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David Trainer
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David is CEO of New Constructs (www.newconstructs.com), an independent research that specializes in unearthing key insights from the Financial Footnotes of Annual Reports. Having analyzed over 50,000 annual reports and their Financial Footnotes, New Constructs research regularly produces Hidden... More
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  • Low Fund Fees Dupe Investors 0 comments
    Feb 14, 2012 10:09 AM | about stocks: INTC, HCP, EQR, AAPL

    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 (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 (EQR) and HCP Inc (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 (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 (AAPL) and Intel (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.

    Themes: etf-analysis Stocks: INTC, HCP, EQR, AAPL
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