David Trainer's  Instablog

Finding the best mutual funds is an increasingly difficult task in a world with so many to choose from.

You Cannot Trust Mutual Fund Labels

There are at least 980 different large cap blend mutual funds and at least 6100 mutual funds across all styles. Do investors need that many choices? How different can these thousands of mutual funds be?

Even in the least popular style, mid cap value, there are 182 separate mutual funds. These mutual funds vary widely in the number and type of holdings they have. For example, Artisan Mid Cap Value Fund (APHQX), Harbor Mid Cap Value Fund (HAMVX), and BMO Mid Cap Value Fund (MRVIX), three of my top rated mutual funds for this style, share none of their top five holdings.

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 other styles, while some styles lie in between with a fair mix of good and bad stocks. For example, large cap growth, per my 2Q Style Rankings report, ranks fourth out of 12 styles when it comes to providing investors with quality mutual funds. Large cap blend ranks first once again, and small cap value ranks last. Details on the Best & Worst mutual funds in each style are here.

The bottom line is: Mutual fund labels do not tell you what kind of stocks you are getting in any given mutual fund. This fact applies equally to index funds too. See "Danger Zone: Passive Investors" for more details.

Paralysis By Analysis

I firmly believe mutual funds for a given style should not all be that different. I think the large number of large cap blend (or any other) style 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, even in a single style. Analyzing mutual funds, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each mutual fund.

Any investor worth his salt knows that analyzing the holdings of a mutual fund is critical to finding the best mutual fund.

Figure 1: Best Mutual Funds By Style

Sources: New Constructs, LLC and company filings

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 mutual find without analyzing its holdings is like buying a stock without analyzing its business and finances. As Barron's says, investors should know the Danger Within. 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 shows my top rated mutual fund for each style. Importantly, my ratings on mutual funds are based primarily on my stock ratings of their holdings. My firm covers over 3000 stocks and is known for the due diligence we do for each stock we cover. Accordingly, our coverage of mutual funds leverages the diligence we do on each stock by rating mutual funds based on the aggregated ratings of the stocks each fund holds.

Manning & Napier Dividend Focus Series (MNDFX) is the top-rated large cap blend mutual fund and the overall top-rated fund of the 6100 style mutual funds I cover. Only the large cap blend, large cap value, large cap growth and all cap blend styles contain any Attractive (i.e. 4-star) rated mutual funds while the best every other style can offer is a Neutral or 3-star fund.

Sometimes, you get what you pay for.

It is troubling to see one of the best style mutual funds, Advisors Series Trust Coldstream Dividend Growth Fund (CMDGX) have just $46 million in assets. The largest mutual fund in large cap value, Dodge & Cox Stock Fund (DODGX), has $45 billion in assets, thought it only gets a Neutral (3-star) rating. DODGX's total annual cost (TAC) at 0.60% is lower than PKW's at 1.52%, but as I state above, no matter how cheap a mutual fund, if it does not hold good stocks it will not perform well. Sometimes, you get what you pay for.

Another example of how you sometimes get what you pay for: T. Rowe Price Institutional Large Cap Growth Fund (TRLGX). TRLGX has over $6.4 billion in assets despite getting a Dangerous (2-star) rating. Investors seem to be attracted to its low TAC of 0.71% with less regard for the quality of its holdings. Meanwhile, the top-rated large cap growth mutual fund, Fidelity Large Cap Growth Enhanced Index Fund (FLGEX), has a 4-star rating but only $179 million in assets.

I cannot help but wonder if investors would leave TRLGX if they knew that it has such a poor portfolio of stocks. It is cheaper than FLGEX, but as previously stated, low fees cannot growth 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 those of ETFs. While 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.

Take Quaker Strategic Growth Fund (QUAGX) for example. QUAGX has over $169 million in assets with total annual costs of 5.12%, a Neutral portfolio management rating, and a Very Dangerous rating overall. Compare this to another large cap growth fund, Barrett Growth Fund (BGRWX), with an Attractive portfolio management rating and costs of 1.43%. One would think this fund would attract more investors than QUAGX, but BGRWX has just $14 million in assets. Sometimes you do not get what you pay for.

Investors should aim to avoid high fees, especially when they are paired with inferior management. There are plenty of funds that offer quality holdings for low prices: Vanguard Dividend Growth Fund (VDIGX) has both an Attractive portfolio management rating and low annual costs of 0.37%.

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 my free ETF and mutual fund screener.

Covering All The Bases, Including Costs

My mutual fund rating also takes into account the total annual costs, which represents the all-in cost of being in the fund. While, my ratings weight the quality of holdings more heavily than these costs, those funds that do charge abnormally high funds to investors are penalized.

