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 your best interests.
Here are three red flags you can use to avoid the worst mutual funds:
- 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 levels of liquidity can lead to a discrepancy between the price of the mutual fund and the underlying value of the securities it holds. In addition, low asset levels tend to mean lower volume in the mutual fund and large bid-ask spreads.
- High Fees
Mutual funds should be cheap, but not all of them are. The first step here is to know what is cheap and expensive.To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs below 2.05%, which is the average total annual cost of the 7221 U.S. equity mutual funds I cover.Figure 1 shows the most and least expensive style mutual funds in the U.S. equity universe based on total annual costs. Rydex provides two of the most expensive mutual funds while Fidelity mutual funds are among the cheapest.Figure 1: 5 Least and Most-Expensive Style Mutual Funds
Sources: New Constructs, LLC and company filingsHowever, investors need not pay high fees for good holdings. Vanguard Fenway Equity Income Fund (VEIRX) is my second rated style mutual fund and earns my Very Attractive (5-star) rating. It also has low total annual costs of only 0.30%.
- Poor 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 style with the worst holdings or portfolio management ratings.
Figure 2: Style Mutual Funds with the Worst Holdings
Sources: New Constructs, LLC and company filings
No one provider appears more often than any other providers in Figure 2, which would mean that they offer the most mutual funds with the worst holdings.
The Danger Within
Buying a mutual fund without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, investment 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
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Kyle Guske II contributed to this article
Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.