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The Telecom sector ranks seventh out of the ten sectors as detailed in my Sector Rankings for ETFs and Mutual Funds report. It gets my Dangerous rating, which is based on aggregation of ratings of 4 ETFs and 13 mutual funds in the Telecom sector as of July 10, 2013. Prior reports on the best and worst ETFs and mutual funds in every sector and style are here.

Figure 1 ranks from best to worst the four Telecom Services ETFs and Figure 2 shows the five best and worst-rated Telecom Services mutual funds. Not all Telecom sector ETFs and mutual funds are created equal. The number of holdings varies widely (from 19 to 54), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Telecom sector, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Telecom ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this sector on my free mutual fund and ETF screener.

Figure 1: ETFs with the Best & Worst Ratings

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* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Figure 2: Mutual Funds with the Best & Worst Ratings - Top 5

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* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

PFS Funds Wireless Fund (WIREX) is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Vanguard Telecom ETF (NYSEARCA:VOX) is my top-rated Telecom ETF and T. Rowe Price Media and Telecommunications Fund (PRMTX) is my top-rated Telecom mutual fund. VOX earns my Dangerous rating, while PRMTX earns my Neutral rating.

SPDR S&P Telecom ETF (NYSEARCA:XTL) is my worst-rated Telecom ETF and Rydex Series Telecommunications Fund (RYTLX) is my worst-rated Telecom mutual fund. XTL earns my Dangerous rating, while RYTLX earns my Very Dangerous rating.

Figure 3 shows that 16 out of the 95 stocks (over 31%% of the market value) in Telecom ETFs and mutual funds get an Attractive-or-better rating. However, zero out of 4 Telecom ETFs and zero out of 13 Telecom mutual funds get an Attractive-or-better rating.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Telecom ETFs hold poor quality stocks.

Figure 3: Telecom Sector Landscape For ETFs, Mutual Funds & Stocks

Sources: New Constructs, LLC and company filings

As detailed in "Low-Cost Funds Dupe Investors", the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Telecom ETFs and mutual funds, as no Telecom sector funds receive an Attractive or better rating, and only one mutual fund in the sector even manages a Neutral rating. Investors should focus on individual Telecom stocks instead.

Verizon (NYSE:VZ) is one of my favorite stocks held by Telecom ETFs and mutual funds and earns my Attractive rating. Verizon has increased profits (NOPAT) by 13% compounded annually since 1998, and has a sizable NOPAT margin of 18% compared with 14% for AT&T (NYSE:T), the next highest margins in its group of competitors. VZ also has earned positive and increasing economic earnings for the past 5 years and has a healthy return on invested capital (ROIC) of 8%. Despite these positive indicators of growth, Verizon stock price still gives it a price to economic book value (PEBV) ratio of .95, which means that the market expects Verizon's profits to permanently drop by 5%. Seeing as the past few years have been VZ's best years ever, this looks unlikely, and investors should seriously consider at this stock while it still trades at a discount.

CenturyLink (NYSE:CTL) is one of my least favorite stocks held by Telecom ETFs and mutual funds and earns my Dangerous rating. CTL has a return on invested capital (ROIC) of 3%, putting it in the bottom quintile of all the companies I cover across all sectors. CTL's profit (NOPAT) growth has been good in recent years, but this is largely due to the acquisition of telecommunications carrier Qwest in 2011. More importantly, CTL has earned negative economic earnings every year since my model began, a trend that has only intensified since 2011. Investors have been attracted to CTL for its high dividend yield, inflating the stock to ~$35.20/share. To justify this lofty valuation, CTL would need to grow NOPAT by 10% compounded annually for 16 years. Outside of the acquisition of Qwest, the company has little history of profit growth in recent years, and the firm's revenue future looks shaky as consumers abandon CTL's landline business for their cell phones. Without significant growth, it will be hard for CTL to maintain its dividend payouts and its high share price.

42 stocks of the 3000+ I cover are classified as Telecom stocks, but due to style drift, Telecom ETFs and mutual funds hold 95 stocks.

Figures 4 and 5 show the rating landscape of all Telecom ETFs and mutual funds.

My Sector Rankings for ETFs and Mutual Funds report ranks all sectors and highlights those that offer the best investments.

Figure 4: Separating the Best ETFs From the Worst ETFs

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Sources: New Constructs, LLC and company filings

Figure 5: Separating the Best Mutual Funds From the Worst Mutual Funds

telecom5

Sources: New Constructs, LLC and company filings

Review my full list of ratings and rankings along with reports on all 4 ETFs and 13 mutual funds in the Telecom sector.

André Rouillard and Sam McBride contributed to this report.

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

Source: Best And Worst ETFs, Mutual Funds And Key Holdings: Telecom Sector