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The Industrials sector ranks second out of the ten sectors as detailed in my Sector Rankings for ETFs and Mutual Funds report. It gets my Neutral rating, which is based on aggregation of ratings of 17 ETFs and 18 mutual funds in the Industrials sector as of April 7, 2014. Prior reports on the best & worst ETFs and mutual funds in every sector are here.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Industrials sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 20 to 347), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Industrials sector, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Industrials ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this sector on my mutual fund and ETF screener. For more products, click here.

Figure 1: ETFs with the Best & Worst Ratings – Top 5

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* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Four ETFs are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5

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* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

ICON Funds: ICON Industrials Fund (ICTRX, ICICX) is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

State Street SPDR Industrial Select Sector SPDR (XLI) is my top-rated Industrials ETF and Fidelity Select Portfolios: Defense and Aerospace Portfolio (FSDAX) is my top-rated Industrials mutual fund. Both earn my Neutral rating.

Market Vectors Environmental Services ETF (EVX) is my worst rated Industrials ETF and Rydex Series Funds: Transportation Fund (RYTSX) is my worst rated Industrials mutual fund. EVX earns my Dangerous rating and RYTSX earns my Very Dangerous rating.

Figure 3 shows that 34 out of the 447 stocks (over 18% of the market value) in Industrials ETFs and mutual funds get an Attractive-or-better rating. However, no ETFs or mutual funds in the sector earn better than a Neutral rating.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Industrials ETFs hold poor quality stocks.

Figure 3: Industrials Sector Landscape For ETFs, Mutual Funds & Stocks

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Sources: New Constructs, LLC and company filings

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Industrials ETFs and mutual funds, as no ETFs and mutual funds in the Industrials sector allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. Investors would be better suited to buy individual stocks for exposure to this sector.

Lockheed Martin Corp (LMT) is one of my favorite stocks held by Industrials ETFs and mutual funds and earns my Attractive rating. Over the past decade, LMT has grown after-tax profit (NOPAT) by 11% compounded annually. LMT currently earns a return on invested capital (ROIC) of 11%, well above the industry average of 6%. Despite this consistent profit growth, LMT remains undervalued. At its current price of ~$160/share, LMT has a price to economic book value (PEBV) ratio of 1.1. This ratio implies that the market expects LMT to grow NOPAT by just 10% for the remainder of its corporate life. Even if growth slows significantly, LMT should still easily surpass this pessimistic expectation. Investors should look at LMT as a low risk, high upside stock.

Ryder System, Inc. (R) is one of my least favorite stocks held by Industrials ETFs and mutual funds and earns my Very Dangerous rating. R has seen NOPAT decline by 1% compounded annually over the past six years and currently earns a bottom quintile ROIC of 3%. To make matters worse, R has not generated positive economic earnings in any of the past 16 years. Despite this lack of growth and profitability, R’s stock price is up over 35% in the past year, making it extremely overvalued. To justify its current price of ~$80/share, R would need to grow NOPAT by 10% compounded annually for the next 22 years. Such high expectations embedded in the stock price are a red flag for any company, even more for one with as poor a profit track record as R. Investors should stay away.

415 stocks of the 3000+ I cover are classified as Industrials stocks.

Figures 4 and 5 show the rating landscape of all Industrials ETFs and mutual funds.

My Sector Rankings for ETFs and Mutual Funds report ranks all sectors and highlights those that offer the best investments.

Figure 4: Separating the Best ETFs From the Worst ETFs

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Sources: New Constructs, LLC and company filings

Figure 5: Separating the Best Mutual Funds From the Worst Mutual Funds

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Sources: New Constructs, LLC and company filings

Review my full list of ratings and rankings along with reports on all 17 ETFs and 18 mutual funds in the Industrials sector. Learn how to protect your portfolio here.

Kyle Guske II contributed to this report.

Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme.