How To Avoid The Worst Sector Mutual Funds 4Q22

Question: Why are there so many mutual funds?

Answer: Mutual fund management is profitable, so Wall Street creates more products to sell.

The large number of mutual funds has little to do with serving your best interests as an investor. More reliable & proprietary fundamental data drives my research and analysis of fund holdings and provides investors with a new source of alpha. I leverage this 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 below 1.88%, – the average total annual costs of the 676 U.S. equity Sector mutual funds my firm covers. The weighted average is lower at 1.14%, which highlights how investors tend to put their money in mutual funds with low fees.

Figure 1 shows Saratoga Energy and Basic Materials Portfolio (SBMBX) is the most expensive sector mutual fund and Fidelity Real Estate Index Fund (FSNRX) is the least expensive. Saratoga Advantage Trust provides four of the most expensive mutual funds while Vanguard 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 earns it a very attractive rating. Fidelity Advisor Global Commodity Stock Fund (FIQRX) is the best ranked sector mutual fund overall. FIQRX’s attractive Portfolio Management rating and 0.97% total annual cost also 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, in spite of its 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.

2. 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 and Rydex appear more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings.

Firsthand Technology Opportunities Fund (TEFQX) is the worst rated mutual fund in Figure 2. Baron Real Estate Income Fund (BRIFX), Rydex Energy Services Fund (RYESX), Fidelity Advisor Utilities Fund (FUGAX), Rydex Financial Services Fund (RYFNXFNX
), and Fidelity Advisor Industrials Fund (FCLAX) also earn a very unattractive 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 OF MUTUAL FUND’s HOLDINGs – FEES = PERFORMANCE OF MUTUAL FUND

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