Cheap Funds Dupe Investors – 1Q13

Fund holdings affect fund performance more than fees or past performance. A cheap fund is not necessarily a good fund. A fund that has done well in the past is not likely to do well in the future (e.g. 5-star kiss of death and active management has long history of underperformance). Yet, traditional fund research focuses only on low fees and past performance.

Our research on holdings enables investors to find funds with high quality holdings – AND – low fees.

Investors are good at picking cheap funds. We want them to be better at picking funds with good stocks. Both are required to maximize success.

Figure 1 shows that 57% of fund assets are in ETFs and mutual funds with low costs but only 3% of assets are in ETFs and mutual funds with Attractive holdings. This discrepancy is astounding.

Sources: New Constructs, LLC and company filings

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

1. A lack of research into the quality of holdings.
   • Not enough research focuses on the quality of Portfolio Management of funds
2. A lack of high-quality holdings or good stocks.
   • With about twice as many funds as stocks in the market, there simply are not enough good stocks to fill all the funds.

These issues are related, in my opinion. If investors had more insight into the quality of funds’ holdings, I think they would allocate a lot less money to funds with poor quality holdings.

Investors deserve research on the quality of stocks held by ETFs and mutual funds.

Quality of holdings is the single most important factor in determining an ETF or mutual fund’s future performance. No matter how low the costs, if the ETF or mutual fund holds bad stocks, performance will be poor. Costs are easy to find but research on the quality of holdings is almost non-existent.

Figure 2 shows investors are not putting enough money into ETFs and mutual funds with high-quality holdings. Only 305 of 7187 (3% of assets) of ETFs and mutual funds allocate a significant amount of value to quality holdings. 97% of assets are in funds that do not justify their costs and over charge investors for poor portfolio management.

Figure 3 shows that Investors successfully find low-cost funds. 57% of assets are held in ETFs and mutual 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 7187 ETFs and mutual funds I cover, 1239 (57% of all assets) earn an Attractive-or-better Total Annual Costs rating.

Clearly, ETF and mutual funds investors are smart shoppers when it comes to finding cheap investments. But cheap is not necessarily good.

iShares FTSE NAREIT Retail Index Fund (RTL) is a great example of a fund with low costs but poor holdings.

Its total annual costs are Attractive at only 0.53%. However, it still gets an overall predictive rating of Very Dangerous because no matter how low its fees, I expect it to underperform because it holds too many Dangerous-or-worse rated stocks. Low fees cannot boost fund performance. Only good stocks can boost performance.

Realty Income Corp (O) is one of my least favorite stocks held by RTL and gets my Very Dangerous rating. O has not earned positive economic earnings since 2004. Its return on invested capital (ROIC) has declined in every single year since 2004. It has a free cash flow yield of -7%. Nevertheless, the market has high expectations for O. Its current share price of ~$44.30 implies 13% growth in after-tax profit (NOPAT) compounded annually over the next 16 years. Betting on this company achieving such impressive growth, which is what investors are doing by holding this stock, is risky given that O’s historical performance.

Source: New Constructs, LLC and company filings

Investors should allocate their capital to funds with both high-quality holdings and low costs because those are the funds that offer investors the best performance potential.

But they do not. Not even close.

Figure 4 shows that 3% of ETF and mutual 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 holdings and the all-in costs to investors.

Note the fund industry offers 3016 Dangerous-or-worse ETFs and mutual funds compared to just 126 Attractive-or-better ETFs and mutual funds, nearly 24 times more bad funds than good funds. That means a lot of fees are being paid to managers that do not deserve them.

Source: New Constructs, LLC and company filings

Investors deserve forward-looking ETF and mutual fund research that assesses both costs and quality of holdings. For example, Advisers Investment Trust: Independent Franchise Partners US Equity Fund (IFPUX).

IFPUX has Attractive total annual costs of only 0.97% and allocates over 52% of its assets to Attractive-or-better rated stocks.

Accenture PLC (ACN) is one of my favorite stocks held by IFPUX and earns my Very Attractive rating. ACN has grown NOPAT by 13% compounded annually for the last 10 years. This growth helps to fuel a top-quintile ROIC of 65%. Only 10 companies in the entire S&P 500 have a higher ROIC. Despite this impressive performance, ACN is valued at only ~$73.13/share, giving it a price to economic book value ratio of 1.0. This ratio implies that ACN will never grow NOPAT from its current level. Low expectations and strong historical profit growth combine for great risk/reward for investors.

Anyone can look at the stocks held by funds, so 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 ETF and mutual fund industry to continue to over charge investors for poor portfolio management. How else could they get away with selling nearly 24 times more Dangerous-or-worse ETFs and mutual funds than Attractive-or-better?

John Bogle is correct – 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 costs, he overlooks the primary driver of fund performance: the stocks held by funds.

Research on the quality of portfolio management of funds empower empowers investors to make better investment decisions. Investors should no longer pay for poor portfolio management.

Sam McBride contributed to this report.

Disclosure: David Trainer owns ACN. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector or theme.