How to Evaluate Mutual Funds

How to Evaluate Mutual Funds

Last week I talked about strategies I try to use to conquer the fear of missing out. Part of that post was focusing on staying the economic course. Part of my course is a focus on buying cheap, index funds. In fact, many personal finance bloggers (it might be most, but not all) also adhere to this rule. Warren Buffett has even argued his financial advice to people would be to stick their money in a low-cost index fund. I figure if it is good enough for the Oracle of Omaha it is good enough for me.

However, even though I promote index funds what index funds should you buy? What should you do if you don’t have index funds in your 401k or 403b? How do you figure this out?

Those are great questions because there are thousands of mutual funds and ETFs (a similar version to a mutual fund). There are hundreds of index funds offered by different providers with different fees, different economic sectors, and different companies. How do you choose from all of these? Here are some guidelines I use in choosing index funds.

Guidelines for Choosing Index/Mutual Funds

*Let me highlight by saying that I am NOT a financial adviser. Before you take any advice here you should do your own research, evaluate your own risk, learn how to read these funds. If need be talk to actual certified financial planner in creating a strategy. The key is to do your OWN research. 

Guideline 1–Long track records. One of the things that I do when choosing mutual funds in my investing portfolio is to look at their track record. Now index funds should have a fairly obvious track record because they basically mirror a financial index (e.g. S&P 500, Dow 30, Russell 2000, MSCI Emerging Markets, etc). So the index fund will basically have the same performance as an index. However, if that mutual fund has been open less than 10 years I don’t even touch it. I want mutual funds, even if they track an index, to have been open a minimum of a decade or longer. It isn’t hard to find the dates when these funds were opened because the fund will list the date, but I don’t buy one that has been open less than a decade even if it is my only choice in my 401k. NOPE, not going to do it.

Guideline 2–Low fees. The great thing about index funds is that they are DIRT CHEAP! The fee for those funds is often less than .2%, which means that it will cost you like 20 cents for every $100. There are some index funds that are .05%. It costs you a nickel for every $100 to invest. Fees are important because some mutual funds and other financial products can have high fees. One of the reasons I don’t like annuities is the high fees that come with them. However, actively-managed funds can have high fees. Fees can cost you tens of thousands of dollars in your retirement account. For example, let’s say you are getting a return of 10% on your investment in a mutual fund, but the fee is 2% per year. That means you lost 1/5 of your investment in one year. Sorry, but I don’t want to give up 20% of my investment return to fees. No way. Over years of having that investment it could be costly.

Guideline 3–Diversification. This example right here can be a little tricky so let me explain why. Financial advisers are always telling us to be diversified in our investments. And that is TRUE. You should be diversified. You should own stocks, bonds, maybe real estate, precious metals (I don’t, but some people like it), etc. Don’t put all of your eggs in one basket. There are some mutual funds where you get instant diversification. For example, the Vanguard Total Stock Market Index Fund essentially buys the entire market, which means that it buys all companies that are publicly traded or at least it buys indices that cover these markets. In fact, there are some people who argue that you only need three funds: A total stock market index fund, a total bond market index fund, and a total international fund. People who are really into Vanguard funds will choose this strategy. That means you own basically a piece of everything for stocks, bonds, and international. That is great. I have that type of fund in my Roth IRA. I own Fidelity’s version of it.

However, I don’t have that kind of mutual fund (a total stock market index fund) in my 401k. I suspect a lot of people don’t have these total stock market index funds in their 401ks. So what do you do? Here is what I do (and it depends on what you have available). Since I want diversification I basically have 3 funds. I have an S&P 500 index fund (which is basically large companies), I have a mid-cap index fund (basically means companies that are growing but are not the big boys yet), and I have a small-cap index fund (these companies are smaller but have a lot of potential for growth). By having all of these funds I basically get diversified in the entire U.S. market.

Full confession: I don’t have bond funds. I don’t mind volatility and I want greater returns so I am ok. However, this depends on your risk tolerance. Just because I don’t have bond funds doesn’t mean you shouldn’t. A good balanced fund can be a good way to mitigate risk if you are little more gun shy.

If you don’t have index funds in your portfolio you can build a portfolio from your 401k fund choices  that focuses on large companies, mid-size companies, and small companies, as well as international. Most 401k plans will have at least those kinds of funds (maybe not index funds). However, look to see what the fees are ahead of time. You can cobble together some diversification by spreading your money around to different types of funds. Don’t put all of your eggs in one basket.

Guideline 4–Risk Tolerance. I guess I already kind of mentioned this, but I encourage everyone to invest, but not everyone is comfortable with investing in the stock market or don’t like its volatility. So you have to determine how much risk you want to take. I mean do you want to just park your money in a cheap bond fund where your returns won’t be much, but your money is safer? Or do you want higher returns but it comes with higher risk? I figure I won’t be tapping this money for at least a decade or so so I can handle risk. I am not afraid if the market goes down because I really believe it will come back. It did after the recession of ’81, the crash of 87, ‘2000, 2007, and other times in the past. I believe in the market. And if it doesn’t come back then we have a whole lot of other problems to worry about.

