Seeking Alpha

David Trainer's  Instablog

David Trainer
  • on ETF Quick Picks And Lists
Send Message
Follow me on Twitter: @NewConstructs David is CEO of New Constructs (www.newconstructs.com), an independent research firm that leverages proprietary technology to find key insights from the Financial Footnotes of 10Ks and 10Qs. Having analyzed over 70,000 annual reports and their Financial... More
My company:
New Constructs
My blog:
The Diligence Institute
My book:
The Valuation Handbook
  • How To Avoid The Worst Sector Mutual Funds

    With up to 226 mutual funds in any given sector and at least 653 across all 10 sectors, picking from the wide variety of mutual funds can be a daunting task.

    The number of mutual funds has little to do with serving investors' best interests. There are so many because they make money for the fund providers. 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. Advice on How to Find the Best Sector mutual funds is 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 levels of liquidity can lead to a discrepancy between the price of the mutual fund and the underlying value of the securities it holds. This makes it difficult to predict future performance.

    How To Avoid High Fees

    Mutual funds should be cheap, but not all of them are. First we measure what is cheap and expensive.

    The difficulty with mutual funds is that there are multiple costs in any given fund. The expense ratio is the most obvious, but many funds also have significant transaction costs and front-end load costs. Less apparent fees can drive the cost of a fund to far higher than its expense ratio. My measurement of total annual costs reflects the all-in cost of a minimum investment in a fund for three years (the average holding period for mutual funds).

    To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs below 2.53%, which is the average total annual cost of the 653 US equity sector mutual funds I cover. Weighting the (TAC) by assets under management, the average expense ratio is lower at 1.54%. The lower weighted-average TAC 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 US equity universe based on total annual costs. Unsurprisingly, Vanguard's index funds comprise all five of the cheapest sector funds. Rydex Series Funds, provided by Guggenheim Investments, comprise three of the five most expensive sector funds.

    Figure 1: Most and Least Expensive Sector Mutual Funds

    (click to enlarge)

    Sources: New Constructs, LLC and company filings

    Unlike ETFs, where costs are generally consistent, mutual fund costs are all over the map. The high costs of the most expensive mutual funds make it much harder for them to perform as well as the cheapest funds.

    Figure 1 shows that the cheapest five funds are almost all better rated than the five most expensive. However, the least expensive fund, VGSNX, and the most expensive, RYELX, both get the same 2 Star (Dangerous) rating. This is because VGSNX allocates over 81% of its assets to Dangerous-or-worse rated stocks, while RYELX allocates only 24% to Dangerous-or-worse stocks. A case in point of how holdings matter more than costs.

    Investors need to look beyond the fees when choosing mutual funds. High fees can destroy value, but not as much as underperforming holdings.

    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 mutual funds are listed in descending order by sector per my sector ratings, detailed in my 1Q Sector Rankings 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.

    Fidelity's mutual funds appear more often than any other provider in Figure 2, which means they offer the most mutual funds with the worst holdings. Only one fund appears in both Figure 1 and Figure 2. SBMBX has the worst holdings of all Energy funds and is one of the top five most expensive sector mutual funds out there, earning it my Very Dangerous (1-Star) rating.

    Do Not Trust Mutual Fund Labels

    Labels only provide the tip of the iceberg of insight need to understand its content or holdings. Based on the labels, one might think that Frost Natural Resources Fund (MUTF:FNRFX) and Thrivent Natural Resources Fund (MUTF:TREIX) hold roughly the same stocks. However, the two funds actually have only one stock (NYSE:SLB) in common out of their top five holdings.

    Just looking at the provider does not give much clarity either. In the Information Technology sector, Fidelity offers the highest rated mutual fund-Fidelity Select Portfolios: Computers Portfolio (MUTF:FDCPX)-and one of the lowest rated ones-Fidelity Advisor Electronics Fund (MUTF:FELAX).

    Looking at providers and labels is no substitute for doing the hard work (i.e. due diligence) of examining the holdings of a mutual fund.

    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

    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 mutual fund to be any better than the performance of its holdings - no matter how cheap it may be.

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

    Dangerous Stocks make up Dangerous Funds

    Prologis Inc. (NYSE:PLD) is one of my least favorite stocks held by KREAX and earns my Very Dangerous rating. This is a company that has not managed to sustain long-term profit growth despite a valuation that indicates otherwise. Its after tax profit (NOPAT) in 2012 is actually 7% less than its 2002 NOPAT. There have been peaks and valleys in the interim, but a decline in profitability over the course of the past decade is troubling. One would think this downward trend would be reflected in the stock price, but that is not the case for PLD. The current market price of ~$40.14/share implies 24% growth in NOPATcompounded annually over the next 11 years. Betting on any company to achieve that level of growth is risky. Heavy allocation to Dangerous-or-worse rated stocks like PLD help to explain why KREAX is one of the worst rated mutual funds I cover.

    Sam McBride contributed to this report.

    Disclosure: David Trainer 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.

