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 79 different Health Care mutual funds and at least 631 mutual funds across all sectors. Do investors need that many choices? How different can the mutual funds be?

Those 79 Health Care mutual funds are very different. With anywhere from 20 to 286 holdings, many of these Health Care mutual funds have drastically different portfolios, creating drastically different investment implications.

The same is true for the mutual funds in any other sector, as each offers a very different mix of good and bad stocks. Some sectors have lots of good stocks and offer quality funds. The opposite is true for some sectors, while others lie in between these extremes with a fair mix of good and bad stocks. For example, the Materials sector, per my 2Q Sector Rankings Report, ranks sixth out of 10 sectors when it comes to providing investors with quality mutual funds. Consumer Staples ranks first. Financials ranks last. Details on the Best & Worst mutual funds in each sector are here.

The bottom line is: mutual fund labels do not tell you the kind of stocks you are getting in any given mutual fund.

Paralysis By Analysis

I firmly believe mutual funds for a given sector should not all be that different. I think the large number of Health Care (or any other) sector 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. 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. As stated above, that can be as many as 286 stocks, and sometimes even more, for one mutual fund.

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

Figure 1: Best Sector Mutual funds

(click to enlarge)

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 fund that might blow up. Buying a 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. No matter how cheap, if it holds bad stocks, the mutual fund's performance will be bad.

PERFORMANCE OF FUND'S HOLDINGS = PERFORMANCE OF FUND

Finding the Sector Mutual funds with the Best Holdings

Figure 1 shows my top rated mutual fund for each sector. 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 mutual fund holds.

Vanguard Consumer Staples Index Fund (VCSAX) is the top-rated Consumer Staples mutual fund and the overall top-rated fund of the 631 sector mutual funds I cover. Only the Consumer Staples sector contains any Attractive (i.e. 4-star) rated mutual funds, while the best every other Sector can offer is a Neutral or 3-star mutual fund, or even a Dangerous or 2-star mutual fund.

Sometimes, you get what you pay for.

It is troubling to see one of the best sector mutual funds, Saratoga Advantage Trust: Health & Biotechnology Fund (SBHIX) have just $18 million in assets despite its 3-star rating. On the other hand, Dangerous-rated T Row Price Health Sciences Fund (PRHSX) has over $6.5 billion in assets. PRHSX has lower total annual costs than SBHIX (0.90% and 2.59% respectively), but low costs cannot drive positive performance. Quality holdings are the ultimate driver of performance.

I cannot help but wonder if investors would leave PRHSX if they knew that it has such a poor portfolio of stocks. It is cheaper than SBHIX, but as previously stated, low fees cannot growth wealth; only good stocks can.

Sometimes, you DON'T get what you pay for.

One of the smallest mutual funds in Figure 1 is American Century Quantitative Equity Funds, Inc: Utilities Fund (BULIX) with just $367 million in assets. Sadly, other Utilities mutual funds with more assets and inferior portfolios charge more than BULIX. In other words, Utilities mutual fund investors are paying extra fees for no reason.

Prudential Jennison Utility Fund (PCUFX) is one of the worst mutual funds in the Utilities sector. It gets my Very Dangerous rating based off the fact that barely 1% of its assets are allocated to Attractive-or-better rated stocks, while over 43% is allocated to Dangerous-or-worse stocks. PCUFX also has total annual costs of 1.94%, much higher than Bulix's 0.87%. One would think that PCUFX would have less assets than BULIX, but instead it has over $3.1 billion. Investors are paying extra fees for poor holdings.

The worst mutual fund in Figure 1 is Energy's (DVFYX), which gets a Dangerous (2-Star) rating. One would think mutual fund providers could do better for this sector.

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 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 mutual fund. This analysis is complex for mutual funds, as one has to consider not only expense ratios, but also front-end load and transaction fees. A high front-end load not only costs investors at the beginning, it also reduces the growth investors can experience later on. While costs play a smaller role than holdings, my ratings penalize those funds with abnormally high costs.

Top Stocks Make Up Top Mutual funds

Verizon Communications (VZ) is one of my favorite stocks held by PRMTX and earns my Attractive rating. VZ has an impressive track record of growth, having grown its after tax profit (NOPAT) by 13% compounded annually over the past 14 years. Nearly $20 million in combined non-operating expenses caused VZ's GAAP net income to decline significantly in 2012, while its true economic earnings were positive and increasing. VZ's misleading low reported earnings have contributed to it being significantly undervalued. At its current valuation of ~$49.57/share, VZ has a price to economic book value ratio of 0.9, implying that its NOPAT will permanently decline by 10%. Given the company's consistent track record, such a decline in profitability seems unlikely. PRMTX's 5.4% allocation to VZ helps to explain why it is my top-rated Telecom mutual fund.

Sam McBride contributed to this post

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

Disclosure: I am long VZ.

Paying customers can access June's 40 Most Dangerous Stocks as of midnight last night. We provide 20 large/mid cap names to sell or short and 20 small cap names in this monthly newsletter.

All Most Dangerous Stocks reports more than 90 days old are free. All reports published in February and earlier are now free - access them here.

Public release will be on Thursday, June 11.

Paying customers can access June's 40 Most Attractive Stocks as of midnight last night. We provide 20 large/mid cap names and 20 small cap names to buy in this monthly newsletter.

All Most Attractive Stocks reports more than 90 days old are free. All reports published in February and earlier are now free - access them here.

Public release will be on Thursday, June 11.