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 best interests as an investor. I leverage my firm’s 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 of them are. The first step is to benchmark what cheap means.
To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs below 1.59% – the average total annual cost of the 5,438 U.S. equity Style mutual funds my firm covers. The weighted average is lower at 0.84%, which highlights how investors tend to put their money in mutual funds with low fees.
Figure 1 shows Northern Lights Fund Issachar Fund (LIONX) is the most expensive style mutual fund and Vanguard 500 Index Fund (VFFSX) is the least expensive. Northern Lights provides two of the most expensive mutual funds while Vanguard and Fidelity mutual funds are among the cheapest.
Figure 1: 5 Most and Least Expensive Style Mutual Funds
Investors need not pay high fees for quality holdings. Fidelity 500 Index Fund (FXAIX) is the best ranked style mutual fund in Figure 1. FXAIX’s unattractive Portfolio Management rating is offset by its 0.02% total annual cost and earns an attractive rating. Fidelity SAI U.S. Value Index Fund (FSWCX) is one of the best ranked style mutual funds overall. FSWCX’s neutral Portfolio Management rating and 0.25% total annual cost earns it a very attractive rating.
On the other hand, Fidelity Small Cap Index Fund (FSSNX) holds poor stocks and earns an unattractive rating, yet has low total annual costs of 0.07%. No matter how cheap a mutual fund, if it holds bad stocks, its performance will be bad. The quality of a mutual fund’s holdings matters more than its price.
2. 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
BNY Mellon appears more often than any other providers in Figure 2, which means that they offer the most mutual funds with the worst holdings.
Transamerica Capital Growth (TCPWX) is the worst rated mutual fund in Figure 2 based on my firm’s predictive overall rating. JPMorgan Small Cap Growth Fund (JGSMX), PGIM Jennison Small Cap Core Equity Fund (PQJCX), BNY Mellon Small Mid Cap Growth Fund (DBMYX), and Bertolet Pinnacle Value Fund (PVFIX) also earn a very unattractive predictive overall rating, which means not only do they hold poor stocks, they charge high total annual costs.
The Danger Within
Buying a mutual fund without analyzing its holdings is like buying a stock without analyzing its business model 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 OF MUTUAL FUND’s HOLDINGs – FEES = PERFORMANCE OF MUTUAL FUND
Disclosure: David Trainer, Kyle Guske II, and Hakan Salt receive no compensation to write about any specific stock, sector or theme.
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