Finding the best mutual funds is an increasingly difficult task as there are more and more to choose from daily.
You Cannot Trust Mutual Fund Labels
There are over 150 mutual funds for the Information Technology sector, and at leas 644 mutual funds across all sectors. Do investors really need that many different mutual funds?
These funds can have a wide variety of holdings, and even more specific labels do not tell investors exactly what is in the fund. Rydex Series Fund: Internet Fund (RYINX) and Kinetics Mutual Funds, Inc: Internet Fund (KINAX) differ in four out of their top holdings. Google (GOOG) is the only company that both funds allocate heavily to.
Mutual funds in any given sector offer a very different mix of good and bad stocks. Some sectors have lots of good stocks and offer lots of good mutual funds. The opposite is true for others. And some sectors lie somewhere in between. For example, the financial sector, per my 1Q Sector Rankings report, ranks last out of the 10 major sectors when it comes to providing investors with quality mutual funds. The consumer staples sector ranks first. Details on the Best & Worst ETFs in each sector are here.
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 mutual fund that might blow up. 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. No matter how cheap, if it holds bad stocks, the mutual fund’s performance will be bad.
PERFORMANCE OF MUTUAL FUND’s HOLDINGs = PERFORMANCE OF MUTUAL FUND
Sources: New Constructs, LLC and company filings
Only the Consumer Staples and Health Care sectors offer any mutual funds that get a 4 star (Attractive) rating. No sector offers a mutual fund that gets a 4 star rating, has sufficient liquidity (at least $100 million in assets) to be a safe investment, and has a low initial minimum investment.
Paralysis By Analysis
The large number of sector 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. For some funds that can be over 1,000 stocks. To make it more complicated, mutual funds only disclose their holdings each quarter. The reported holdings of a mutual fund may not correspond to its actual holdings two months after the disclosure.
Any investor, worth his salt, knows that knowing the holdings of a mutual fund is critical to finding the best mutual fund.
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 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 World Funds: Vanguard Consumer Staples Index (VCSAX) is my top rated Consumer Staples fund and my overall top rated sector mutual fund. Its $100,000 initial minimum, however, may keep it from being a feasible option for many investors. The $5 million minimum investment for Davis Series Funds: Davis Financial Fund (DVFYX) prices out many investors.
Other top rated mutual funds have a problem with inadequate liquidity. Funds with under $100 million in assets can end up with greater volatility and can have more of a disconnect between the price of the fund and the underlying value of the equities it holds. For this reason, investors should think twice about Oak Associates Funds: Live Oak Health Sciences Fund (LOGSX) even though the quality of its holdings gives it a 4 star rating.
Fidelity Select Portfolios: Computers Portfolio (FDCPX) is my top rated mutual fund that meets the liquidity requirement and has a reasonably low minimum investment ($2,500). It earns my 3 star (Neutral) rating.
You can find more liquid alternatives for the other funds on my free ETF and 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 much more complicated for mutual funds than ETFs because they charge front- and back-end loads and transaction costs. Just looking at the expense ratio alone is not enough to understand the true costs of being in a fund. For more detail on the ways hidden costs can hurt investors, see Danger Zone 3/4/2013: Wilmington Small Cap Growth Fund (ARPAX).
My ratings penalize those funds with abnormally high costs. However, low costs alone cannot make a good fund, as detailed in Low Cost Funds Dupe Investors.
Top Stocks Make Up Top Mutual Funds
Amgen Inc. (AMGN) is one of my favorite holdings in LOGSX. This stock gets my Very Attractive raing. Amgen has achieved impressively consistent growth in profitability for the past decade and a half, growing after tax profit (NOPAT) by 15% compounded annually since 1998. It has increased economic earnings every year since 2004. The $23 billion in excess cash that the company has on hand also puts it in good position to fund research and support marketing and distribution of its drugs. AMGN’s share price increased by over 20% a week ago on news of encouraging test results for is new melanoma drug, but the stock remains significantly undervalued. At its current share price of ~$98.66, AMGN has a price to economic book value ratio of 0.8, implying that the company will experience a permanent 20% decline inNOPAT. Such low market expectations, combined with a strong track record of economic profitability, gives this stock a very attractive risk/reward for investors.
Sam McBride contributed to this report
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.