When three Boston money managers pooled their money in 1924, the first mutual fund was born. In the subsequent eight decades, that simple concept has grown into one of the biggest industries in the world, now controlling trillions of dollars in assets and allowing small investors a means to compound their wealth through systematic investments via a dollar cost averaging plan. In fact, the mutual fund industry has spawned its own stars with cult-like followings: Peter Lynch, Bill Gross, Marty Whitman, and the folks at Tweedy, Browne & Company just to name a few.
With so much at stake, what should an investor look for in a mutual fund? This handy ten-step guide, which is part of the Complete Beginner's Guide to Investing in Mutual Funds can make the process a lot easier and give you some peace of mind as you sift through the thousands of available options. As always, grab a cup of coffee, sit back, and in no time you can feel like a mutual fund pro!
Some mutual funds charge what is known as a sales load. This is a fee, usually around 5% of assets, that is paid to the person who sells you the fund. It can be a great way to make money if you are a wealth manager, but if you are putting together a portfolio, you should only buy no-load mutual funds. Why? It's simple math!
Imagine you have inherited a $100,000 lump sum and want to invest it. You are 25 years old. If you invest in no-load mutual funds, your money will go into the fund and every penny - the full $100,000 - will immediately be working for you. If, however, you buy a load fund with, say, a 5.75% sales load, your account balance will start at $94,250.
Assuming an 11% return, by the time you reach retirement, you'll end up with $373,755 less money as a result the capital lost to the sales load. So, repeat after us: Always buy no load mutual funds. Always buy no load mutual funds. (Keep Saving It!)
Pay Attention to the Expense Ratio – It Can Make or Break You!
It takes money to run a mutual fund. Things such as copies, portfolio management and analyst salaries, coffee, office leases, and electricity have to be taken care of before your cash can even be invested! The percentage of assets that go toward these things – the management advisory fee and basic operating expenses – is known as the expense ratio. In short, it is the cost of owning the fund. Think of it as the amount a mutual fund has to earn just to break even before it can even begin to start growing your money.
All else being equal, you want to own funds that have the lowest possible expense ratio. If two funds have expense ratios of 0.50% and 1.5%, respectively, the latter has a much bigger hurdle to beat before money starts flowing into your pocketbook. Over time, you would be shocked to see how big of a difference these seemingly paltry percentages can cause in your wealth. Just flipping open the Morningstar Funds 500 2006 Edition sitting on my desk provides an interesting illustration. Take for example, a random chosen fund, FBR Small Cap (symbol FBRVX). When all of the fees are added up, the expense projection for 10 years is $1,835. This is the amount you might be expected to pay indirectly (that is, it would be deducted from your returns before you ever saw them) if you bought $10,000 worth of the fund today. Compare that with the Vanguard 500 Index which is a passively managed fund that seeks to mimic the S&P 500 with its fees of only 0.16% per year and projected 10-year cost of $230 and it’s not hard to see why you might end up with more money in your pocket owning the latter.
Combined with the low turnover ratio, which we’ll talk about later, and it’s not hard to see how a boring low-cost fund can actually make you more money than sexier offerings.
Avoid Mutual Funds with High Turnover Ratios
Sometimes it’s easy to forget what you set out to do. Many investors simply think they have to get the highest return possible. Instead, they forget that the goal is to end up with the most money after taxes. That’s why it’s hard for them to believe that they can actually get wealthier by owning a fund that generates 12% growth with no turnover than one that has 17% growth and 100%+ turnover. The reason is that age old bane of our existence: Taxes.
Obviously, if you are investing solely through a tax free account such as a 401k, Roth IRA, or Traditional IRA, this is not a consideration, nor does it matter if you manage the investments for a non-profit. For everyone else, however, taxes can take a huge bite out of the proverbial pie, especially if you are fortune enough to occupy the upper rungs of the income ladder. It’s important to focus on the turnover rate – that is, the percentage of the portfolio that is bought and sold each year – for any mutual fund you are considering. Unless it is a specialty fund such as a convertible bond fund where turnover is part of the deal, you should be wary of funds that habitually turnover 50% or more of their portfolio. These managers are renting stocks, not buying businesses; such figures seem to convey that they are extraordinarily unsure of their investment thesis and have little solid reason for owning the investments they do.
