How To Avoid The Worst Sector Mutual Funds 1Q22

Question: Why are there so many mutual funds?

Answer: Mutual fund providers tend to make lots of money on each fund, so they create more products to sell.

The large number of mutual funds has little to do with serving your best interests. I identify three red flags you can use to avoid the worst mutual funds:

1. Inadequate Liquidity

This issue is the easiest 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.

2. 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 1.86%, which is the average total annual costs of the 623 U.S. equity Sector mutual funds my firm covers. The weighted average is lower at 1.15%, which highlights how investors tend to put their money in mutual funds with low fees.

Figure 1 shows Saratoga Trust Energy and Basic Materials Portfolio (SBMBX) is the most expensive sector mutual fund and Vanguard Real Estate II Index Fund (VRTPX) is the least expensive. Saratoga Trust (SBMBX, SFPAX, SEPCX, SFPCX) provides four of the most expensive mutual funds while Vanguard (VRTPX, VFAIX, VITAX, VHCIX, VINAX) mutual funds are among the cheapest.

Figure 1: 5 Most and Least Expensive Sector Mutual Funds

Investors need not pay high fees for quality holdings. Vanguard Financials Index Fund (VFAIX) is the best ranked sector mutual fund in Figure 1. VFAIX’s neutral Portfolio Management rating and 0.12% total annual cost earn it an attractive rating. Fidelity Insurance Portfolio (FSPCX) is the best ranked sector mutual fund overall. FSPCX’s attractive Portfolio Management rating and 0.96% total annual cost earns it a very attractive rating.

On the other hand, Vanguard Real Estate II Index Fund (VRTPX) holds poor stocks and receives a very unattractive rating, despite low total annual costs of 0.10%. 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.

3. Poor Holdings

Avoiding poor holdings is by far the hardest part of avoiding bad mutual funds, 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.

Figure 2: Sector Mutual Funds with the Worst Holdings

Fidelity (FGKMX, FSAVX, FIKAX, FSVLX, FSDAX, FIKIX) appears more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings.

Baron Health Care Fund (BHCHX) is the worst rated mutual fund in Figure 2. Victory RS Science and Technology Fund (RIFYX), DFA Real Estate Securities Portfolio (DFREX), Fidelity Defense and Aerospace Portfolio (FSDAX), and Fidelity Advisor Energy Fund (FIKAX) also earn a very anattractive predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs.

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, 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 FUNDs HOLDINGS = PERFORMANCE OF MUTUAL FUND

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