Finding the best mutual funds is an increasingly difficult task in a world with so many mutual funds.
You Cannot Trust Mutual Fund Labels
There are at least 6,202 mutual funds across all styles. Do investors need that many choices? How different can the mutual funds be?
Even in the least popular style, mid cap value, there are at least 199 mutual funds. These mutual funds vary widely in the number and type of holdings they have. Artisan Mid Cap Value Fund (ARTQX) and PNC Mid Cap Value Fund (PMVIX) share no common stocks in their top five holdings.
In some styles, the label will tell you something about the stocks the fund holds. I am sure that large cap value funds hold many of the same big stocks such as International Business Machines (IBM), Chevron (CVX) and 3M (MMM). However, investors need to know what else those mutual funds hold before they can say they have done their due diligence.
The same is true for the mutual funds in any style as each offers a very different mix of good and bad stocks. Some styles have lots of good stocks and offer lots of good mutual funds. The opposite is true for others while some styles lie in between. For example, large cap growth, per my1Q Style Rankings report, ranks fourth out of 12 styles when it comes to providing investors with quality mutual funds. Large cap blend ranks first. Small cap value ranks last. Details on theBest & Worst ETFs in each style are here.
The bottom line is that investors cannot trust mutual fund labels or names. They do not tell you enough about what you are getting when you buy a mutual fund.
Figure 1: Best Style Mutual Funds
Sources: New Constructs, LLC and company filings
Paralysis By Analysis
I firmly believe mutual funds for a given style should not all be that different. I think the large number of 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 funds, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each mutual fund, which can be up to 3,262 stocks or more. To make matters even more complicated, some mutual funds allocate heavily to ETFs, so investors need to analyze all the stocks in those ETFs as well.
The holdings of a mutual fund drive its performance. Any investor worth his salt knows that analyzing the holdings is critical to finding the best mutual fund.
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 fund without analyzing its holdings is like buying a stock without analyzing its business and finances. 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
Finding the Style Mutual Funds with the Best Holdings
Figure 1 above shows my top rated mutual fund for each style. Importantly, myratings on mutual fundsare based primarily on mystock ratingsof their holdings. My firm covers over 3000 stocks and is known foruniquely thorough due diligencefor each stock we cover. Accordingly, our coverage of mutual funds leverages the diligence we do on each stock by rating ETFs based on the aggregated ratings of the stocks each ETF holds. Here is asample mutual fund report.
GMO Trust: GMO Quality Fund (GQLOX) is the top rated large cap blend fund and the overall top rated fund across all styles. However, the $300,000,000 initial minimum investment keeps it from being an option for most investors. Pear Tree Funds: Pear Tree Quality Fund (USBOX) is the top rated large cap blend fund to have a manageable minimum investment ($2,500).
Sometimes, you get what you pay for.
It is troubling to see one of the best style mutual funds, Advisors Series Trust: Scharf Funds (LOGIX), have just $45 million in assets. The largest mutual fund in all cap growth, Fidelity Mt. Vernon Street Trusts: Fidelity Growth Company Fund (FGRFX), has over $44 billion in assets thought it only gets a Neutral (3-star) rating. FGRFX’s expense ratio at 0.80% is much lower than LOGIX’s at 1.43%, but as I state above, no matter how cheap a mutual fund is, if it does not hold good stocks it will not perform well. Sometimes, you get what you pay for.
Similarly, Fidelity Commonwealth Trust II: Fidelity Large Cap Growth Enhanced Index Fund (FLGEX) has only $172 million in assets despite being the top rated Large Cap Growth Fund. The slightly cheaper Growth Fund of America (RGAGX) soaks up most of the assets in the style.
I cannot help to wonder if more investors would buy FLGEX if they knew it has a superior portfolio of stocks. It is more expensive than RGAGX, but as I have stated, low fees cannot grow wealth, only good stocks can.
Sometimes, you DON’T get what you pay for.
This is especially true for mutual funds, as their costs can be harder to discern than ETFs. Just look atWilmington Small Cap Growth Fund (ARPAX). Whereas the only significant costs for ETFs are expense ratios, investors have to factor in front-end load and transaction costs to determine the true cost of a mutual fund.
Without a careful examination of all the fees involved, investors can end up paying significantly more in fees for inferior management. ARPAX has $137 million in assets despite havingtotal annual costsof 8.51% and a Dangerousportfolio management rating. Compare this to another small cap growth fund, Oak Associates Funds: River Oak Discovery Fund (RIVSX). RIVSX has total annul costs of 2.16% and a Neutral portfolio management rating. It stands to reason that it would attract more investors than ARPAX, but it has only $11 million in assets.
Investors should avoid high fees especially when they are for inferior management. There are plenty of funds that offer quality holdings for low prices. Bridgeway Funds, Inc: Blue Chip 35 Index Fund (BRLIX) offers extremely low costs of 0.23% and Attractive holdings.
Along with quality holdings and low fees, liquidity is an important factor in picking mutual funds. I recommend investors only buy mutual funds with more than $100 million in assets. You can find more liquid alternatives for the other funds on myfree ETF and mutual fund screener.
Covering All The Bases, Including Costs
My mutual fund rating also takes into account thetotal annual costs, which represents the all-in cost of being in the fund. While I weight the quality of holdings more heavily than costs in my analysis, my ratings penalize those funds that charge abnormally high fees to investors.
Top Stocks Make Up Top Mutual Funds
One of my favorite holdings in GQLOX is Oracle Corporation (ORCL), which earns my Very Attractive rating. The consistency with which ORCL creates value for investors is impressive. It has earned a return on invested capital (ROIC) of over 20% for every year since at least 1998 when my model begins. Over the past 10 years it has grown after tax profit (NOPAT) by 18% compounded annually. Investors usually have to pay quite a premium for such consistent growth, but ORCL’s valuation is actually quite cheap. At ~$32.41/share, the stock’sprice to economic book value ratiois 0.9, implying that the company will experience a permanent 10% decline inNOPAT.
Big Data is not going anywhere, and Oracle remains at the forefront of database software services. The field may be growing more competitive, but Oracle retains a competitive advantage due to its scale and resources. The market is expecting Oracle’s profits to start declining, reversing a decade long trend. While I could see some slowdown in the company’s earnings growth, such a pessimistic projection seems unlikely to me. Such a low valuation makes Oracle a great deal for investors. Heavy allocation to Oracle helps to explain why GQLOX is my top rated mutual fund.
Sam McBride contributed to this report
Disclosure: David Trainer owns ORCL. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.