How To Find the Best Sector Mutual Funds

Finding the best mutual funds is an increasingly difficult task in a world with so many to choose from.

You Cannot Trust Mutual Fund Labels

There are at least 146 different Information Technology mutual funds and at least 632 mutual funds across all sectors. Do investors need that many choices? How different can the mutual funds be?

Those 146 Information Technology mutual funds are very different. With anywhere from 25 to 416 holdings, many of these Information Technology mutual funds have drastically different portfolios, creating drastically different investment implications.

The same is true for the mutual funds in any other sector, as each offers a very different mix of good and bad stocks. Some sectors have lots of good stocks and offer quality funds. The opposite is true for some sectors, while others lie in between these extremes with a fair mix of good and bad stocks. For example, the Materials sector, per my 3Q Sector Rankings Report, ranks sixth out of 10 sectors when it comes to providing investors with quality mutual funds. Consumer Staples ranks first. Financials ranks last again. Details on the Best & Worst mutual funds in each sector are here.

The bottom line is: mutual fund labels do not tell you the kind of stocks you are getting in any given mutual fund.

Paralysis By Analysis

I firmly believe mutual funds for a given sector should not all be that different. I think the large number of Information Technology (or any other) sector of mutual funds hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many mutual funds. Analyzing mutual funds, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each mutual fund. As stated above, that can be as many as 416 stocks, and sometimes even more, for one mutual fund.

Any investor worth his salt recognizes that analyzing the holdings of a mutual fund is critical to finding the best mutual fund.

The Danger Within

Why do investors need to know the holdings of mutual funds before they buy? They need to know to be sure they do not buy a fund that might blow up. Buying a fund without analyzing its holdings is like buying a stock without analyzing its business and finances. As Barron’s says, investors should know the Danger Within. No matter how cheap, if it holds bad stocks, the mutual fund’s performance will be bad.

PERFORMANCE OF FUND’S HOLDINGS = PERFORMANCE OF FUND

Finding the Sector Mutual funds with the Best Holdings

Figure 1 shows my top rated mutual fund for each sector. Importantly, my ratings on mutual funds are based primarily on my stock ratings of their holdings. My firm covers over 3000 stocks and is known for the due diligence we do for each stock we cover. Accordingly, our coverage of mutual funds leverages the diligence we do on each stock by rating mutual funds based on the aggregated ratings of the stocks each mutual fund holds.

Vanguard Consumer Staples Index Fund (VCSAX) is the top-rated Consumer Staples mutual fund and the overall top-rated fund of the 632 sector mutual funds I cover. Only the Consumer Staples sector contains any Attractive (i.e. 4-star) rated mutual funds, while the best every other sector can offer is a Neutral or 3-star mutual fund.

Sometimes, you get what you pay for.

It is troubling to see one of the best sector mutual funds, ICON Consumer Staples Fund (ICLEX) have just $3 million in assets despite its 4-star rating. On the other hand, Dangerous-rated Fidelity Select Construction and Housing Portfolio (FSHOX) has over $746 billion in assets. FSHOX has lower total annual costs than ICLEX (1.19% and 1.86% respectively), but low costs cannot drive positive performance. Quality holdings are the ultimate driver of performance.

I cannot help but wonder if investors would leave FSHOX if they knew that it has such a poor portfolio of stocks. It is cheaper than ICLEX, but as previously stated, low fees cannot growth wealth; only good stocks can.

Sometimes, you DON’T get what you pay for.

The smallest mutual fund in Figure 1 is Oak Associates Live Oak Health Sciences Fund (LOGSX) with just $40 million in assets. Sadly, other Health Care mutual funds with more assets and inferior portfolios charge more than LOGSX. In other words, Health Care mutual fund investors are paying extra fees for no reason.

Prudential Jennison Health Sciences Fund (PHLAX) is one of the worst mutual funds in the Health Care sector. It gets my Very Dangerous rating based off the fact that barely 10% of its assets are allocated to Attractive-or-better rated stocks, while 43% is allocated to Dangerous-or-worse stocks. PHLAX also has total annual costs of 3.59%, much higher than LOGSX’s 1.41%. One would think that PHLAX would have fewer assets than LOGSX, but instead it has over $1.7 billion. Investors are paying extra fees for poor holdings.

The worst mutual fund in Figure 1 is Energy’s ICON Energy Fund (ICENX), which gets a Neutral (3-Star) rating. One would think mutual fund providers could do better for this sector.

I recommend investors only buy mutual funds with more than $100 million in assets. You can find more liquid alternatives for the other funds on my free mutual fund screener.

Covering All The Bases, Including Costs

My mutual fund rating also takes into account the total annual costs, which represents the all-in cost of being in the mutual fund. This analysis is complex for mutual funds, as one has to consider not only expense ratios, but also front-end load and transaction fees. A high front-end load not only costs investors at the beginning, it also reduces the growth investors can experience later on. While costs play a smaller role than holdings, my ratings penalize those funds with abnormally high costs.

Top Stocks Make Up Top Mutual funds

Seagate Technologies (STX) is one of my favorite stocks held by Fidelity Select Computers Portfolio (FDCPX) and earns my Very Attractive rating. STX has an impressive track record of profit (NOPAT) growth: 19% compounded annually over the past 9 years. STX also has a return on invested capital (ROIC) of 45%, which puts it in the top quintile of all companies I cover. Still, at its current valuation of ~$41/share, STX has a price to economic book value ratio of 0.4, implying that its NOPAT will permanently decline by 60%. Given the company’s impressive growth in the past and STX’s new ultra-thin hard drives focused on the burgeoning tablet market, this kind of decline looks unlikely. FDCPX’s 4.7% allocation to the heavily undervalued STX helps to explain why it is my top-rated Information Technology mutual fund.

André Rouillard contributed to this post

Disclosure: David Trainer owns STX. David Trainer and André Rouillard receive no compensation to write about any specific stock, sector, or theme.