Invest Wisdom

I write a lot in this blog about analyzing companies and company stocks. But the fact of the matter is that most investors, especially those who have better things to do than troll through a balance sheet, should devote most or all of their investments to mutual funds. If you have only a little time to devote to investing or if you have little money to invest, mutual funds can provide you plenty of diversification at a good price.

But unfortunately, picking a mutual fund isn’t as easy as you might think. According to the Investment Company Institute, there were 8,029 mutual funds in the U.S. in 2007, and 66,350 worldwide, not including most funds of funds (such as lifecycle and target-date retirement funds). To put that in perspective, the Fidelity Spartan Total Market Index fund, which is supposed to track the performance of the broad U.S. stock market, only holds 3,193 stocks.

For most investors, the great majority of mutual funds and ETFs are unnecessarily complicated or expensive. Despite that, building a portfolio of mutual funds isn’t hard.

Over the next two days, I’m going to go through the process of choosing mutual funds, whether it be for an IRA, Roth IRA, 401(k), or taxable account. This is going to assume that you’ve already determined what your asset allocation should be. If you haven’t, check out the calculator here for a quick rundown. It’s pretty simplistic, but it’ll give you a place to start.

Today, I’ll discuss the reasons passive, index funds are better choices than actively-managed funds most of the time, and what you should pay attention to with mutual fund fees.

Tomorrow, I’ll address the mutual fund vs. ETF debate and the benefits and drawbacks of funds of funds (including balanced funds).

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If I had to break down my requirements for a mutual fund into as few words as possible, it’d go like this:

Index funds, low fees, no loads.

Simply follow that, and it will be hard to go wrong.

But if you want to see some of the reasoning behind that advice or get into more detail, read on.

* Pick funds with low expenses.

Though there are thousands of funds out there, you’ll dramatically cut down on your choices simply by picking funds with below average fees. As you scan the list of available funds in your 401(k) or use a screener like the one at Morningstar, eliminate any that have expense ratios above 1.5% and red flag any others with expenses above 1%.

According to ICI, the average stock mutual fund in 2008 had an expense ratio of 0.99%. The average bond fund came in lower at 0.75%. Paying above (or even at) those averages just doesn’t make sense in nearly any circumstance when there are so many that can beat those fees.

The great majority of investors should also never pay a front-end or back-end load on a mutual fund. These are common in funds sold by commission-based financial advisers. With a load fund, you have to pay a commission (sometimes up to 5% of your total investment) upfront when you invest, or alternately you have to pay the percentage when you withdraw. Even funds with a share class that charges a load most often have share classes with no load. There are few reasons to pick a load fund. So, don’t.

You should also focus on funds with as little turnover as possible. Turnover is a percentage that measures how many of the holdings inside the mutual fund are changed within the year. Mutual funds that trade often spend a lot on brokerage fees and taxes. Very large mutual funds, which have to buy millions of dollars worth of stock at once, also pay a hidden cost, as their large purchases drive up the price of the stock they’re trying to accumulate.

* Think twice before choosing an actively-managed fund over an index fund.

It’s been well documented that active fund managers—that is, managers who try to pick stocks to outperform the market—underperform the index over time. Last year, the S&P 500 outperformed 72% of large-cap mutual funds.

While mutual funds’ records have been better in past years, picking a winning active fund manager is still a crap shoot. Even those who perform well one year, often underperform in subsequent years, erasing any advantage you had. In addition, active mutual fund managers charge you more than index funds for their expertise. So even if an active fund manager mirrored the index, the passive fund would make you more money, because it charged lower fees.

It’s not clear why actively-managed funds aren’t able to do better than average. Some people point out that since so much of the stock market is controlled by money managers, when you combine their returns, you’d just about have to get an average. When you have a stock market as closely monitored as that of the U.S., it’s also harder to find bargains that others haven’t already found (or so the argument goes). But in the end, the reason doesn’t really matter. The proof’s in the pudding. (Side note: For an explanation as to why I’m not using “proof in the pudding” correctly, see here.)

If you have choices between funds that track the same index, simply pick the no-load fund with the lowest fees. Those run by Vanguard and Fidelity are good, low-fee options. Some of Charles Schwab’s index funds also recently became the low-fee index fund leaders.

So, after all that, you still want to take a look at actively-managed funds? If you insist, take a look at Morningstar.com, enter the potential fund’s ticker symbol, and take a look at the fund’s track record over the last five years. Pay particular attention to the second row, where Morningstar compares the fund’s returns to that of the comparable index. You want a manager who has consistently beaten the index by a substantial margin.

If you’re using the active fund to fill out part of your overall asset allocation, scroll down the “Snapshot” page to see the “Asset Allocation %” of the fund. There you can see how true to the fund’s name the manager stays. The FPA Capital fund, for example, is a stock fund, but right now, its managers have 31% of the fund’s money in cash. That doesn’t mean the manager’s messing up. But it does mean that if you used only that fund to make up the “stock” portion of your allocation, you’d really have nearly a third of your stock money in cash.

It’s a bit of homework, but it’ll pay off if you want to choose an active manager. Even after doing all that work, I’d still devote only a portion of your portfolio (10% or less) to active funds and put the rest in low-cost index funds. You won’t regret it.

Come back tomorrow to read a little bit about the mutual fund vs. ETF debate and funds of funds.

— Joe Light