The Telecom Services sector ranks fifth out of the ten sectors as detailed in my Sector Rankings for ETFs and Mutual Funds report. It gets my Neutral rating, which is based on aggregation of ratings of 6 ETFs and 13 mutual funds in the Telecom Services sector as of July 16, 2014. Prior reports on the best & worst ETFs and mutual funds in every sector are here.

Figure 1 ranks from best to worst all six Telecom Services ETFs and Figure 2 shows the five best and worst-rated Telecom Services mutual funds. Not all Telecom Services sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 21 to 65). This variation creates drastically different investment implications and, therefore, ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Telecom Services sector, investors need a predictive rating based on (1) the stocks ratings of the holdings, (2) the all-in expenses of each ETF and mutual fund, and (3) the fund’s rank compared to all other ETFs and mutual funds. As a result, only the cheapest funds with the best holdings receive Attractive or better ratings. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Telecom Services ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off. Here’s the list of our top-rated Telecom Services stocks.

Get my ratings on all ETFs and mutual funds in this sector on my free mutual fund and ETF screener.

Figure 1: ETFs with the Best & Worst Ratings

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* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5

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* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

PFS Funds: Wireless Fund (WIREX) is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity minimums.

Vanguard Telecommunication Services Sector ETF (VOX) is my top-rated Telecom Services ETF and T Rowe Price Media & Telecommunications Fund, Inc (PRMTX) is my top-rated Telecom Services mutual fund. Both earn my Neutral rating.

ProShares Ultra Telecommunications ETF (LTL) is my worst-rated Telecom Services ETF and Rydex Series Funds: Telecommunications Fund (RYTLX) is my worst-rated Telecom Services mutual fund. LTL earns my Neutral rating and RYTLX earns my Very Dangerous rating.

Figure 3 shows that 12 out of the 139 stocks (over 21% of the market value) in Telecom Services ETFs and mutual funds get an Attractive-or-better rating. However, 0 out of 6 Telecom Services ETFs and 0 out of 13 Telecom Services mutual funds get an Attractive-or-better rating.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Telecom Services ETFs hold poor quality stocks.

Figure 3: Telecom Services Sector Landscape For ETFs, Mutual Funds & Stocks

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Sources: New Constructs, LLC and company filings

As detailed in “Low-Cost Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Telecom Services ETFs and mutual funds, as there are many bad choices and few good ones. No ETFs or Telecom Services mutual funds in the Telecom Services sector allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. Investors should focus on individual stocks to get exposure to this sector.

Neustar Inc. (NSR) is one of my favorite stocks held by Telecom Services ETFs and mutual funds and earns my Very Attractive rating. With so few quality stocks in the Telecom Services sector, NSR remains one of my favorites. The company has grown after-tax profit (NOPAT) by 19% compounded annually since 2005. NSR also earns a return on invested capital (ROIC) of 15%, placing it in the top quintile of all companies I cover.

As I mentioned in my recent article, NSR is priced for a win-win scenario. Even if it loses its big contract with NAPM, NSR is slightly undervalued. At its current price of ~$29/share, NSR has a price to economic book value (PEBV) ratio of 0.7. This ratio implies the market expects NSR’s NOPAT to permanently decline by 30% from its current levels. This expectation seems awfully pessimistic given the company’s proven ability to grow NOPAT since 2005. Investors should buy NSR.

Telephone & Data Systems, Inc. (TDS) is one of my least favorite stocks held by Telecom Services ETFs and mutual funds and earns my Very Dangerous rating. Since 2005, TDS’s NOPAT has declined by 15% compounded annually. Add this decline to TDS’s bottom quintile ROIC of 1% and you have a company not worthy of the high valuation given to it by the market. To justify its current price of ~$27/share TDS would need to grow NOPAT by 10% compounded annually for 15 years. This expectation seems rather unlikely given the decline in NOPAT since 2005.

38 stocks of the 3000+ I cover are classified as Telecom Services stocks, but due to style drift, Telecom Services ETFs and mutual funds hold 65 stocks.

Figures 4 and 5 show the rating landscape of all Telecom Services ETFs and mutual funds.

My Sector Rankings for ETFs and Mutual Funds report ranks all sectors and highlights those that offer the best investments.

Figure 4: Separating the Best ETFs From the Worst ETFs

Telecom-ETFs

Sources: New Constructs, LLC and company filings

Figure 5: Separating the Best Mutual Funds From the Worst Mutual Funds

Telecom-Mutual-Fund

Sources: New Constructs, LLC and company filings

Review my full list of ratings and rankings along with reports on all 6 ETFs and 13 mutual funds in the Telecom Services sector.

Kyle Guske II contributed to this report.

Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme.

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