Guideline 5–Time Horizon. If you are thinking about investing, but think you might want to take this money out in less than 5 years then don’t invest it. Stick it in a CD or a money market account or savings account and just let it sit there. In my opinion if you are going to invest you should do it for the long-term. In other words, I don’t care if I lose 30% one year because most likely I won’t lose that much the following year. Most likely it will actually go up. Not a guarantee, but that is a pretty good likelihood. I want you to be Ron Popeil for investing. Set it and forget it. Now I want you to continually add to your totals, but don’t look at them everyday. Set it and forget it. Take a look once a year or maybe twice, but just keep adding to it and then check it out in 20 years. Investing, particularly for retirement, is about time horizon. The longer you let it sit the more money it will grow. That is why I like investments with long-track records because I can see how well they operate. I have one mutual fund that has been around for 50 years and its track record is pretty good.

Guideline 6–Don’t Have Too Many Mutual Funds. Part of this statement is how much money you have in your account. For example, if you have $5000 it makes no sense to me that some people put $100 in 50 different mutual funds (most won’t even let you do that because they have investment minimums). I only have 5 mutual funds in my entire portfolio across 3 different accounts (401a, 403b, and Roth IRA). I am fine with that. However, the more money you get you might want to mitigate some risk by moving the money around. Maybe instead of 3 or 5 you have 10 with $50,000 in each fund. You determine what is best for you, but don’t get crazy and spread across 100 funds if you have a million dollars. Part of that is because there is redundancy in a lot of those funds. In other words, they have the same stock and/or bond holdings. Why should I own 4 mutual funds that have Apple stock in it when I can just own 1 that does that same thing.

Guideline 7–Passive vs. Active Investing. This guideline focuses on what type of mutual fund do you want. Passive investing is essentially index funds because they mirror a market. You don’t have a manager of that fund who is picking different stocks here and there. They basically buy the index (e.g. S&P 500). Actively managed funds are those that have a manager or a bunch of managers ACTIVELY picking stocks for their funds. Those funds could have hundreds of stocks or just maybe 30 or so. Most mutual funds are actively managed. You have to make the decision if you want those funds. Sometimes those funds have better returns than indexes, but they also come with fees. If you choose actively managed funds look at its prospectus. In that prospectus (basically the guidebook for the fund) it will tell you what it’s fees are, its historical track record of returns, its major investments, who the managers are and how long they have been there, etc.

Full Confession: I own one actively managed fund: Fidelity Contrafund. I could change this and put the money in my S&P Index Fund. However, the fund has relatively low fees and has brought me pretty good returns. In time, I am sure I will move this money to index funds, but for the moment I am ok with having a small portion of my portfolio in this fund. Most of my assets, however, are in index funds.

Guideline 8–Asset Allocation. This is where you have to decide how much money you are going to put into each of your funds. So I have already said you should be diversified across different asset classes and not have too many mutual funds, but how do you divvy up the money? Well, if you follow the 3 fund rule it might be pretty easy. However, I put 50% of my money in large-cap growth funds (e.g. S&P 500 fund), 25% in mid-cap and 25% in small-cap. Some of you might want more diversity and divvy up the percentages equally. Some of you might put all of it in ONE fund (e.g. Total Stock Market Index Fund). I don’t necessarily think you should do that. You could put 80% in stocks and 20% in bonds. And maybe 80% of those stocks are in 50% of x, 25% of x, and 25% of x or reverse it. It is up to you. And it depends partly on your risk tolerance. You should, however, diversify your holdings. And there are some mutual funds that will do this for you. For example, a Target date fund is basically a fund that invests in different indexes and then adjusts the assets and risks overtime. For example, if you choose the 2040 target date fund you are saying that you want to retire in 2040. In 2017, that fund will be weighted more to stocks, but as time goes along they will weight the fund more and more to less riskier assets. Target date funds are fine, but I like to make my own decisions. For others who aren’t as savvy, target date funds can be great products (if they are available to you). Just note that the further the date out (e.g. 2025 vs. 2050) the more volatility of the fund that has a longer horizon. The reason for that is because you are taking more risk for the long-term than the shorter 2025 fund. That is up for you to decide.

There are certainly other guidelines out there, but these are the ones I use in making investment decisions for mutual funds. Remember, mutual funds and ETFs (the kissing cousin of a mutual fund) are NOT the only type of investment. There is real estate, art, precious metals, currencies, beanie babies, pet rocks, whatever. However, I stick with things that I understand and are bread and butter. If you understand real estate…great invest and buy income properties or a REIT (Real Estate Investment Trust). If you think the world is coming to an end put your money in physical gold and silver. Personally, I think the rate of return is horrible, but to each his own. If you want to put your money under your mattress, you probably shouldn’t be reading this blog.

I think passive, index fund investing is the way to go. However, before you make any choices do your own research. Talk with others. Talk with a certified financial planner if you have too, but make sure you do your due diligence. What do you think of the guidelines? Write your comments below.

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