By
David
Trainer
:
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.
Data as of 11/17/11.
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.
Data as of 11/17/11.
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.
Data as of 11/17/11.
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.
Data as of 11/17/11.
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.
Data as of 11/17/11.
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.
Data as of 11/17/11.
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 am long MSFT, INTC, DISH, LRCX.
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