With the ever-growing list of similar-sounding mutual funds, it’s becoming increasingly difficult to find the best one. How can investors change the rules of the game to put the odds in their favor?

Don’t trust mutual fund labels

There are at least 166 different real estate funds and at least 635 mutual funds in eleven sectors. Do investors need on average more than 58 choices per sector? How different can the mutual funds be?

These 166 real estate funds differ greatly from one another. With 22 to 159 holdings, many of these real estate funds have completely different portfolios with different risk profiles and performance prospects.

The same is true for mutual funds in all other sectors, as each offers a very different mix of good and bad stocks. Energy ranks first in stock selection. Utilities come last.

Avoiding analysis paralysis

I think the large number of sector funds does more harm than good to investors. Manually performing a thorough analysis of each fund is simply not a realistic option. It exposes investors to inadequate analysis and misses out on lucrative opportunities. Analyzing mutual funds is far more difficult than analyzing stocks with due diligence because all the stocks in each mutual fund must be analyzed. As mentioned above, a mutual fund can have as many as 159 stocks or more.

Figure 1 shows the top-rated mutual funds for each sector.

Figure 1: The best mutual fund in each sector

* The best mutual funds exclude funds with TNAs below $100 million due to insufficient liquidity.

Among the mutual funds in Figure 1, Davis Financial Fund (DVFYX) ranks first, Vanguard Energy Index Fund (VENAX) ranks second, and Vanguard Consumer Staples Index Fund (VCSAX) ranks third. Hennessy Gas Utility Fund (HGSAX) ranks last.

How to avoid “the danger within”

Why do you need to know mutual fund holdings before you buy?

You need to be sure that you are not buying a fund that could fail. Buying a fund without analyzing its holdings is like buying a stock without analyzing the business and finances. No matter how cheap the fund is, if it holds bad stocks, the mutual fund’s performance will be poor.

PERFORMANCE OF FUND HOLDINGS – FEES = PERFORMANCE OF THE FUND

If only investors could find funds that are valued according to their holdings

Davis Financial Fund (DVFYX) is not only the highest-rated mutual fund in the financials sector, but also the highest-rated sector mutual fund overall among the 635 sector mutual funds my firm covers.

The worst performing mutual fund in Figure 1 is the Hennessy Gas Utility Fund (HGSAX), which receives an “Unattractive” rating. One might think that mutual fund providers could do better in this sector.

Disclosure: David Trainer, Kyle Guske II and Hakan Salt do not receive compensation to write about specific stocks, sectors or topics.