Picking from the multitude of sector mutual funds is a daunting task. In any given sector there may be as many as 231 different mutual funds, and there are at least 630 mutual funds across all sectors.
Why are there so many mutual funds? The answer is: because mutual fund providers are making lots of money selling them. The 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:
- Inadequate liquidity
- High fees
- Poor quality holdings
I address these red flags in order of difficulty. Advice on How to Find the Best Sector Mutual Funds is here. Details on the Best & Worst mutual funds in each sector are here.
How To Avoid Mutual Funds with Inadequate Liquidity
This is the easiest issue to avoid, and my 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. In addition, low asset levels tend to mean lower volume in the mutual fund and large bid-ask spreads.
How To Avoid High Fees
Mutual funds should be cheap, but not all of them are. The first step 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 1.97%, which is the average total annual costs of the 630 U.S. equity mutual funds I cover. Weighting the total annual costs by assets under management, the average total annual costs are lower at 1.31%. A lower weighted average is a good sign that investors are putting money in the cheaper mutual funds.
Figure 1 shows the most and least expensive sector mutual funds in the U.S. equity universe based on total annual costs. Rydex provides three of the most expensive funds while Vanguard’s are among the cheapest.
Figure 1: 5 Least and Most Expensive Sector Mutual Funds
