PowerShares S&P SmallCap Utilities Portfolio ETF (PSCU) gets an overall predictive rating of Very Dangerous because no matter how low its fees (0.32%), we expect it to underperform because it holds too many Dangerous-or-worse rated stocks. Low fees cannot boost fund performance. Only good stocks can boost performance.

Figure 3: Distribution of ETFs & Mutual Funds (Count & Assets) By Total Annual Costs Ratings

Source: New Constructs, LLC and company filings

Investors should allocate their capital to funds with both high-quality holdings and low costs because those are the funds that offer investors the best performance potential.

But they do not. Not even close.

Figure 4 shows that less than half (49%) of ETF and mutual fund assets are allocated to funds with low costs and high-quality holdings according to our Predictive Fund Ratings, which are based on the quality of holdings and the all-in costs to investors.

Figure 4: Distribution of ETFs & Mutual Funds (Count & Assets) By Predictive Ratings

NewConstructs_FundDistributionPredictiveRating_4Q15

Source: New Constructs, LLC and company filings

Investors deserve forward-looking ETF and mutual fund research that assesses both costs and quality of holdings. For example, PowerShares KBW Property & Casualty Insurance Portfolio ETF (KBWP) has both low costs and quality holdings.

Why is the most popular fund rating system based on backward-looking past performance?

We do not know, but we do know that the transparency into the quality of portfolio management provides cover for the ETF and mutual fund industry to continue to over charge investors for poor portfolio management. How else could they get away with selling so many Dangerous-or-worse rated ETFs and mutual funds?

John Bogle is correct — investors should not pay high fees for active portfolio management. His index funds have provided investors with many low-cost alternatives to actively managed funds.

However, by focusing entirely on costs, he overlooks the primary driver of fund performance: the stocks held by funds. Investors also need to beware certain Index Label Myths.

Research on the quality of portfolio management of funds empowers investors to make better investment decisions. Investors should no longer pay for poor portfolio management.

Disclosure: David Trainer and Blaine Skaggs receive no compensation to write about any specific stock, sector or theme.

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