How To Avoid The Worst Style Mutual Funds 2Q15

Question: Why are there so many mutual funds?

Answer: Mutual fund providers tend to make lots of money on each fund so they create more products to sell.

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Photo Credit: Trevor Batchelor (Flickr)

The large number of mutual funds has little to do with serving investors’ best interests. Below are three red flags investors can use to avoid the worst mutual funds:

1. Inadequate Liquidity

This issue is the easiest issue to avoid, and our advice is simple. Avoid all mutual funds with less than $100 million in assets. Low levels of liquidity can lead to a discrepancy between the price of the mutual fund and the underlying value of the securities it holds. Plus, low asset levels tend to mean lower volume in the mutual fund and larger bid-ask spreads.

2. High Fees

Mutual funds should be cheap, but not all of them are. The first step here is to know what is cheap and expensive.

To ensure you are paying at or below average fees, invest only in mutual funds with total annual costs below 1.95%, which is the average total annual cost of the 6391 U.S. equity Style mutual funds we cover.

Figure 1 shows the most and least expensive style mutual funds. Empiric provides one of the most expensive mutual funds while Vanguard mutual funds are among the cheapest.

Figure 1: 5 Least and Most Expensive Style Mutual Funds

How to Avoid the Worst Style Mutual Funds 2Q15 Figure 1

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings. Eaton Vance Hexavest US Equity Fund (EHUIX) earns our Very Attractive rating and has low total annual costs of only 1.22%.

On the other hand, 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.

3. 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.

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Disclosure: New Constructs staff receive no compensation to write about any specific stock, sector, or theme.

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