So I’ve noticed that while I have talked a lot lately about how to deal with debt or credit cards, we haven’t really gone over how exactly to invest. Sure, I say invest in a Vanguard index fund, but what does that mean exactly? Let’s fill in the gaps a little on what specifically I consider good investments, and how I picked them, so you can hopefully walk away from this article with the basic knowledge needed on how to get a decent return on your investments.
Rule #1: Trust no one!
Ok, so if the recent scandal with Chase hasn’t reminded you that big banks don’t have your best interest at heart, or if 2008 wasn’t enough of a wakeup call that investment banks like Goldman Sachs and Morgan Stanley aren’t interested in wisely investing your money, let me reiterate this one more time: trust no one. If you use a financial advisor, financial planner, accountant, etc. to help you do your investments, that’s fine, but what I’m trying to say here is to verify and validate everything you’re told through multiple sources to make sure that you are getting good advice. This includes the advice in this article.
Now that I have that out of the way, let’s look at the criteria you should use for selecting a good mutual fund. The first step is deciding what kind of fund you want. There is a mutual fund for everything from small-cap growth international stocks to technology sector funds to REIT (real estate investment trust) funds. The reason I always say that index funds are the best type of fund is the broad diversity they give you. Why do people pick mutual funds in the first place? They want to diversify their portfolio. If I wanted to just buy $2,000 worth of stock in Apple, I can do that directly through Scottrade, E-trade, etc. I don’t need a mutual fund for that. What if I want to invest that $2,000 in say 100 companies? Well, that money would be spread pretty thin because individual shares are around $20-80 on average (well, except for Apple..) and that means you’re only getting around 30-60 shares total. However, if you invest $2,000 in a mutual fund that say has 2,000 stocks in its portfolio, instead of getting only 30-60 shares in 100 companies, each of which may incur a transaction fee for buying the stocks, you’re getting a certain number of shares in 2,000 companies. This is increasing your diversity by a factor of 20 in this case. This is where index funds come in…they provide diversity by allowing you to invest in thousands of stocks instead of a handful. The greatest way to diversify is not to chase a specific sector or type of stock but to just invest in the entire stock market through index mutual funds.
An index fund, very simply, tracks a certain stock index. The most popular stock indices, which track the entire U.S. stock market, are the S&P 500 and the Wilshire 5000 index. The S&P 500 tracks the 500 largest companies and the Wilshire 5000 tracks the 5,000 largest companies. Now, if your goal is to diversify as much risk as possible, and to have your long-term return match that of the market (since you can almost never beat the market in the long run), this is why you want an index fund. Interesting enough, so far the returns for the S&P 500 index funds and Wilshire 5000 index funds are very, very similar. We’re talking about 0.2 to 0.3% return difference, according to John Bogle in his book Common Sense on Mutual Funds. Now, from 1926 through 2011, which includes both the stock market crashes of 1929 as well as 2008, the stock market return was 9.9% according to Vanguard. This return is based off of various indices throughout the years that Vanguard thought best represented market return, starting with the S&P 90, then the S&P 500, then the Wilshire 5000 and now the MSCI US Broad Market Index. Regardless of which index you choose, the same concept remains. You will get an average of around 9-10% long-term return if you invest in an index fund that tracks the total U.S. stock market.
The single biggest thing you should consider when picking a mutual fund is the cost. What is the expense ratio? What is the cost to buy shares (front or back end load charges) or sell shares (redemption fees)? Are there any hidden fees such as 12b1 fees? Is there a redemption fee for selling shares within a certain time period? Good funds don’t have any of these, although many international funds (even Vanguard’s) will have redemption fees if you hold the shares for less than 90 days. Let’s take a look at bond funds for example. Fidelity has a Total Bond Fund (FTBFX) on their website which has a 5-year return of 7.13% and an expense ratio of 0.45%. Vanguard has a Total Bond Market Fund (VBMFX) on their website which has a 5-year return of 6.71% and an expense ratio of 0.22%. So the Fidelity fund beat Vanguard’s by 0.42% but this is primarily because the underlying bonds did better. If both funds had a similar return, Vanguard’s fund would have given a better return due to lower cost. What about other bond funds? Oppenheimer’s Core Bond Fund has a 5-year return of -3.27% if you include the sales charges they have. This is a shortfall of over 3% versus Fidelity or Vanguard’s bond funds and is directly a result of a much higher expense ratio as well as sales charges. See why cost is important?
Let’s look at one more example, this time for stocks. Let’s compare the Vanguard 500 Index fund to the Fidelity Spartan 500 Index fund and then compare those to some actively managed funds. The Vanguard 500 Index fund has a 10-year return of 5.23% and an expense ratio of 0.17%. The Fidelity Spartan 500 Index fund has a 10-year return of 5.26% with an expense ratio of 0.10%. This is the kind of difference we’re looking for in index funds…only a 0.03% difference and it looks like a good chunk of that difference is simply the difference in cost. Why are they so close together? Because they’re just tracking the total stock market…no active investing, no high expenses, just simplicity.
