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Low Fund Fees Dupe Investors

|Includes:AAPL, EQR, HCP, Intel Corporation (INTC)

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

Sources: New Con­structs, LLC and com­pany filings

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

  1. A lack of funds with high-quality hold­ings aka good Port­fo­lio Man­age­ment ratings
  2. 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

Source: New Con­structs, LLC and com­pany filings

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

Source: New Con­structs, LLC and com­pany filings

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

Source: New Con­structs, LLC and com­pany filings

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.

Disclosure: I am long AAPL, INTC.