Sign Up For The Next
New Constructs Webinar






Navigation

ETFs vs Mutual Funds: The Winner Is…

Tuesday, November 22nd, 2011

For US equities, ETFs offer a higher percentage (10%) of attractive investment options than mutual funds (1%) at a lower cost. The radically higher number of US equity mutual funds (4,700+) versus ETFs (380+) is not indicative of better stock selection from active management. On the contrary, the vast majority of actively-managed funds do not justify the higher fees they charge. They do not, in terms of stock selection and expected returns, add value versus passively managed benchmarks.

My analysis on funds and ETFs starts with researching and valuing every stock held by the ETF or mutual funds according to New Constructs stock ratings. New Constructs’ ratings on the stocks held by funds are aggregated according to the allocation the fund makes to each stock. The aggregated ratings of the holdings translate into the “portfolio management” rating of the fund. This is a bottoms-up assessment of funds based on the quality of the stocks they hold. In addition, New Constructs assesses the “all-in” costs of investing in funds, which means accounting for the impact of loads, fees, expenses and transaction costs over a given holding period. Funds with higher total annual costs score worse than those with lower costs.

The results of this analysis applied to the entire ETF and mutual fund universe for US equities reveals that investors should be even more cautious when considering mutual funds than ETFs. As I have written often on ETFs, there are many funds with the same label that are radically different funds. This problem is far worse for mutual funds because the number of mutual funds is so much higher, the quality of stocks held is worse and the costs are higher.

I will justify this conclusion from both a macro and micro perspective, made possible by leveraging the same rating system for stocks, ETFs and mutual funds.

Let’s start by comparing the costs of mutual funds and ETFs. Figure 1 clearly shows that mutual funds charge more than ETFs. These higher charges, in theory, are justified by the benefits of active management or superior stock selection, which should lead to better performance. This theory does not hold true across the mutual fund landscape. It is true in a few small pockets, but that is all.

Figure 1: Average Total Annual Costs Comparison

Sources:   New Constructs, Lipper Data and company filings

Figures 2 and 3 show the count and net asset values of mutual funds and ETFs distributed across New Constructs’ predictive ratings. $43 billion of the total ($437 billion) net assets of US equity ETFs are attributed to attractive-rated ETFs compared to only $15 billion out of ($1,633 billion) for US equity mutual funds.

These figures illustrate how most actively managed funds do not deliver the superior stock selection required to justify their higher costs detailed in figure 1.

Figure 2: ETF NAV Distribution

Sources:   New Constructs, Lipper Data and company filings

Figure 3: Mutual Fund NAV Distribution

Sources:   New Constructs, Lipper Data and company filings

Figure 4 shows the combined net asset values of ETFs and mutual funds distributed across the predictive fund rating system.

Figure 4: Mutual Fund & ETF Total NAV Allocation

Sources:   New Constructs, Lipper Data and company filings

Using the same rating system for stocks, ETFs and mutual funds allows me to show how the micro details support the macro conclusions above.

For example, Figure 5 reveals how the ETFs and mutual funds in the All Cap Blend category stack up. As mentioned above, just because there are more All Cap Blend mutual funds does, investors should not assume there are more good investment options. The opposite is true in this case. Mutual funds (HFLGX, FDSAX, and PBFDX) make up three of the top five funds in this category and all get an attractive rating; however, those attractive-rated funds are outnumbered by the five very-dangerous-rated mutual funds that are also in the category: CRMEX, RYRSX, RYMKX, BKPIX, and PEOFX.

Figure 5:  All Cap Blend Category: Best/Worst Funds

        *MF designates Mutual Funds and ETF designates Exchange Traded Funds.

*Analysis uses the class with the largest Total Net Asset value for each fund.

Sources:   New Constructs, Lipper Data and company filings

Figure 6 provides a look-through into the portfolio management analysis of the funds in Figure 5. It shows how each fund’s portfolio allocates value as well as the total annual costs for each fund. This figure makes clear why the attractive rating funds are attractive: they allocate the most value to attractive-or-better-rated stocks – and – they have relatively lower costs. On the other hand, the very-dangerous-rated funds allocate primarily to dangerous-or-worse-rated stocks or to cash. I do not believe that investors should pay active-management fees to funds that allocate so much to dangerous-or-worse-rated stocks. Making matters worse, RYRSX, RYMKX, and BKPIX are levered 2x, 1.5x and 1.5x, respectively, which makes them even more risky

Figure 6:  All Cap Blend Category: Best & Worst Fund Allocations

*MF designates Mutual Funds and ETF designates Exchange Traded Funds.

*Analysis uses the class with the largest Total Net Asset value for each fund.

Sources:   New Constructs, Lipper Data and company filings

The next step is to show the individual stocks that make up each fund along with the ratings and allocations for each stock. Figure 7 lists the 18 Very Attractive-rated stock held by the Hennessy Cornerstone Large Growth Fund (HFLGX). HFLGX allocates 36.6% of its value to very-attractive-rated stocks and another 36.4% to attractive-rated stocks for a total allocation of 73% to attractive-or-better-rated stocks. Having the same rating system for stocks, ETFs and mutual funds provides powerful insights.

Figure 7: Very Attractive-rated Constituents: Hennessy Cornerstone Large Growth Fund (HFLGX)

Sources:   New Constructs, Lipper Data and company filings

In conclusion, it should come as no surprise that the best funds hold the best stocks and have the lowest costs. Determining the relative merit of a mutual fund or ETF is simple as long as you analyze the merits of each of the fund’s holdings and its costs.

I find it very interesting that other fund research providers focus very little, if at all, on researching the quality of a fund’s holdings. While it is refreshing to see Morningstar improve upon their backward-looking Star Ratings, the new Analyst Ratings add little analytical substance. True, this new rating overlay adds value to the Star Ratings, but they do not add as much value as they could by analyzing the holdings of the funds.

A consistent rating system for stocks, ETFs and mutual funds offers a powerful analytical tool for navigating the cluttered and confusing world of equities. The better the stock rating system upon which ETF and fund ratings, the better the ETF and fund ratings. New Constructs’ stock ratings are regularly featured as among the best by Barron’s over the past three years.

Dis­clo­sure: I have a long position in MSFT, INTC, DISH, and LRCX. I receive no com­pen­sa­tion to write about any spe­cific stock, sec­tor or theme.

Suggested Stories

Leave a Message

Your email address will not be published. Required fields are marked *