Index funds, by the nature of how the S&P 500 and Wilshire 5000 indices are weighted, are primarily large cap funds since the index tracks the 500 or 5,000 largest companies. Let’s see how other large-cap actively managed funds compare. The Janus Fund (JANDX) has been around since 1970 and boasts of a 12.08% return versus 10.11% for the S&P 500. The only problem? The Janus Fund has an expense ratio of 0.78%, so that return had a huge chunk taken out of it before you ever got to see it. The gross return was 12.86% before the expenses were taken out…just imagine if you had an index fund where if you had a gross return of close to 13% you’d get to keep close to 13%. Is this 1.97% surplus above the market return sustainable? Unlikely. In exchange for an additional 1.97% return, you’re getting far more risk since they’re trying to “beat the market” by making hundreds of trades a year. Also, if your investments are in a taxable account, you’ll get slaughtered on taxes since all these trades will realize short-term capital gains which are taxed at your normal rate. How about more recent returns for Janus? The 10-year return for the Janus fund is 4.14% versus a return of 5.23% and 5.26% for Vanguard and Fidelity’s total stock market index funds. Not exactly impressive. Most likely Janus simply got lucky since the inception of the fund in the 1970s, because if you went further and looked at the last 5 years, 3 years, 1 year and even year to date, the total market index funds fared better in every single category.
Let’s look at one more actively managed fund. T. Rowe has a U.S. Large-Cap Core Fund (TRULX) with a 3-year return of 14.71% and an expense ratio of 1.53%. This is a huge cost but some funds can even go north of 3% in cost. Vanguard’s 500 Index Fund did 16.25% in the last 3 years and Fidelity’s Spartan 500 Index fund did 16.31%. So T. Rowe’s fund not only had a lower return, but thanks to cost, Vanguard and Fidelity had a huge edge over T. Rowe from the beginning and they slaughtered T. Rowe’s fund. Why did I only look at 3 years? Well, as it turns out, this fund of T. Rowe’s didn’t exist any longer than that. This brings me to the big problem with actively managed funds…we can only look at the ones that survived. A lot of actively managed funds fail so horribly that they are closed or rolled into other funds. There are other index funds out there of course. T. Rowe has an Equity Index 500 Fund with a 10-year return of 5.08% with an expense ratio of 0.30%. But why invest in it? Because the cost is three times that of Fidelity’s fund, and almost twice that of Vanguard’s, your return even in their index fund isn’t as good.
Now that we’ve established why index funds are safer, more diverse, and better long-term investments, as well as why cost is so important, let me just finish the discussion on cost with a reminder that you should never invest in any funds that have load fees, sales charges, 12b1 fees, etc. If a fund has such fees in the first place, it should make you wonder why they have them at all…the answer is to bilk more money out of you.
Aside from total stock market or bond market index funds, expense ratios, and possible other sales/load fees, what else should you look at in a mutual fund? Account minimums are a consideration, since many mutual funds won’t let you invest in them without at least $2,000 or $3,000, regardless of who you buy the mutual fund through. You should also pay attention to transaction fees, since these can add up over time and may be separate from sales or load charges. If you have a brokerage account with say Scottrade or E-trade, it may cost you $10-20 per transaction to buy shares in a mutual fund. A much cheaper way of buying mutual fund shares is to buy it directly from the firm who offers it. I have a Vanguard mutual fund account and it costs me $0 to buy shares. If you had a Fidelity account to get their Spartan 500 Index fund, I’m sure it would likewise be far cheaper if not free than buying the shares through a brokerage company.
Lastly, I want to finish this topic with a note about Dollar Cost Averaging (DCA). Granted, to get started with a mutual fund, you will need to buy $2,000 or $3,000 or whatever the account minimum is to get the fund going. However, once the fund is established, how should you make contributions? The one proven method of increasing return is to dollar cost average. Very simply, this means that instead of say buying $3,000 of shares all at once, buy $1,000 of shares once a month for the next 3 months. Now, if you have a brokerage account with say E-trade, this will cost you more money because that’s 3 transactions times $20 a pop versus 1 transaction. This is all the more reason why you should invest directly with the firm, so you can take advantage of dollar cost averaging without incurring a lot of transaction fees. The idea behind DCA is that all equities, bonds, etc. fluctuate in price, sometimes quite substantially, in the short-term. When you buy shares, maybe the market rallied and those shares are relatively expensive to a month ago. Perhaps the market plummeted and you got a good deal. If you buy in small, steady, constant increments though, it has been proven that on average the price of the shares you buy will be lower than if you just bought them all at once.
So if you pick funds that invest in the entire market, instead of trying to find the next good growth stock fund or the next hot sector, you will get a better return in the long run with less risk. Worst case scenario, your return will be the same but you will still have a better risk-adjusted return. Avoid unnecessary fees or high-cost funds, and using dollar cost averaging, and you will have a recipe for success in investing.