    Tags: Mutual Funds
    Apr 10 2:37 PM | Link | Comment!
  • How To Find The Best Style Mutual Funds

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

    You Cannot Trust Mutual Fund Labels

    There are at least 6,202 mutual funds across all styles. Do investors need that many choices? How different can the mutual funds be?

    Even in the least popular style, mid cap value, there are at least 199 mutual funds. These mutual funds vary widely in the number and type of holdings they have. Artisan Mid Cap Value Fund (MUTF:ARTQX) and PNC Mid Cap Value Fund (MUTF:PMVIX) share no common stocks in their top five holdings.

    In some styles, the label will tell you something about the stocks the fund holds. I am sure that large cap value funds hold many of the same big stocks such as International Business Machines (NYSE:IBM), Chevron (NYSE:CVX) and 3M (NYSE:MMM). However, investors need to know what else those mutual funds hold before they can say they have done their due diligence.

    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 others while some styles lie in between. For example, large cap growth, per my 1Q Style Rankings report, ranks fourth out of 12 styles when it comes to providing investors with quality mutual funds. Large cap blend ranks first. Small cap value ranks last. Details on the Best & Worst ETFs in each style are here.

    The bottom line is that investors cannot trust mutual fund labels or names. They do not tell you enough about what you are getting when you buy a mutual fund.

    Figure 1: Best Style Mutual Funds

    (click to enlarge)

    Sources: New Constructs, LLC and company filings

    Paralysis By Analysis

    I firmly believe mutual funds for a given style should not all be that different. I think the large number 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 funds, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each mutual fund, which can be up to 3,262 stocks or more. To make matters even more complicated, some mutual funds allocate heavily to ETFs, so investors need to analyze all the stocks in those ETFs as well.

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

    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 fund without analyzing its holdings is like buying a stock without analyzing its business and finances. 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 above shows my top rated mutual fund for each style. Importantly, my ratings on mutual fundsare based primarily on my stock ratings of their holdings. My firm covers over 3000 stocks and is known for uniquely thorough due diligence for each stock we cover. Accordingly, our coverage of mutual funds leverages the diligence we do on each stock by rating ETFs based on the aggregated ratings of the stocks each ETF holds. Here is a sample mutual fund report.

    GMO Trust: GMO Quality Fund (MUTF:GQLOX) is the top rated large cap blend fund and the overall top rated fund across all styles. However, the $300,000,000 initial minimum investment keeps it from being an option for most investors. Pear Tree Funds: Pear Tree Quality Fund (MUTF:USBOX) is the top rated large cap blend fund to have a manageable minimum investment ($2,500).

    Sometimes, you get what you pay for.

    It is troubling to see one of the best style mutual funds, Advisors Series Trust: Scharf Funds (MUTF:LOGIX), have just $45 million in assets. The largest mutual fund in all cap growth, Fidelity Mt. Vernon Street Trusts: Fidelity Growth Company Fund (FGRFX), has over $44 billion in assets thought it only gets a Neutral (3-star) rating. FGRFX's expense ratio at 0.80% is much lower than LOGIX's at 1.43%, but as I state above, no matter how cheap a mutual fund is, if it does not hold good stocks it will not perform well. Sometimes, you get what you pay for.

    Similarly, Fidelity Commonwealth Trust II: Fidelity Large Cap Growth Enhanced Index Fund (MUTF:FLGEX) has only $172 million in assets despite being the top rated Large Cap Growth Fund. The slightly cheaper Growth Fund of America (MUTF:RGAGX) soaks up most of the assets in the style.

    I cannot help to wonder if more investors would buy FLGEX if they knew it has a superior portfolio of stocks. It is more expensive than RGAGX, but as I have stated, low fees cannot grow 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 ETFs. Just look atWilmington Small Cap Growth Fund (MUTF:ARPAX). Whereas 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.

    Without a careful examination of all the fees involved, investors can end up paying significantly more in fees for inferior management. ARPAX has $137 million in assets despite having total annual costs of 8.51% and a Dangerous portfolio management rating. Compare this to another small cap growth fund, Oak Associates Funds: River Oak Discovery Fund (MUTF:RIVSX). RIVSX has total annul costs of 2.16% and a Neutral portfolio management rating. It stands to reason that it would attract more investors than ARPAX, but it has only $11 million in assets.

    Investors should avoid high fees especially when they are for inferior management. There are plenty of funds that offer quality holdings for low prices. Bridgeway Funds, Inc: Blue Chip 35 Index Fund (MUTF:BRLIX) offers extremely low costs of 0.23% and Attractive holdings.

    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 I weight the quality of holdings more heavily than costs in my analysis, my ratings penalize those funds that charge abnormally high fees to investors.

    Top Stocks Make Up Top Mutual Funds

    One of my favorite holdings in GQLOX is Oracle Corporation (NYSE:ORCL), which earns my Very Attractive rating. The consistency with which ORCL creates value for investors is impressive. It has earned a return on invested capital (ROIC) of over 20% for every year since at least 1998 when my model begins. Over the past 10 years it has grown after tax profit (NOPAT) by 18% compounded annually. Investors usually have to pay quite a premium for such consistent growth, but ORCL's valuation is actually quite cheap. At ~$32.41/share, the stock's price to economic book value ratio is 0.9, implying that the company will experience a permanent 10% decline in NOPAT.

