Picking from the multitude of sector mutual funds is a daunting task. In any given sector there are up to 227 different mutual funds. There are at least 577 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 trading volume 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 577 U.S. sector mutual funds that I cover. If you weight the TACs by assets under management, then the average TAC is lower at 2.19%. 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 and Rydex Series Funds each provide two out of the five most expensive funds. Vanguard, on the other hand, provides all five of the cheapest sector mutual funds.

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

Screen shot 2013-11-07 at 4.23.20 PMSources: 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 7% 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 top rated mutual sector 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 4Q13 Sector Ratings report.

Figure 2: Sector Mutual Funds with the Worst Holdings

Screen shot 2013-11-07 at 4.24.49 PMSources: 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.

Rydex appears more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings. The Rydex Real Estate Fund (RYREX) also appears in Figure 1 as the second-most expensive mutual fund that I cover with a total annual cost of 7.32%. Poor holdings and high costs combine for a bad fund.

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 Rydex Leisure Fund (RYLSX) receives a Neutral portfolio management rating, its high annual cost of 4.74% lowers its overall rating to Dangerous or 2 stars.

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.


Best & Worst Stocks In These Mutual Funds

Prologis Inc. (PLD) is one of my least favorite stocks held by Rydex Series Funds: Real Estate Fund (RYREX) and earns my Very Dangerous rating.  Prologis’ after-tax profits (NOPAT) have declined by 6% compounded annually over the last seven years. The company has generated negative economic earnings for the last fifteen years.  The company earns a bottom-quintile return on invested capital (ROIC) of only 1%.  Worse yet, PLD has dangerously high growth expectations embedded in its stock price.  To justify its current price of ~$41/share, the company must grow NOPAT by 26% compounded annually over the next 12 years.  These expectations seem too high given the company’s track record of poor profit growth.  Investors should avoid PLD.

EMC Corporation (EMC) is one of my favorite stocks held by Fidelity Select Portfolios: Computers Portfolio (FDCPX) and earns my Attractive rating.  EMC corporation has grown after-tax profits (NOPAT) by 19% compounded annually over the last eight years and has earned positive economic earnings in every year over the same time period.  The company also currently generates a return on invested capital (ROIC) of 15%, which puts it in the top quintile of stocks that I cover.  Despite this track record of robust growth, EMC is still cheaply valued.  EMC currently trades at ~$24/share, which gives it a price-to-economic book share value ratio of 1.1.  This valuation implies that the market expects EMC to grow NOPAT by only 10% over the remainder of its corporate life.  Having grown NOPAT by 19% compounded annually over the last eight years, these expectations seem low.  Strong profit growth and low expectations make EMC an attractive pick for investors.

Jared Melnyk contributed to this article

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

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