research needed to fulfill the fiduciary duty of care. More of the biggest names in the financial industry (see At BlackRock, Machines Are Rising Over Managers to Pick Stocks) are now leveraging technology in the investment research process. Technology may be the only solution to the dual mandate for research: cut costs and fulfill the fiduciary duty of care. Investors, clients, advisors, and analysts deserve the latest technology to get the diligence required to make prudent investment decisions.

This article was originally published on February 10, 2023.

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

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^[1] Three independent studies from respected institutions prove the superiority of our data, models, and ratings. Learn more here.

^[2] Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.

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