Friday, August 1, 2008

How to pick mutual funds

Important disclaimer - before you get started, I want to warn you that this post is a bit longer and a bit more complex then my previous posts.  It covers a tremendous amount of important information and I urge you to read through it.  I think that you will be glad you did.

Now that you understand the benefits of investing in mutual funds, you are faced with the challenge of determining how to sort through the thousands and thousands of funds out there to find the best ones for you.  When you are looking for a fund, there are three factors that you need to consider to make an informed decision: what the fund invests in, how it is managed, and how much it will cost you.  You can find the answers to all of these questions in the fund's prospectus (a legal document that lists the details of the fund) or on websites that sell the funds.

Different kinds of funds

Discovering what the fund invests in is pretty easy - this is generally prominently displayed in any prospectus or other literature about the fund.  While there are almost unlimited possibilities for what funds can invest in, there are a few major categories:

U.S. stock funds - these funds invest in stocks of U.S. companies.  Some of these funds will invest only in large companies (large cap), medium size (mid cap), or small companies (small cap).  Others will invest according to a certain investment style such as growth (investing in stocks of companies that are growing quickly) or value (investing in stocks of companies that are out of favor and might be underpriced).

Foreign stock funds - these funds invest in stocks of foreign companies.  Some will invest only in certain countries or certain regions and like U.S. stock funds can often be further categorized as growth or value funds and as small, mid, or large cap.

Bond funds - these funds invest in U.S. bonds.  These funds might invest in federal government bonds, high quality (relatively safe with relatively low yields) corporate bonds, high yield or junk (relatively higher risk but relatively higher yield) bonds, municipal bonds, or foreign bonds.

Asset Allocation - These funds invest in both bonds and stocks.

Sector funds - these funds invest in stocks, but only in a certain sector.  For example, they might invest only in technology companies, energy companies, or healthcare companies.

Target date funds - these funds are designed for retirement investing.  They invest in stocks and bonds.  As time goes by and you approach retirement, these funds becomes more conservative by shifting money from stocks into bonds.

Active management vs. passive management

There are two primary methods to manage a mutual fund - actively and passively.  An active fund manager and his team of analysts actively choose the investments that they think are best for the fund.  They will monitor the economy and the market and will buy and sell investments as they feel appropriate.

A passively managed fund, or index fund, simply sets up its fund to mirror a specific portfolio of investments.  This type of fund follows a model portfolio (or index).  The most popular index to follow is the Standard and Poor's 500 (S&P 500).  This is an index of 500 of the largest publicly traded companies in the United States.  It includes companies such as General Electric, Microsoft, General Motors, Amazon.com, and Boeing.

Actively managed funds certainly sound like a great idea.  Who wouldn't want a team of professionals carefully selecting the best investments for them.  However, over the past ten years, the cheapest S&P 500 index funds beat over sixty percent of actively managed funds investing in similar stocks.

Costs

All mutual funds charge annual recurring fees.  Some funds also have a one time sales charge called a load.

Typically a load ranges from 1% - 8% of the amount of money you are investing.  For example, if you invest $1000 in a fund with a 5% load, $950 dollars would be invested in your account and $50 would be kept by the company or salesperson.  Funds without a load are called... wait for it... no load funds. 

Be wary of paying these fees.  When I was a financial advisor I sold load funds.  When my clients purchased these funds the load paid me for my advice and I believe that their money was well spent.  If you chose to invest in funds with a load make sure that you are getting something for your money.

All mutual funds have annual expenses (that come in several different categories).  These expenses pay for the management of the funds, the trading costs, the marketing, and other expenses.  The charges are absolutely invisible.  You never see them taken from your account and you never receive a bill for them.  They only way that you know about them is by reading up.  Both Etrade and Morningstar will tell you the net expense ratio of just about any fund.

These expense range from about .15% on the low end to upwards of 2% on the high end.  Index funds tend to have lower fees than actively managed funds.  This is one of the reasons that so many actively managed funds can not keep up with the cheaper index funds.  While these numbers sound small, they really add up.  Lets pretend that you start investing right out of college at age 22.   For the next 43 years you invest $1,000 a year into each of two different funds.  Both funds earn 10% per year before expenses and one has an expense ratio of 1% and the other has an expense ratio of 1.5%.  By the time you are 65, your investment in the fund with the lower expense ration will be worth $480,000 while the investment in the fund with only .5% higher fees will only be worth $413,000.  So that .5% cost you almost $70,000 over the course of your working life.

Picking the best funds for you

Congratulations, you now know the basics of how funds work and know enough to start picking some funds for yourself.  Here is my final guidance to get you started:

1.  Remember, simpler is generally better.  Don't invest in 18 different funds just because you can't decide which funds are best.  Generally, owing only a few funds is better than owning many funds.

2.  Stick to the basics if you are just getting started.  Invest in a fund that invests in U.S. large cap stocks (such as an S&P 500 index fund) and a U.S. bond fund.  A good rule of thumb is to "invest your age" (as a percentage) in a bond fund, and the rest in a stock fund.  This means that if you are 30 years old, you should put 30% of your investment into the bond fund and 70% into the stock fund.  We will talk about asset allocation (how to divide your money into different types of investments) in more detail in a future post.

3.  Low fees are better then high fees.  Personally, I like both Vanguard and Etrade brand mutual funds.  They are both among the cheapest options out there.

4.  If you are paying a load, make sure that you are getting some value out of it.

That's all for today.  We covered a ton of important info.  If you were not previously, you are now in a position to be a very well-informed investor.  Congratulations on making it this far.  

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