Rating Breakdown: Best & Worst ETFs & Mutual Funds by Style

This report identifies the “best” ETFs and mutual funds based on the quality of their holdings and their costs. As detailed in “Low-Cost Funds Dupe Investors”, there are few funds that have both good holdings and low costs. While there are lots of cheap funds, there are very few with high-quality holdings.

Without speculating on the cause for this disconnect, I think it is fair to say that there is a severe lack of quality research into the holdings of mutual funds and ETFs. There should not be such a large gap between the quality of research on stocks and funds, which are simply groups of stocks.

After all, investors should care more about the quality of a fund’s holdings than its costs because the quality of a fund’s holdings is the single most important factor in determining its future performance.

My Predictive Rating system rates 7400+ mutual funds and ETFs according to the quality of their holdings (portfolio management rating) and their costs (total annual costs rating).

The following is a summary of my top picks and pans for all style ETFs and mutual funds. I will follow this summary with a detailed report on each style, just as I did for each sector.

Figure 1 shows the best ETF or mutual fund in each investment style as of July 11, 2013. No fund provider appears more than once in Figure 1.

For a full list of all ETFs and mutual funds for each investment style ranked from best to worst, see our freeETF and mutual fund screener.

SunAmerica Focused Series, Inc: Focused Dividend Strategy Porftolio (FDSWX) is my top rated Large Cap Blend mutual fund and currently the only ETF or mutual fund to earn my Very Attractive rating. SFVAX allocates an impressive 79% of its assets to Attractive-or-better rated stocks. FDSWX also hastotal annual costs of only 0.92%, surprisingly low for an actively managed fund. FDSWX, with its quality holdings and low costs, shows that it is possible for investors to have their cake and eat it too. For those who are priced out by FDSWX’s $50,000 initial minimum, FDSTX offers the same holdings but with roughly double the total annual costs.

GameStop Corporation (GME) is one of my favorite stocks held by FDSWX and earns my Very Attractive rating. GME has thrived in a struggling economy, earning a return on invested capital (ROIC) of over 10% for each of the past six years. GME had misleadingly low reported earnings last year, as a $627 milliongoodwill impairment charge caused it to report a net loss. Adjusting this and other non-operating charges out of operating expenses reveals that GME actually earned a net operating profit after tax (NOPAT) of $414 million in the most recent fiscal year.

GME has been on a tear this year, up nearly 70%. The stock still is cheap at ~$42.42/share though. GME has a price to economic book value ratio of 0.9, implying a permanent 10% decrease in NOPAT. Analysts were worried that console makers Sony (SNE) and Microsoft (MSFT) would restrict used-game sales on their new consoles (used game sales account for nearly 50% of GME’s gross profit). With announcements from both console makers that they will not restrict the reselling of games, there does not appear to be any immediate catalyst for a decline in GME’s profitability. GME is a well-run company that looks set to reward investors, which includes investors in FDSWX.

Figure 2 shows the worst ETF or mutual fund for each investment style as of July 11, 2013. 360 Capital Management and Munder Capital Management both have two funds that appear in Figure 2.

Dangerous-or-worse-rated funds have a combination of low-quality portfolios (i.e. they hold too many Dangerous-or-worse rated stocks) and high costs (they charge investors too much for the [lack of] management they provide).

John Hancock Funds III: Small Cap Opportunities Fund (JCPAX) is the worst-rated Small Cap Growth fund and earns my Very Dangerous rating. JCPAX allocates nearly 50% of its assets to Dangerous-or-worse stocks while allocating only 1% to Attractive stocks. For this poor management, JCPAX charges investors total annual costs of 6.53%.

CoStar Group (CSGP) is one of my least favorite stocks held by JCPAX and earns my Dangerous rating. CSGP’s 3% ROIC in 2012 and negative free cash flow for the past four years attests to management failure to create value for shareholders. Despite the fact that CSGP’s NOPAT declined by 14% last year, it is priced for significant growth. To justify its valuation of ~$135.90/share, CSGP would need to grow NOPAT by 23% compounded annually for 15 years. Investors can find better value elsewhere.

Traditional mutual fund research has focused on past performance and low management costs. The quality of a fund’s holdings has been ignored. Our portfolio management rating examines the fund’s holdings in detail and takes into account the fund’s allocation to cash. Our models are created with data from over 40,000 annual reports. This kind of diligence is necessary for understanding just what you are buying when you invest in a mutual fund or an ETF.

Figure 3 shows the best fund based on our Portfolio Management Rating for each investment style as of July 11, 2013. Again, no fund provider appears more than once.

Attractive-or-better-rated funds own high-quality stocks and hold very little of the fund’s assets in cash – investors looking to hold cash can do so themselves without paying management fees. Only 2% of funds receive our Attractive or Very Attractive ratings, so investors need to be cautious when selecting a mutual fund or ETF – there are thousands of Neutral-or-worse-rated funds.

Figure 4 shows the worst fund based on our Portfolio Management Rating for each investment style as of July 11, 2013.

The worst fund for all but one investment style is an actively managed mutual fund. Actively managed funds should hold better stocks than ETFs to justify their higher fees. Investors pay mutual fund managers to pick stocks for them. Even ignoring costs, these mutual fund managers do a poor job investing money for their clients.

Investors should care about all of the fees associated with a fund in addition to the quality of the fund’s holdings. The best funds have both low costs and quality holdings – and there are plenty of low cost funds available to investors.

Figure 5 shows the best fund in each investment style according to our total annual costs rating. An ETF ranks as the lowest cost for seven of the twelve style categories.

Total Annual Costs incorporates all expenses, loads, fees, and transaction costs into a single value that is comparable across all funds. Passively managed ETFs and index mutual funds are generally the cheapest funds. Vanguard funds make up half of the funds in Figure 5.

Figure 5: Style Funds With Lowest Costs

The most expensive fund for each investment style has a Very Dangerous Total Annual Costs Rating. Investors should avoid these funds and other funds with a Very Dangerous Total Annual Costs Ratings because they charge investors too much. For every fund with a Very Dangerous Total Annual Costs Rating there is an alternative fund that offers similar exposure and holdings at a lower cost. We cover over 7000 mutual funds and over 400 ETFs. Investors have plenty of alternatives to these overpriced funds.

Figure 6 shows the worst fund in each investment style according to our total annual costs rating. No ETFs ranks as the most expensive for any style category.

Figure 6: Style Funds With Highest Costs 

Sam McBride contributed to this report.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector or theme.