Look for an Experienced, Disciplined Management Team
In this day of easy access to information, it shouldn’t be hard to find information on your portfolio manager. It’s astounding that some of these men and women still have jobs – despite turning in horrific performance, they are still able to raise capital from investors who somehow think the next time around will be different. If you find yourself holding a mutual fund with a manager that has little or no track record or, even worse, a history of massive losses when the stock market as a whole has performed well (you can’t hold it against them if they run a domestic equity fund and they were down 20% when the Dow was down 20% as well) you should consider running as fast as you can in the other direction.
The ideal situation is a firm that is founded on one or more strong investment analysts / portfolio managers that have built a team of talented and disciplined individuals around them that are slowly moving into the day-to-day responsibilities, ensuring a smooth transition. It is in this way that firms such as Tweedy, Browne & Company in New York have managed to turn in decade after decade of market-crushing returns while having virtually no internal upheaval. Another good example is Marty Whitman and Third Avenue Funds, the organization he built and continues to oversee.
Finally, you want to insist that the managers have a substantial portion of their net worth invested alongside the fund holders. It’s easy to pay lip service to investors but it’s a different thing entirely to have your own capital at risk alongside their's causing your wealth to grow, or fall, in proportional lockstep with the performance of your funds.
Find a Philosophy that Agrees with Your Own when Selecting a Mutual Fund
Like all things in life, there are different philosophical approaches to managing money. Personally, I am a value investor. I believe that every asset has what is known as an “intrinsic value”, that is a “true” value that is equal to all of the cash it will generate for the owner from now until doomsday discounted back to the present at an appropriate rate that takes into account the risk-free Treasury return, inflation, and an equity risk premium.
Over time, I look for businesses that I believe are trading at a substantial discount to my estimate of intrinsic value. This causes me to buy very few businesses each year and, over time, has led to very good results. This doesn’t always mean owning bad companies with low price-to-earnings ratios because, theoretically, a company could be cheaper at 30 times earnings than another enterprise at 8 times earnings if you could accurately value the cash flows. In the industry, there are mutual funds that specialize in this type of value investing – Tweedy, Browne & Company, Third Avenue Value Funds, Fairholme Funds, Oakmark Funds, Muhlenkamp Funds, and more.
Other people believe in what is known as “growth” investing which means simply buying the best, fastest growing companies almost regardless of price. Still others believe in owning only blue chip companies with healthy dividend yields. It is important for you to find a mutual fund or family of mutual funds that shares the same investment philosophy you do.
Look for Ample Diversification of Assets
Warren Buffett, known for concentrating his assets into a few key opportunities, has said that for those who know nothing about the markets, extreme diversification makes sense. It’s vitally important that if you lack the ability to make judgment calls on a company’s intrinsic value, you spread your assets out among different companies, sectors, and industries. Simply owning four different mutual funds specializing in the financial sector (shares of banks, insurance companies, etc.) is not diversification.
Were something to hit those funds on the scale of the real estate collapse of the early 1990’s, your portfolio would be hit hard.
What is considered good diversification? Here are some rough guidelines:
- Don’t own funds that make heavy sector or industry bets. If you choose to despite this warning, make sure that you don’t have a huge portion of your funds invested in them. If it’s a bond fund, you typically want to avoid bets on the direction of interest rates as this is rank speculation.
- Don’t keep all of your funds within the same fund family. Witness the mutual fund scandal of a few years ago where portfolio management at many firms allowed big traders to market time the funds, essentially stealing money from smaller investors. By spreading your assets out at different companies, you can mitigate the risk of internal turmoil, ethics breaches, and other localized problems.
- Don’t just think stocks – there are also real estate funds, international funds, fixed income funds, arbitrage funds, convertible funds, and much, much more. Although it is probably wise to have the core of your portfolio in domestic equities over long periods of time, there are other areas that can offer attractive risk-adjusted returns.
The Case for Index Funds
In the article If You Can't Beat 'Em, Join 'Em - The Case for Investing in Index Funds, I pointed out that, "According to the folks at the Motley Fool, only ten of the ten thousand actively managed mutual funds available managed to beat the S&P 500 consistently over the course of the past ten years. History tells us that very few, if any, of these funds will manage the same feat in the decade to come.