Top Stocks Make Up Top Mutual Funds

One of my favorite holdings in Coldstream Dividend Growth Fund (CMDGX) is AFLAC, Inc. (AFL), which gets my Very Attractive (5-star) rating. AFL has an impressive track record of growth over long periods of time. Since 1998, it has grown after-tax profit (NOPAT) by 14% compounded annually. On top of this, AFLAC has maintained a high return on invested capital (ROIC) every year. Since the beginning of my model in 1998, ALF's ROIC never dips below 13% and currently sits at 19%. Despite this track record of growth and stability, its valuation of ~$56.80/share gives it a price to economic book value ratio of only 1.0. This valuation implies that the company will never grow its profits from their current levels. A track record of profitability combined with a low valuation means an attractive risk/reward for investors. Allocating a place in its top five holdings for AFL helps to explain why CMDGZ gets my Attractive rating.

Accenture PLC (ACN) is one of my favorite holdings in Advisers Investment Trust: Independent Franchise Partners US Equity Fund (IFPUX). ACN has been a model of consistency, growing NOPAT by 13% compounded annually for the past decade. Its ROIC over that time has never dipped below 30% and currently sits at an impressive 65%. As I've previously written, ACN's business model puts it in an ideal position to profit off of innovation around the world without the pressure to innovate itself, and its superior human capital gives it a competitive advantage in its industry. One would expect a company with ACN's track record of profitability and growth to have an expensive stock, but that is not the case. At its current valuation of $80.41/share, ACN has a price to economic book value ratio of only 1.1, implying that it will never grow NOPAT by more than 10% from its current level for the remainder of its corporate life. Solid fundamentals and a cheap valuation means ACN should be set to reward investors, including those invested in IFPUX.

André Rouillard and Sam McBride contributed to this report.

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

Picking from the multitude of sector mutual funds is a daunting task. In any given sector there may be as many as 229 different mutual funds, and there are at least 631 mutual funds across all sectors.

Why are there so many mutual funds? The answer is: because mutual fund providers are making lots of money selling them. The number of mutual funds has little to do with serving investors' best interests. Below are three red flags investors can use to avoid the worst mutual funds:

1. Inadequate liquidity
2. High fees
3. Poor quality holdings

I address these red flags in order of difficulty. More details on the best & worst mutual funds by sector are here.

How To Avoid Mutual Funds with Inadequate Liquidity

This is the easiest issue to avoid, and my advice is simple. Avoid all mutual funds with less than $100 million in assets. Low asset levels tend to mean lower volume in the mutual fund and larger bid-ask spreads.

How To Avoid High Fees

Mutual funds should be cheap, but not all of them are.

To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs (TAC) below 2.45%, which is the average TAC of the 6732 U.S. equity mutual funds I cover. If you weight the TACs by assets under management, then the average TAC is lower at 1.20%. A lower weighted average is a good sign that investors are putting money in the cheaper mutual funds.

Figure 1 shows the most and least expensive sector mutual funds in the U.S. equity universe based on total annual costs. Rydex Series Funds, provided by Guggenheim Investments, make up three of the top five most expensive sector funds, while Saratoga Advantage Trust provides the other two. Vanguard, on the other hand, provides all five of the cheapest sector mutual funds, all of which are index funds.

Figure 1: 5 Least and Most-Expensive Sector Mutual Funds

(click to enlarge)Sources: New Constructs, LLC and company filings

While costs among ETFs fall into a generally narrow range, mutual fund costs are more varied. The high costs of the most expensive mutual funds, sometimes above 8% annually, make it much harder for them to perform as well as the cheapest mutual funds.

However, investors need not pay high fees for good holdings. Vanguard Consumer Staples Index Fund (VCSAX) is my number one rated mutual fund overall, yet it has a low total annual cost of 0.17%.

On the other hand, the Vanguard REIT Index Funds (VGSNX, VGRSX, VGSLX) and Vanguard Utilities Index Fund (VUIAX) hold poor stocks, each getting a 2-star or Dangerous rating. And no matter how cheap a mutual fund, if it holds bad stocks, its performance will be bad.

This result highlights why investors should not choose mutual funds based only on price. The quality of holdings matters more than price.

How To Avoid Mutual Funds with the Worst Holdings

This step is by far the hardest, 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. The sectors are listed in descending order by overall rating as detailed in my 2Q13 Sector Ratings report.

Figure 2: Sector Mutual Funds with the Worst Holdings

(click to enlarge)Sources: New Constructs, LLC and company filings

My overall ratings on mutual funds are based primarily on my stock ratings of their holdings. My firm covers over 3000 stocks and is known for the due diligence done on each stock we cover.

Rydex Series Funds by Guggenheim Investments appear more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings. Rydex Transportation Fund (RYTSX) and Rydex Real Estate Fund (RYREX) both receive a 1-star or Very Dangerous rating overall, while Rydex Basic Materials Fund (RYBMX) and Rydex Leisure Fund (RYLSX) receive 2-star or Dangerous ratings.

