01Why You Should Always Buy No-Load Mutual Funds
When three Boston money managers pooled their money in 1924, the first mutual fund was born. In the subsequent nine 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 of 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!)
02Pay 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.
03Avoid Mutual Funds With High Turnover Ratios
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. The reason is that age-old bane of our existence: Taxes.
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 fortunate enough to occupy the upper rungs of the income ladder. You should be wary of funds that habitually turnover 50% or more of their portfolio.
04Look 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. 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 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.
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 theirs.
05Find 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. Over time, I look for businesses that I believe are trading at a substantial discount. This causes me to buy very few businesses each year and, over time, has led to very good results.
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.
06Look 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, for example, 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.
- Don’t keep all of your funds within the same fund family. 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 good returns.
07The Case for Index Funds
For the average investor who has a decade or longer to invest and wants to regularly put aside money to compound over time, 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 indexes such as the Wilshire 5000 or the Dow Jones Industrial Average.
08A Word on International Funds
When you invest outside of the U.S., the costs are higher. But 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, though they do offer potentially higher returns.
09Know the Appropriate Benchmark for Your Mutual Funds
;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 Russell 2000, the Nasdaq Composite, and the S&P 400 Midcap. It's easy these days to search online to see what benchmarks funds are tied to. 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.
10Always Dollar Cost Average
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. 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 the Mutual Fund site which goes into much greater depth on all of these topics and more. Morningstar is also an excellent resource. 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.