Question: Why are there so many mutual funds?
Answer: Mutual fund management is profitable, so Wall Street creates more products to sell.
I leverage my firm’s data to identify two red flags you can use to avoid the worst mutual funds:
1. High Fees
Mutual funds should be cheap, but not all of them are. The first step is to benchmark what cheap means.
To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs (TAC) below 1.87%, the average total annual costs of the 627 U.S. equity Sector mutual funds I cover. The weighted average TAC is lower at 1.11%, which highlights how investors tend to put their money in mutual funds with low fees.
Figure 1 shows Saratoga Financial Services Portfolio (SFPAX) is the most expensive sector mutual fund and Fidelity Real Estate Index Fund (FSRNX) is the least expensive. Saratoga (SFPAX, SMBMX, SHPAX, STPAX, SFPCX) provides all five of the most expensive mutual funds while Vanguard (VRTPX, VHCIX, VUIAX) 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 Health Care Index Fund (VHCIX) is the best ranked sector mutual fund in Figure 1. VHCIX’s neutral Portfolio Management rating and 0.12% total annual cost earns it an attractive rating. BlackRock Natural Resources Trust (MAGRX) is the best ranked sector mutual fund overall. MAGRX’s attractive Portfolio Management rating and 1.14% total annual cost earns it a very attractive rating.
Despite having low total annual costs of 0.10%, Fidelity Real Estate Index Fund (FSRNX) holds poor stocks and receives a very unattractive rating. 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.
2. Poor Holdings
A mutual fund’s holdings have more weight in determining overall performance than its costs. Therefore, avoiding poor holdings is the most important (and hardest) part of avoiding mutual funds. 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
Vanguard (VMIAX, VCDAX, VUIAX) and Fidelity (FRXMX, FIKEX, FONMX) appear more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings.
Davis Real Estate Fund (DREYX) is the worst rated mutual fund in Figure 2 based on predictive overall rating. Firsthand Technology Opportunities Fund (TEFQX), Fidelity Disruptive Medicine Fund (FRXMX), and Vanguard Utilities Index Fund (VUIAX) also earn a very unattractive predictive overall rating, which means not only do they hold poor stocks, but they also 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. To put it differently, research on mutual fund holdings is necessary due diligence because a mutual fund’s performance is only as good as its holdings.
PERFORMANCE OF MUTUAL FUND’s HOLDINGS – FEES = PERFORMANCE OF MUTUAL FUND
Disclosure: David Trainer, Kyle Guske II, and Italo Mendonça receive no compensation to write about any specific stock, sector, or theme.