This report identifies the “best” ETFs and mutual funds based on the quality of their holdings and their costs. As detailed in “Low-Cost Funds Dupe Investors ”, there are few funds that have both good holdings and low costs. While there are lots of cheap funds, there are very few with high-quality holdings.
Without speculating on the cause for this disconnect, I think it is fair to say that there is a severe lack of quality research into the holdings of mutual funds and ETFs. There should not be such a large gap between the quality of research on stocks and funds, which are simply a portfolio of stocks.
After all, investors should care more about the quality of a fund’s holdings than its costs because the quality of a fund’s holdings is the single most important factor in determining its future performance.
The following is a summary of my top picks and pans for all style ETFs and mutual funds. I will follow this summary with a detailed report on each style, just as I did for each sector .
Figure 1 shows the best ETF or mutual fund in each investment style as of October 12, 2012. Large Cap Blend is the only style with a Very Attractive fund. No Small Cap style receives an Attractive-or-better rating.
For a full list of all ETFs and mutual funds for each investment style ranked from best to worst, see our free ETF and mutual fund screener .
Figure 1: Best ETFs and Mutual Funds In Each Style
Source: New Constructs, LLC and company filings
GMO Trust: GMO Quality Fund (GQLOX) receives our Very Attractive rating. Four out of GQLOX’s top five holdings are Very Attractive stocks. In addition, GQLOX’s 0.51% Total Annual Costs place it in the 96th percentile of funds with the lowest Total Annual Costs.
One of GQLOX’s largest holdings is Phillip Morris (PM). PM earns by Very Attractive rating. This is driven by PM’s ROIC  of 35.5%, placing it in the 96th percentile of our coverage universe. The past 3 years PM has increased its economic earnings margin  from 21.6% to 24.4% to 29.6% in 2011. This growth in profitability is impressive on its own, but is especially impressive considering only about one-third of our coverage universe has a positive economic earnings margin. In return for this profitability, the market has assigned PM a price-to-economic book value  of .94. While there are legitimate concerns about the future of the tobacco industry, the market expects PM’s NOPAT  to decline permanently by 6%. To place these expectations into perspective, PM has grown NOPAT by 12.4% and 19.0% the past two years. In this case, the market’s expectations seem overly pessimistic. Strong profit grwoth and a valuation with expectations for profit decline add up to PM’s Very Attractive rating.
Figure 2 shows the worst ETF or mutual fund for each investment style as of October 12, 2012. The Large Cap style is the only style without any Very Dangerous funds.
Dangerous-or-worse-rated funds have a combination of low-quality portfolios (i.e. they hold too many Dangerous-or-worse rated stocks) and high costs (they charge investors too much for the [lack of] management they provide).
Figure 2: Worst ETFs and Mutual Funds In Each Style
Bhirud Funds, Inc: Apex Mid Cap Growth Fund (BMCGX) is our worst-rated fund and receives our Very Dangerous rating. This is due to BMCGX’s allocation; it allocates 42.32% of its value to Dangerous-or-worse rated stocks and only 12.04% to Attractive-or-better. In addition, this poor allocation comes at a cost. Its Total Annual Costs of 9.74% make it the costliest fund we cover.
One of the stocks that makes BMCGX Very Dangerous is Rentech Inc. (RTK). Rentech is a provider of clean-energy solutions. RTK gets our Dangerous rating because of the incredibly high expectations baked into RTK’s stock price. It currently trades at a price-to-economic book value  of 6.89. In DCF terms, this mean RTK must grow NOPAT at nearly 20% compounded annually for 10 years and achieve an ROIC of over 30% (versus 8% currently). RTK has never generated positive economic earnings  in our thirteen years of coverage. In this case, the market’s expectations of RTK’s future performance are materially different than its past performance. While these expectations may come to fruition, we prefer stocks like PM with proven past performance and low future expectations.
Traditional mutual fund research has focused on past performance and low management costs. The quality of a fund’s holdings has been ignored. Our portfolio management rating  examines the fund’s holdings in detail and takes into account the fund’s allocation to cash. Our models are created with data from over 40,000 annual reports. This kind of diligence is necessary for understanding just what you are buying when you invest in a mutual fund or an ETF.
Figure 3 shows the best fund based on our Portfolio Management Rating for each investment style as of October 12, 2012. Only three Styles earn Very Attractive Portfolio Management Rating: All Cap Blend, Large Cap Blend, and Mid Cap Blend.
Attractive-or-better-rated funds own high-quality stocks and hold very little of the fund’s assets in cash – investors looking to hold cash can do so themselves without paying management fees. Only 2.8% of funds receive our Attractive or Very Attractive ratings, so investors need to be cautious when selecting a mutual fund or ETF – there are thousands of Neutral-or-worse-rated funds.
Figure 3: Style Funds With Highest Quality Holdings
Source: New Constructs, LLC and company filings
Figure 4 shows the worst funds based on our Portfolio Management Rating for each investment style as of October 12, 2012.
Actively managed funds rank as the worst fund for every investment style (except Large Cap Value). Investors pay mutual fund managers to pick stocks for them. Even ignoring costs, these mutual fund managers do a poor job investing money for their clients, making their funds dangerous investments for investors.
Figure 4: Style Funds With Lowest Quality Holdings
Investors should care about all of the fees associated with a fund in addition to the quality of the fund’s holdings. The best funds have both low costs and quality holdings – and there are plenty of low cost funds available to investors.
Figure 5 shows the best fund in each investment style according to our Total Annual Costs rating . An ETF ranks as the lowest cost for ten of the twelve style categories.
Total Annual Costs incorporates all expenses, loads, fees, and transaction costs into a single value that is comparable across all funds. Passively managed ETFs and index mutual funds are generally the cheapest funds.
Figure 5: Style Funds With Lowest Costs
The most expensive fund for each investment style has a Very Dangerous Total Annual Costs Rating. Investors should avoid these funds and other funds with a Very Dangerous Total Annual Costs Ratings because they charge investors too much. For every fund with a Very Dangerous Total Annual Costs Rating there is an alternative fund that offers similar exposure and holdings at a lower cost. We cover over 7000 mutual funds and over 400 ETFs. Investors have plenty of alternatives to these overpriced funds.
Figure 6 shows the worst fund in each investment style according to our total annual costs rating . No ETFs rank as the most expensive for any style category.
Figure 6: Style Funds With Highest Costs
Disclosure: I own PM. I receive no compensation to write about any specific stock, sector or theme.