The lesson is simple; unless you are convinced you are capable of selecting the 0.001% of mutual funds that are going to beat the broad market, you would best be served by investing in the market itself. How? By beginning a dollar cost averaging plan into low-cost index funds, you can be absolutely certain you will out perform a majority of managed mutual funds on a long-term basis."
For the average investor who has a decade or longer to invest and wants to regularly put aside money to compound to their benefit, index funds can be a great choice. They combine almost unfathomably low turnover rates with rock bottom expense ratios and widespread diversification; in other words, you really can have your cake and eat it, too.
Interested? Check out Vanguard and Fidelity as they are the undisputed leaders in low-cost index funds. Typically, look for an S&P 500 fund or other major index such as the Wilshire 5000 or the Dow Jones Industrial Average.
A Word on International Funds
When you invest outside of the U.S., the costs are higher as a result of currency conversions, trust procedures for foreign investments, analysts capable of understanding foreign accounting rules, and a host of other things. Although high, it is not unusual for an international equity fund to have an expense ratio of 2%. Why do some investors bother owning international funds? In the past, stocks of foreign countries have shown low-correlation with those in the United States.
When constructing portfolios designed to build wealth over time, the theory is that these shares aren’t as likely to be hit hard when the American equities are crashing and visa versa.
First, if you are going to venture into the international equity market by owning a fund, you should probably only own those that invest in established markets such as Japan, Great Britain, Germany, Brazil, and other stable countries. The alternatives are emerging markets which pose far greater political and economic risk. The economic basis for digging a gold mine in the Congo might be stable, but there is nothing stopping an armed military group from kicking you out the day your work is finished, reaping all of the rewards for themselves.
Second, virtually all international funds chose to remain unhedged. This means that you are exposed to fluctuations in the currency market. Your stocks, in other words, could go up 20% but if the dollar falls 30% against the yen, you may experience a 10% loss (the opposite is also true.) Trying to play the currency market is pure speculation as you cannot accurately predict with any reasonable certainty the future of the British pound.
That’s why I personally prefer the Tweedy Browne Global Value fund which hedges its exposure, protecting investors against currency fluctuations. Even better, it’s expense ratio is a very reasonable 1.38%.
Each fund has a different approach and goal. That’s why it’s important to know what you should compare it against to know if your portfolio manager is doing a good job. For example, if you own a balanced fund that keeps 50% of its assets in stocks and 50% in bonds, you should be thrilled with a return of 10% even if the broader market did 14%. Why? Adjusted for the risk you took with your capital, your returns were stellar!
Some popular benchmarks include the Dow Jones Industrial Average, the S&P 500, the Wilshire 5000, the Russell 2000, the MSCI-EAFE, the Solomon Brothers World Bond Index, the Nasdaq Composite, and the S&P 400 Midcap. One quick and easy way to see which benchmarks your funds should be measured against is to head over to Morningstar.com and sign up for a premium subscription which is only around $14.95 per month. You can then research reports on various funds and find out how they evaluate them, view historical data, and even get their analyst’s thoughts on the quality and talent of the portfolio management team. Talk to your accountant – it may even be tax deductible as an investment research expense!
You know, you’d think we’d get tired of saying it but dollar cost averaging really is the single best way to lower your risk over long periods of time and help lower your overall cost basis for your investments. In fact, you can find out all the information on dollar cost averaging – what it is, how you can implement your own program, and how it can help you lower your investment risk over time – in the article Dollar Cost Averaging: A Technique that Drastically Reduces Market Risk.
Take a moment and check it out right now; your portfolio could be much better served because you invested a few minutes of your time.
In Conclusion …There are a ton of great resources out there about choosing and selecting a mutual fund including About.com’s very own Mutual Fund site which goes into much greater depth on all of these topics and more. Morningstar is also an excellent resource (I personally have a copy of their Funds 500 book on my desk as I write this article.) Just remember that the key is to remain disciplined, rational, and avoid being moved by short term price movements in the market. Your goal is to build wealth over the long-term. You simply can’t do that moving in and out of funds, incurring frictional expenses and triggering tax events.
Good luck! We here at Investing for Beginners wish you many happy returns!