Time value of money, long term equity fund investment for sustainable growth, financial concept
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 below 1.84%, – the average total annual costs of the 596 U.S. equity Sector mutual funds my firm covers. The weighted average is lower at 1.08%, 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, SBMBX, SHPAX, STPAX, SFPCX) provides 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
Least Most Expensive Sector Mutual Funds 3Q23
New Constructs, LLC
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. Vanguard Energy Index Fund (VENAX) is the best ranked sector mutual fund overall. VENAX’s attractive Portfolio Management rating and 0.12% total annual cost earns it a very attractive rating.
On the other hand, Fidelity Real Estate Index Fund (FSRNX) holds poor stocks and receives a very unattractive rating, yet has 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
Worst Sector Mutual Funds 3Q23
New Constructs, LLC
Fidelity (FIJZX, FIKCX, FSDAX) appears more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings.
Firsthand Funds Technology Opportunities (TEFQX) is the worst rated mutual fund in Figure 2 based on predictive overall rating. Manning & Napier Real Estate Series and PGIM Jennison Utility Fund (PRUQX) 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, Kyle Guske II, Hakan Salt, and Italo Mendonça receive no compensation to write about any specific stock, sector, or theme.
