Investors are good at picking funds with low costs. They are not good at picking funds with good stocks. Both are required to maximize future returns .
Figure 1 shows that 52% of fund assets are in funds with the lowest costs while only 4% are in the funds with the best holdings. This discrepancy is astounding.
Figure 1: Allocation of Fund Assets By Holdings Quality and By Costs
Two key shortcomings in the fund industry cause this large discrepancy:
- A lack of funds with high-quality holdings aka good Portfolio Management ratings
- A lack or research into the quality of fund holdings
I am not sure if the two issues are related, but I am sure that investors deserve research on the quality of stocks held by funds.
Fund costs are easy to find. Research on the quality of a fund's holdings has been almost non-existent.
Yet, the quality of a fund's holdings is the single most important factor in determining its future performance.
No matter how low the fund's costs, if it holds bad stocks, performance will be poor. And the future performance of a fund determines whether or not investors make money.
Figure 2 shows the unfortunate fact that investors are not putting money into funds with high-quality holdings. Less than 4% (200 of 6622) of style funds allocate a significant portion of their value to quality holdings. Over 95% of all style funds do not justify their costs and overcharge investors.
Figure 2: Distribution of Funds and Assets By Portfolio Management Rating
Figure 3 shows that Investors find and seek low-cost funds. 52% of investment style assets are held in 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 6,622 investment style ETFs and mutual funds, 987 investment style funds earn an Attractive-or-better Total Annual Costs rating. And 52% of all style fund assets are in those 987 funds.
Clearly, fund investors are smart shoppers when it comes to finding cheap funds. But cheap is not necessarily good.
The Fidelity Salem Street Trust: Spartan Real Estate Index Fund (MUTF:FSRVX) is one of many funds with low costs but with a Very Dangerous Portfolio Management rating. It gets an overall predictive rating of Very Dangerous because no matter how low its fees, I expect its performance to be poor because it holds too many Dangerous-or-worse stocks. Low fees cannot boost fund performance. Only good stocks can boost performance.
Two of the bad stocks held by FSRVX are Equity Residential (NYSE:EQR) and HCP Inc (NYSE:HCP). Both of these stocks get my Very Dangerous rating because they have misleading earnings and expensive valuations. Both firms ROIC is just 5%, well below their cost of capital. To justify its valuation, HCP must grow its after-tax cash flow (NOPAT) at over 30% compounded annually for 10 years. EQR's valuation implies the company will growth NOPAT at over 20% compounded annually for 10 years. It is hard to make a straight-faced argument for betting on such high expectations.
Figure 3: Distribution of Funds and Assets By Total Annual Costs Ratings
Investors should focus their capital in funds with both high-quality holdings and low costs.
But, they do not. Not even close.
Figure 4 shows that less than 2% of style 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 a fund's holdings and the all-in costs to investors.
Note the fund industry offers 2,979 Dangerous-or-worse funds compared to just 77 Attractive-or-better funds. That is nearly 40 times more bad funds than good funds.
Figure 4: Distribution of Funds and Assets By Predictive Ratings
Investors deserve forward-looking fund research that assesses both the costs of funds and the quality of their holdings. For example, Bridgeway Funds, Inc: Blue-Chip 35 Index Fund (MUTF:BRLIX) is a fund with both low costs and an Attractive Portfolio Management rating. The list of all funds that get an Attractive-or-better rating are here.
Two of the good stocks held by BRLIX are Apple (NASDAQ:AAPL) and Intel (NASDAQ:INTC). Both stocks get my Very Attractive rating. They have rising cash flows, high ROICs and cheap valuations. Apple's ROIC is nearly 300%. More details on INTC are here.
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 fund industry to continue to over charge investors for poor portfolio management. How else could they get away with selling nearly 40 times more Dangerous-or-worse funds than Attractive-or-better funds?
John Bogle is correct that 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 the cost of funds, he overlooks the primary driver of fund performance: the stocks held by funds.
Research on the quality of portfolio management of funds empowers investors to make better investment decisions. Investors should no longer pay for poor portfolio management.