Note that no mutual funds with a dangerous portfolio management rating earn an overall rating better than two stars. These scores are consistent with my belief that the quality of a mutual fund is more about its holdings than its costs. If the mutual fund's holdings are dangerous, then the overall rating cannot be better than dangerous because one cannot expect the performance of the fund to be any better than the performance of its holdings.

Still, while the Rydex Leisure Fund (RYLSX) receives a Neutral portfolio management rating, its high annual cost of 5.36% lowers its overall rating to a Dangerous or 2-stars. Even worse, the Rydex Transportation Fund also receives a Neutral portfolio rating, but its annual cost of 6% puts it in the 1-star or Very Dangerous category. Even mutual funds with more highly rated holdings must be considered Dangerous or Very Dangerous if their costs are too great. Both of these funds are in my top 10 most expensive of all sector mutual funds.

Find the mutual funds with the worst overall ratings on my mutual fund screener. More analysis of the Best Sector mutual funds is here.

The Danger Within

Buying a mutual fund without analyzing its holdings is like buying a stock without analyzing its business and finances. As Barron's says, investors should know the Danger Within. 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.

PERFORMANCE OF MUTUAL FUND's HOLDINGs = PERFORMANCE OF MUTUAL FUND

Best & Worst Stocks In These Mutual Funds

Aspen Technology, Inc. (AZPN) is one of my least favorite stocks held by Ivy Funds Science and Technology Fund (ISTEX) and earns my Dangerous rating. Aspen has earned negative profits (NOPAT) for three years running now, losing over $96 million in 2010 and over $12 million last year. Its return on invested capital (ROIC) is also a dismal -3%. One would think investors would be wary of such a poorly performing business, but AZPN is ISTEX's largest holding with a 7% allocation. Large allocations to Dangerous-rated stocks result in ISTEX's Dangerous portfolio management rating and Very Dangerous rating overall.

Intel (INTC) is one of favorite holdings in Vanguard Information Technology Index Fund (VITAX), the only low-cost mutual fund in Figure 1 to get my 3-star rating. INTC gets my Very Attractive rating. Intel has more than doubled profits since 1998, with a NOPAT of $10.8 billion in 2012. Intel also boasts an impressive return on invested capital of 20%, in the top quintile of all companies I cover. And yet, Intel has a price to economic book value ratio of 0.75, implying that the market expects Intel's profits to permanently decline by 25%. With a long history of turning a profit and making effective use of its capital, a permanent 25% decline in NOPAT seems unlikely. VITAX's allocation to attractive stocks, such as its 3.6% allocation to INTC, earn it the top overall rating of my five cheapest mutual funds.

Sam McBride and André Rouillard contributed to this article

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

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

This report previews our series of reports on how to convert GAAP data to economic earnings and derive true shareholder value in a discounted cash flow model.

Reported earnings don't tell the whole story of a company's profits. They are based on accounting rules designed for debt investors, not equity investors, and are manipulated by companies to manage earnings. Only economic earnings provide a complete and unadulterated measure of profitability.

Converting GAAP data into economic earnings should be part of every investor's diligence process. Meeting the challenge of performing detailed analysis of footnotes and the MD&A is a fiduciary responsibility. We will follow this report with a series of reports on all the following adjustments we make to accounting data:

A) Adjustments for NOPAT: to convert reported GAAP income to net operating profit after tax (NOPAT):

1. Remove asset write-downs hidden in operating expenses
2. Remove non-operating expenses hidden in operating earnings
3. Remove non-operating income hidden in operating earnings
4. Add back change in reserves
5. Remove revenue from discontinued operations (except for REITs)
6. Add back implied interest for the present value of operating leases
7. Adjust for non-operating tax expenses
8. Historical adjustments: Add back goodwill amortization prior to 2002 and include employee stock option expense prior to 2006

B) Adjustments for Invested Capital: to convert reported net assets to invested capital:

1. Add back reserves
2. Add back off-balance sheet debt due to operating leases
3. Remove discontinued operations
4. Remove accumulated Other Comprehensive Income
5. Add back asset write-downs
6. Remove deferred compensation assets and liabilities
7. Remove deferred tax assets and liabilities
8. Remove under or over funded pensions
9. Adjust for the fair value of debt
10. Prior to 2002: Add back unrecorded and accumulated goodwill

C) Adjustments for accurate Discounted Cash Flow values: to determine true shareholder value we adjust for:

1. Employee stock options
2. Excess cash
3. Discontinued operations
4. Deferred compensation
5. Deferred taxes
6. Unconsolidated subsidiary assets
7. Adjusted total debt (including off-balance sheet debt)
8. Preferred stock
9. Minority interests
10. Under or over funded pensions

We've performed unrivalled due diligence on over 55,000 annual reports over the past decade. This diligence enables us to provide unrivaled earnings quality and valuation research.