Question: Why are there so many mutual funds?
Answer: Mutual fund providers tend to make lots of money on each fund so they create more products to sell.
The large number of mutual funds has little to do with serving investors’ best interests. Below are three red flags investors can use to avoid the worst mutual funds:
- Inadequate Liquidity
This issue is the easiest issue to avoid, and our 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. Plus, low asset levels tend to mean lower volume in the mutual fund and larger bid-ask spreads.
- High Fees
Mutual funds should be cheap, but not all of them are. The first step here is to know what is cheap and expensive.
To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs below 1.92%, which is the average total annual cost of the 6336 U.S. equity Style mutual funds we cover. The weighted average is lower at 1.28%, which highlights how investors tend to put their money in mutual funds with low fees.
Figure 1 shows that American Growth Fund Series Two (AMREX) is the most expensive style mutual fund and Vanguard Total Stock Market Index (VSMPX) is the least expensive. American Growth Fund (AMREX, AMRHX, AMRAX, AMRBX, and AMRGX) provides five of the most expensive mutual funds while Vanguard mutual funds (VSMPX, VIIIX, and VITPX) are among the cheapest.
Figure 1: 5 Least and Most Expensive Style Mutual Funds
Sources: New Constructs, LLC and company filings
Investors need not pay high fees for quality holdings. Calvert Large Cap Portfolio (CMIIX) earns our Very Attractive rating and has low total annual costs of only 0.91%.
On the other hand, a fund such as State Street Small Mid Cap Equity Index (SSMXH) holds poor stocks. No matter how cheap a mutual fund (0.03% TAC), if it holds bad stocks, its performance will be bad. The quality of a mutual fund’s holdings matters more than its price.
- Poor Holdings
Avoiding poor holdings is by far the hardest part of avoiding bad mutual funds, 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 style with the worst holdings or portfolio management ratings.
Figure 2: Style Mutual Funds with the Worst Holdings
Sources: New Constructs, LLC and company filings
PACE Select Advisors Trust ( PVEYX and PUMYX) appears more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings.
Goldman Sachs Absolute Return Tracker (GARUX) is the worst rated mutual fund in Figure 2. Seven other mutual funds (ARVIX, IDVIX, PVEYX, PUMYX, MOFQX, SYIMX, HDPCX, ETILX, and NAAIX) also earn a Very Dangerous predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs.
Our overall ratings on mutual funds are based primarily on our stock ratings of their holdings.
The Danger Within
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.
PERFORMANCE OF MUTUAL FUND’s HOLDINGs = PERFORMANCE OF MUTUAL FUND
Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.
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Photo Credit: Ross (Flickr)