How To Avoid The Worst Sector Mutual Funds 3Q22

Question: Why are there so many mutual funds?

Answer: Mutual fund management is profitable, so Wall Street creates more products to sell.

The large number of mutual funds has little to do with serving your interests as an investor. I use more reliable and proprietary data to identify two red flags you can use to avoid the worst mutual funds:

1. High fees

Mutual funds should be cheap, but not all are. The first step is to compare what cheap means.

To ensure you’re paying average or lower fees, only invest in mutual funds with total annual expenses under 1.82% — the average annual total expenses of the 664 US equity sector mutual funds my firm covers. The weighted average is lower at 1.16%, showing how investors tend to put their money in mutual funds with low fees.

Exhibit 1 shows that the Saratoga Energy and Basic Materials Portfolio (SMBBX) is the most expensive mutual fund in the sector and the Vanguard Real Estate II Index Fund (VRTPX) is the cheapest. Saratoga (SMBBX, SEPCX, STPAX, SEPIX) offers four of the most expensive mutual funds, while Vanguard’s mutual funds (VRTPX, VFAIX, VITAX, VMIAX, VHCIX) are among the cheapest.

Figure 1: The 5 most expensive and cheapest mutual funds in the sector

Investors don’t have to pay high fees for quality stocks. The Vanguard Materials Index Fund (VMIAX) is the top-rated sector retail fund in Figure 1. VMIAX’s neutral portfolio management rating and 0.12% total annual expense make it a very attractive valuation. David Financial Fund (DVFYX) is the industry’s top rated minimum liquidity fund. DVFYX’s attractive portfolio management rating and total annual expense of 0.79% also give it a very attractive rating.

On the other hand, the Vanguard Real Estate II Index Fund (VRTPX) holds bad stocks and gets a very unattractive rating, but has a low annual total expense of 0.10%. No matter how cheap a mutual fund is, if it holds bad stocks, its performance will be poor. The quality of a mutual fund’s holdings is more important than its price.

2. Bad stocks

Avoiding bad holdings is by far the hardest part of avoiding bad mutual funds, but it’s also the most important, since 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.

Figure 2: Sector funds with the worst holdings

Fidelity and Rydex feature more frequently than any other provider in Figure 2, meaning they offer the most mutual funds with the worst holdings.

T. Rowe Price Global Technology Fund (PGTIX) is the worst-rated mutual fund in Figure 2. Manning & Napier Real Estate Series (MNRWX), Rydex Energy Services Fund (RYVIX), Prudential PGIM Jennison Utility Fund (PRUQX), and Fidelity Select Defence and Aerospace Portfolio (FSDAX) also get a very unattractive overall forward-looking rating, meaning they not only hold poor stocks but also charge high total annual expenses.

The inner danger

Buying a mutual fund without analyzing its holdings is like buying a stock without analyzing its business and finances. In other words, researching mutual fund holdings is necessary due diligence, as a mutual fund’s performance is only as good as its holdings.

PERFORMANCE OF HOLDINGS IN THE FUND – CHARGES = PERFORMANCE OF THE FUND

Disclosure: David Trainer, Kyle Guske II, Matt Shuler and Brian Pellegrini are not compensated to write about specific stocks, sectors or topics.