Rating Breakdown: Best & Worst ETFs & Mutual Funds by Sector (October 2012)

This report focuses on my top picks and pans for all sector funds. I will follow this summary with a detailed report on each sector.

My top ETFs and mutual funds have high-quality holdings and low costs. As detailed in “Low-cost funds dupe investors”, there are few funds that have both good holdings and low costs. While there are lots of cheap funds, there are very few with high-quality holdings.

I think there are at least two causes for this disconnect. First, there is, in general, a lack of independent research on ETFs and funds. Second, I think it is fair to say that there is a severe lack of quality research into the holdings of mutual funds and ETFs. There should not be such a large gap between the quality of research on stocks and funds, which are simply groups of stocks.

After all, investors should care more about the quality of a fund’s holdings than its costs because the quality of a fund’s holdings is the single most important factor in determining its future performance.

My Predictive Rating system rates 7400+ ETFs and mutual funds according to the quality of their holdings (Portfolio Management Rating) and their costs (Total Annual Costs Rating).

Figures 1 shows the best ETF or mutual fund in each sector as of October 8, 2012.

For a full list of all ETFs and mutual funds for each sector ranked from best to worst, see my free ETF & mutual fund screener.

The Health Care Select Sector SPDR (XLV) is the only sector fund to get my Very Attractive rating. XLV gets the Very Attractive rating due to the quality of its holdings. It allocates 39.44% to Very Attractive stocks and 27.75% of its value to Attractive stocks. It allocates no value to Very Dangerous stocks and only 1.63% to Dangerous stocks. This allocation coupled with a 0.18% Expense Ratio makes XLV a very attractive ETF for investors.

When you purchase an ETF, you are buying an ownership stake in a variety of businesses. XLV allocates 12.15% of its value to Johnson & Johnson (JNJ). JNJ has an ROIC of 17%, which places it in the top quintile of all companies. Usually that kind of profitability comes at a price. In this case, the valuation of JN”s stock price implies the company’s profits will permanently decline by 26%. XLV’s large allocation to a highly profitable, yet undervalued stock, exemplifies why XLV gets a Very Attractive rating.

Figure 2 shows the worst ETF or mutual fund for each sector as of October 8, 2012.

Dangerous-or-worse-rated funds have a combination of low-quality portfolios (i.e. they hold too many Dangerous-or-worse rated stocks) and high costs (they charge investors too much for the [lack of] management they provide).

Not all sector funds are created equal. As mentioned above, The Health Care sector had the only Very Attractive ETF or mutual fund; however, it also has a Very Dangerous fund in Fidelity Advisor Series VII: Fidelity Advisor Biotechnology Fund (FBTAX). FBTAX has a 1.54% Expense Ratio and a 2.19% Front End Load. Over a ten-year period (assuming a 10% return and a $10,000 investment), these fees would cost an investor over $4,000. In return for these high fees, FBTAX allocates 43% of its value to Dangerous stocks. High costs and poor allocation are a bad combination, which results in a Very Dangerous rating for FBTAX.

The fact that one can find both Very Attractive and Very Dangerous ETFs and mutual funds in the same sector underscores the importance of analyzing its holdings. Investors cannot trust ETF or mutual fund labels, and there is no substitute for assessing The Danger Within.

FBTAX not only has costly fees, but it also invests in expensive stocks. It holds Regeneron Pharmaceuticals Inc. (REGN). REGN has had a negative operating margin the past 14 years, yet it still commands a 36x forward P/E ratio. According to my DCF model, to justify its current price (~$159/share), the company would have to grow revenues at 20% compounded annually for 35 years while also drastically improving its margins. Not matter how you slice the valuation of this stock, it is expensive. Poor operating performance and high valuation result in REGN receiving a Dangerous rating.

Traditional mutual fund research has focused on past performance and low management costs. The quality of a fund’s holdings has been ignored. Our Portfolio Management Rating examines the fund’s holdings in detail and takes into account the fund’s allocation to cash. Our models are created with data from over 50,000 annual reports. This kind of due diligence is necessary for understanding just what you are buying when you invest in a mutual fund or an ETF.

Figure 3 shows the best ETF or mutual fund based on our Portfolio Management Rating for each sector as of October 8, 2012.

Figure 4 shows the worst ETF or mutual fund based on our Portfolio Management Rating for each sector as of October 8, 2012.

Many ETFs and mutual funds managers do a poor job identifying quality stocks. These funds are not worth owning at any cost.

Investors should care about all of the fees associated with a fund in addition to the quality of the fund’s holdings. The best ETFs and mutual funds have both low costs and quality holdings – and there are plenty of low cost funds available to investors.

Figure 5 shows the best ETF or mutual fund in each sector according to our Total Annual Costs Rating.

Total Annual Costs incorporates all expenses, loads, fees, and transaction costs into a single value that is comparable across all ETFs and mutual funds. Passively managed ETFs and index mutual funds are generally the cheapest.

Figures 6 shows the worst fund in each sector according to our Total Annual Costs Rating.

The most expensive fund for each sector has a Very Dangerous Total Annual Costs Rating. Investors should avoid these funds and other funds with Very Dangerous Total Annual Costs Ratings because they charge investors too much. For every fund with a Very Dangerous Total Annual Costs Rating there is an alternative fund that offers similar exposure and holdings at a lower cost. We cover over 7000 mutual funds and over 400 ETFs and the ratings of each can be found at our free ETF & mutual fund screener. Investors have plenty of alternatives to these over priced funds.

Disclosure: I own JNJ. I receive no compensation to write about any specific stock, sector or theme.