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Summary

  • Fund holdings matter more than costs or past performance.
  • Investors are good at picking cheap funds, but bad at picking ones with quality holdings.
  • Investors don't have to settle for either/or. There are funds with low costs and good stocks.

Fund holdings affect fund performance more than fees or past performance. A cheap fund is not necessarily a good fund. A fund that has done well in the past is not likely to do well in the future (e.g. 5-star kiss of death and active management has long history of underperformance). Yet, traditional fund research focuses only on low fees and past performance.

Our research on holdings enables investors to find funds with high quality holdings - AND - low fees.

Investors are good at picking cheap funds. We want them to be better at picking funds with good stocks. Both are required to maximize success.

Figure 1 shows that 37% of fund assets are in ETFs and mutual funds with low costs but less than 1% of assets are in ETFs and mutual funds with Attractive holdings. This discrepancy is astounding.

Figure 1: Allocation of Fund Assets By Holdings Quality and By Costs

Sources: New Constructs, LLC and company filings

Two key shortcomings in the ETF and mutual fund industry cause this large discrepancy:

  1. A lack of research into the quality of holdings.
  1. A lack of high-quality holdings or good stocks.
  • With about twice as many funds as stocks in the market, there simply are not enough good stocks to fill all the funds.

These shortcomings are related. If investors had more insight into the quality of funds' holdings, I think they would allocate a lot less money to funds with poor quality holdings. Many funds would cease to exist.

Investors deserve research on the quality of stocks held by ETFs and mutual funds

Quality of holdings is the single most important factor in determining an ETF or mutual fund's future performance. No matter how low the costs, if the ETF or mutual fund holds bad stocks, performance will be poor. Costs are easy to find but research on the quality of holdings is almost non-existent.

Figure 2 shows investors are not putting enough money into ETFs and mutual funds with high-quality holdings. Only 38 of 6965 (<1% of assets) of ETFs and mutual funds allocate a significant amount of value to quality holdings. Almost 100% of assets are in funds that do not justify their costs and overcharge investors for poor portfolio management.

Figure 2: Distribution of ETFs & Mutual Funds (Count & Assets) By Portfolio Management Rating

Source: New Constructs, LLC and company filings

Figure 3 shows that investors successfully find low-cost funds. 37% of assets are held in ETFs and mutual funds that have Attractive-or-better rated Total Annual Costs, my apples-to-apples measure of the all-in cost of investing in any given fund.

Out of the 6965 ETFs and mutual funds I cover, 852 (37% of all assets) earn an Attractive-or-better Total Annual Costs rating.

Clearly, ETF and mutual funds investors are smart shoppers when it comes to finding cheap investments. But cheap is not necessarily good.

American Beacon Funds: American Beacon Small Cap Index Fund (MUTF:ASCIX) is a good example of a fund with low costs but poor holdings. Its total annual costs are Very Attractive at 0.45%. However, it gets an overall predictive rating of Dangerous because no matter how low its fees, I expect it to underperform because it holds too many Dangerous-or-worse rated stocks. Low fees cannot boost fund performance. Only good stocks can boost performance.

Acuity Brands, Inc. (NYSE:AYI) is one of my least favorite stocks held by ASCIX and earns my Dangerous rating. AYI's after-tax profits (NOPAT) have declined by 1% compounded annually since 2008. During this same time, the company's return on invested capital (ROIC) has decreased from 18% to 12%. While a 12% ROIC is still respectable, this decline in profitability is cause for concern. More importantly, at ~$142/share, AYI has become significantly overvalued. To justify this valuation, AYI would need to grow NOPAT by 15% compounded annually for the next 26 years. These growth levels may be attainable in the short term, but to sustain them for so long is quite optimistic, especially given AYI's recent track record of profit decline. Investors should avoid AYI.

Figure 3: Distribution of ETFs & Mutual Funds (Count & Assets) By Total Annual Costs Ratings

Source: New Constructs, LLC and company filings

Investors should allocate their capital to funds with both high-quality holdings and low costs because those are the funds that offer investors the best performance potential.

But they do not. Not even close.

Figure 4 shows that less than 1% of ETF and mutual fund assets are allocated to funds with low costs and high-quality holdings according to my Predictive Fund Ratings, which are based on the quality of holdings and the all-in costs to investors.

Note the fund industry offers 3897 Dangerous-or-worse ETFs and mutual funds compared to just 15 Attractive-or-better ETFs and mutual funds, over 250 times more bad funds than good funds. That means a lot of fees are being paid to managers that do not deserve them.

Figure 4: Distribution of ETFs & Mutual Funds (Count & Assets) By Predictive Ratings

Source: New Constructs, LLC and company filings

Investors deserve forward-looking ETF and mutual fund research that assesses both costs and quality of holdings. For example, Market Vectors Semiconductor ETF (NYSEARCA:SMH) has Very Attractive total annual costs of just 0.39%, but still manages to allocate over 35% of its assets to Attractive-or-better rated stocks. This fund is proof that investors can find low cost funds with quality holdings.

Intel Corporation (NASDAQ:INTC) is one of my favorite stocks held by SMH and earns my Very Attractive rating. Over the past decade, INTC has grown after-tax profits (NOPAT) by 6% compounded annually and currently earns a top quintile return on invested capital (ROIC) of 17%. On top of these achievements, INTC has generated positive economic earnings every year for the last decade. Despite this impressive profit growth, Intel's stock price has remained relatively flat over the past year.

As I wrote in November 2013, INTC is poised to benefit from recent market fear. With the stock price at ~$25/share, INTC has a price to economic book value (PEBV) ratio of 0.9. This ratio implies that the market expects INTC's NOPAT to decline by 20% for the life of the company. This pessimistic expectation contradicts Intel's actual achievements over the last 10 years and overlooks the growth potential in its mobile and datacenter businesses. Low market expectations for the stock coupled with consistent profit growth of the company make for a great buying opportunity in INTC.

SMH has not been a great performer recently. Its total return of 15% over the last year falls well short of the S&P 500. However, past performance is not a good indicator of future results, and with quality holdings like INTC, SMH is set up to perform well for investors in the future.

Why is the most popular fund rating system based on backward-looking past performance?

I do not know, but I do know that the lack of transparency into the quality of portfolio management provides cover for the ETF and mutual fund industry to continue to over charge investors for poor portfolio management. How else could they get away with selling nearly 250 times more Dangerous-or-worse ETFs and mutual funds than Attractive-or-better?

John Bogle is correct - investors should not pay high fees for active portfolio management. His index funds have provided investors with many low-cost alternatives to actively managed funds.

However, by focusing entirely on costs, he overlooks the primary driver of fund performance: the stocks held by funds. Investors also need to beware certain Index Label Myths.

Research on the quality of portfolio management of funds empower empowers investors to make better investment decisions. Investors should no longer pay for poor portfolio management.

Kyle Guske II contributed to this report

Disclosure: David Trainer owns INTC. David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme.

Disclosure: I am long INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Low-Cost Funds Dupe Investors - Q1 2014