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 227 different Financials mutual funds and at least 559 mutual funds across all sectors. Do investors need that many choices? How different can the mutual funds be?

Those 227 Financials mutual funds are very different. With anywhere from 21 to 535 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 Materials sector, per my 4Q Sector Rankings Report, ranks seventh 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 535 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

FindTheBestSectorMutualFunds_4Q13_table1Sources:   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 559 sector mutual funds I cover. Only the Consumer Staples sector contains any Attractive (i.e. 4-star) rated mutual funds, while the best every other sector can offer is a Neutral or 3-star mutual fund, or even as low as a 2-star (Dangerous) fund.

Sometimes, you get what you pay for.

It is troubling to see one of the best sector mutual funds, the ICON Consumer Discretionary Fund (ICCCX) have just $45 million in assets despite its 3-star rating. On the other hand, Dangerous-rated Fidelity Select Multimedia Portfolio (FBMPX) has over $965 million in assets. FBMPX has lower total annual costs than ICCCX (1.04% and 1.76% 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 FBMPX if they knew that it has such a poor portfolio of stocks. It is cheaper than ICCCX, 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.

Franklin Natural Resources Fund (FRNRX) is one of the worst mutual funds in the Health Care sector. It gets my Very Dangerous rating based off the fact that barely 6% of its assets are allocated to Attractive-or-better rated stocks, while 36% is allocated to Dangerous-or-worse stocks. FRNRX also has total annual costs of 3.46%, much higher than LOGSX’s 2.04%. One would think that FRNRX would have fewer assets than WCOMX, but instead it has over $866 million. 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

Colgate-Palmolive (CL) is one of my favorite stocks held by Vanguard Consumer Staples Index Fund (VCSAX) and earns my Attractive rating. CL has a stable track record of profit (NOPAT) growth: 8% compounded annually since 1998, all while consistently increasing its profit margins and revenues. CL also has a return on invested capital (ROIC) of 23%, which puts it in the top quintile of all companies I cover, and the company has earned positive economic earnings every year since the beginning of my model.

Still, at its current valuation of ~$65/share, CL has a price to economic book value ratio of 1.3, implying that its NOPAT will permanently increase by 30% and stay at that level. Given CL’s consistent profit growth in the past and its dominating 45% share in the toothpaste market, investors can rely on the company to beat these expectations. VCSAX’s 3.42% allocation to Colgate-Palmolive help it earn my Attractive fund rating.

André Rouillard contributed to this post

Disclosure: David Trainer owns CL. David Trainer and André Rouillard receive no compensation to write about any specific stock, sector, or theme.

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