How to Avoid the Worst Sector Mutual Funds

Picking from the multitude of sector mutual funds is a daunting task. In any given sector there may be as many as 234 different mutual funds, and there are at least 632 mutual funds across all sectors.

Why are there so many mutual funds? The answer is: because mutual fund providers are making lots of money selling them. The 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
  2. High fees
  3. Poor quality holdings

I address these red flags in order of difficulty. More details on the best & worst mutual funds by sector are here.

How To Avoid Mutual Funds with Inadequate Liquidity

This is the easiest issue to avoid, and my advice is simple. Avoid all mutual funds with less than $100 million in assets. Low asset levels tend to mean lower volume in the mutual fund and larger bid-ask spreads.

How To Avoid High Fees

Mutual funds should be cheap, but not all of them are.

To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs (TAC) below 2.40%, which is the average TAC of the 632 U.S. sector mutual funds I cover. If you weight the TACs by assets under management, then the average TAC is lower at 1.51%. A lower weighted average is a good sign that investors are putting money in the cheaper mutual funds.

Figure 1 shows the most and least expensive sector mutual funds in the U.S. equity universe based on total annual costs. Saratoga Advantage Trust provides four out of the five most expensive funds.. Vanguard, on the other hand, provides all five of the cheapest sector mutual funds, all of which are index funds.

Figure 1: 5 Least and Most-Expensive Sector Mutual Funds

htawsectormfs1Sources: New Constructs, LLC and company filings

While costs among ETFs fall into a generally narrow range, mutual fund costs are more varied. The high costs of the most expensive mutual funds, sometimes above 8% annually, make it much harder for them to perform as well as the cheapest mutual funds.

However, investors need not pay high fees for good holdings. Vanguard Consumer Staples Index Fund (VCSAX) is my number one rated mutual fund overall, yet it has a low total annual cost of 0.17%.

On the other hand, the Vanguard REIT Index Funds (VGSNX, VGRSX, VGSLX) and Vanguard Utilities Index Fund (VUIAX) hold poor stocks, each getting a 2-star or Dangerous rating. And no matter how cheap a mutual fund, if it holds bad stocks, its performance will be bad.

This result highlights why investors should not choose mutual funds based only on price. The quality of holdings matters more than price.

How To Avoid Mutual Funds with the Worst Holdings

This step is by far the hardest, 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 sector with the worst holdings or portfolio management ratings. The sectors are listed in descending order by overall rating as detailed in my 3Q13 Sector Ratings report.

Figure 2: Sector Mutual Funds with the Worst Holdings

htawsectormf2Sources: New Constructs, LLC and company filings

My overall 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 done on each stock we cover.

Fidelity appear more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings. The five Fidelity mutual funds in Figure 2 are cheap, but their  

Note that no mutual funds with a dangerous portfolio management rating earn an overall rating better than two stars. These scores are consistent with my belief that the quality of a mutual fund is more about its holdings than its costs. If the mutual fund’s holdings are dangerous, then the overall rating cannot be better than dangerous because one cannot expect the performance of the fund to be any better than the performance of its holdings.

Still, while the Ivy Science & Technology Fund (ISTEX) receives a Dangerous portfolio management rating, its high annual cost of 3.91% lowers its overall rating to Very Dangerous or 1-star.

Find the mutual funds with the worst overall ratings on my mutual fund screener. More analysis of the Best Sector mutual funds is here.

The Danger Within

Buying a mutual 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. 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.

PERFORMANCE OF MUTUAL FUND’s HOLDINGs = PERFORMANCE OF MUTUAL FUND

Best & Worst Stocks In These Mutual Funds

Williams Companies (WMB) is one of my least favorite stocks held by Hennessy Gas Utilities Index Fund (GASFX) and earns my Very Dangerous rating. I argued a few months ago that WMB was not going to see much benefit from the growing use of natural gas to its pipeline business. It seems the market agreed with me, as WMB is down 8% since I wrote that article while the S&P 500 is up 9%. The stock remains overvalued, though, as WMB would need to grow after tax profit (NOPAT) by 12% compounded annually for 13 years to justify its valuation of ~$34/share. It’s hard to see a company that functions essentially as a utility achieving that level of profit growth.

3M Company (MMM) is one of my favorite stocks held by Vanguard Industrials Index Fund (VINAX) and earns my Attractive rating. MMM has grown NOPAT by 10% compounded annually over the past 10 years and earned a top-quintile return on invested capital (ROIC) of 18% in 2012. MMM’s diversity of products and consumer markets worldwide makes it less susceptible to short-term macroeconomic shocks than most companies.

Growth Appreciation Period (GAP) measures the number of years that a business is expected to grow its economic earnings. MMM has been around for over a century and it produces staple products that will continue to be necessary for years to come. It would be reasonable for MMM to have a very long growth horizon or GAP, but at its current valuation of ~$117/share its market-implied GAP is only six years. The market is undervaluing a company that should continue creating shareholder value for many years to come.

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