    Big Data is not going anywhere, and Oracle remains at the forefront of database software services. The field may be growing more competitive, but Oracle retains a competitive advantage due to its scale and resources. The market is expecting Oracle's profits to start declining, reversing a decade long trend. While I could see some slowdown in the company's earnings growth, such a pessimistic projection seems unlikely to me. Such a low valuation makes Oracle a great deal for investors. Heavy allocation to Oracle helps to explain why GQLOX is my top rated mutual fund.

    Sam McBride contributed to this report

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

    Disclosure: I am long ORCL.

    Tags: Mutual Funds
    Apr 09 10:21 AM | Link | Comment!
  • How To Find The Best Sector Mutual Funds

    Finding the best mutual funds is an increasingly difficult task as there are more and more to choose from daily.

    You Cannot Trust Mutual Fund Labels

    There are over 150 mutual funds for the Information Technology sector, and at leas 644 mutual funds across all sectors. Do investors really need that many different mutual funds?

    These funds can have a wide variety of holdings, and even more specific labels do not tell investors exactly what is in the fund. Rydex Series Fund: Internet Fund (MUTF:RYINX) and Kinetics Mutual Funds, Inc: Internet Fund (MUTF:KINAX) differ in four out of their top holdings. Google (NASDAQ:GOOG) is the only company that both funds allocate heavily to.

    Mutual funds in any given sector offer a very different mix of good and bad stocks. Some sectors have lots of good stocks and offer lots of good mutual funds. The opposite is true for others. And some sectors lie somewhere in between. For example, the financial sector, per my 1Q Sector Rankings report, ranks last out of the 10 major sectors when it comes to providing investors with quality mutual funds. The consumer staples sector ranks first. Details on the Best & Worst ETFs in each sector are here.

    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 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. 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

    Figure 1: Top Rated Mutual Funds By Sector

    (click to enlarge)

    Sources: New Constructs, LLC and company filings

    Only the Consumer Staples and Health Care sectors offer any mutual funds that get a 4 star (Attractive) rating. No sector offers a mutual fund that gets a 4 star rating, has sufficient liquidity (at least $100 million in assets) to be a safe investment, and has a low initial minimum investment.

    Paralysis By Analysis

    The large number of sector 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. For some funds that can be over 1,000 stocks. To make it more complicated, mutual funds only disclose their holdings each quarter. The reported holdings of a mutual fund may not correspond to its actual holdings two months after the disclosure.

    Any investor, worth his salt, knows that knowing the holdings of a mutual fund is critical to finding the best mutual 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 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 World Funds: Vanguard Consumer Staples Index (MUTF:VCSAX) is my top rated Consumer Staples fund and my overall top rated sector mutual fund. Its $100,000 initial minimum, however, may keep it from being a feasible option for many investors. The $5 million minimum investment for Davis Series Funds: Davis Financial Fund (MUTF:DVFYX) prices out many investors.

    Other top rated mutual funds have a problem with inadequate liquidity. Funds with under $100 million in assets can end up with greater volatility and can have more of a disconnect between the price of the fund and the underlying value of the equities it holds. For this reason, investors should think twice about Oak Associates Funds: Live Oak Health Sciences Fund (MUTF:LOGSX) even though the quality of its holdings gives it a 4 star rating.

    Fidelity Select Portfolios: Computers Portfolio (MUTF:FDCPX) is my top rated mutual fund that meets the liquidity requirement and has a reasonably low minimum investment ($2,500). It earns my 3 star (Neutral) rating.

    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 mutual fund. This analysis is much more complicated for mutual funds than ETFs because they charge front- and back-end loads and transaction costs. Just looking at the expense ratio alone is not enough to understand the true costs of being in a fund. For more detail on the ways hidden costs can hurt investors, see Danger Zone 3/4/2013: Wilmington Small Cap Growth Fund (MUTF:ARPAX).

    My ratings penalize those funds with abnormally high costs. However, low costs alone cannot make a good fund, as detailed in Low Cost Funds Dupe Investors.

    Top Stocks Make Up Top Mutual Funds

    Amgen Inc. (NASDAQ:AMGN) is one of my favorite holdings in LOGSX. This stock gets my Very Attractive rating. Amgen has achieved impressively consistent growth in profitability for the past decade and a half, growing after tax profit (NOPAT) by 15% compounded annually since 1998. It has increased economic earnings every year since 2004. The $23 billion in excess cash that the company has on hand also puts it in good position to fund research and support marketing and distribution of its drugs. AMGN's share price increased by over 20% a week ago on news of encouraging test results for is new melanoma drug, but the stock remains significantly undervalued. At its current share price of ~$98.66, AMGN has a price to economic book value ratio of 0.8, implying that the company will experience a permanent 20% decline in NOPAT. Such low market expectations, combined with a strong track record of economic profitability, gives this stock a very attractive risk/reward for investors.

    Sam McBride contributed to this report

    Disclosure: David Trainer 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. 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.

    Apr 03 11:14 AM | Link | Comment!
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.