By Dr. James M. Dahle, WCI Founder
[This article published as one of my monthly columns for ACEP NOW and is about how to choose the right mutual fund. Many investors mistakenly skip the pre-requisite steps of setting goals and developing an asset allocation and hope to simply pick some good funds out of their 401(k) to invest in. It's not surprising that their investment returns reflect the fact that they aren't actually following any kind of a reasonable plan.]
Q: How Do I Choose the Right Mutual Fund? I Feel Overwhelmed When I See All of the Funds Available in My 401(k).
A: Mutual funds are an excellent way to invest in stocks, bonds, and other securities. Mutual funds provide for broad diversification, economies of scale, and professional management not available to individual investors selecting securities on their own. This task can be delegated to a competent advisor, but even if you use an investment manager, understanding this process will allow for evaluation of an advisor’s advice and performance.
Prior to evaluating a mutual fund for inclusion in your portfolio, it is important to first complete several prerequisite tasks. These include:
- Setting appropriate goals,
- Developing an overriding investment plan (asset allocation),
- Selecting the most appropriate and tax-efficient combination of investing accounts (such as 401(k), Roth IRA, or a taxable brokerage account).
Deciding on an asset allocation (what percentage of your portfolio to invest in each asset class) can be a difficult decision, but once completed, selecting appropriate mutual funds to fulfill the chosen asset allocation can be ridiculously easy.
How to Choose the Right Mutual Fund in 5 Steps
Step 1: Match Funds to the Asset Allocation
This might seem obvious, but many investors seem to get it wrong. If your hypothetical asset allocation plan calls for 30 percent of your portfolio to be invested in U.S. stocks, 30 percent in bonds, 20 percent in international stocks, 10 percent in real estate, and 10 percent in small value stocks, then you just need to select one fund for each of those categories.
When evaluating a mutual fund, the first consideration is to determine which assets the fund actually holds. If you are looking for a fund for your U.S. stock allocation, you do not want to look at a balanced fund (contains both stocks and bonds) or an all-world fund (invests in both U.S. and international stocks). Likewise, if you want a broadly diversified international stock fund, you can eliminate funds that invest solely in Japanese stocks, European stocks, or Brazilian stocks.
This information can easily be found in the first few pages of the prospectus, on the fund summary page on the fund’s website, or on an independent website like Morningstar.com.
Step 2: Avoid Playing the Loser’s Game of Active Management
All mutual funds are managed by professionals. However, the mission of most mutual funds is to “beat the market”, outperforming an index composed of all of the stocks (or bonds) in a particular asset class. The managers of these active funds try to buy investments likely to go up in value and sell investments likely to go down in value. Although it seems intuitive that highly trained, hard-working professionals could easily do this, it turns out to be extraordinarily difficult to outperform the market in the long run. Very few active managers will do this over any given period, and there is no reliable way to select them in advance.
According to data published in Allan Roth’s How a Second Grader Beats Wall Street, a typical actively managed mutual fund has about a 38 percent chance of beating an appropriate index in any given year. Over five years, that falls to 22 percent, and after 25 years (a typical physician career length), it is just 1 percent. In a five-fund portfolio, the chances are even worse, about 20 percent in any given year and 7 percent after five years.
The solution to this dilemma is to avoid playing the game at all, despite all the time, effort, and money spent by financial institutions trying to get you to do so.
Step 3: Capture the Market Return with Index Funds
There is another category of mutual funds called passive funds, which simply try to capture the market return rather than beat it. Most of these funds are index funds, which try to match the market return rather than beat it.
Highways in Baja could use a little active management.
The main reason index funds have better long-term returns than the vast majority of actively managed funds is that it costs a lot of money to try to beat the market. You have to hire a small army of analysts to meet with company executives and pore through earnings reports. The funds also spend a lot of money on commissions and bid/ask spreads every time the manager decides to buy or sell an investment. Unfortunately, it turns out to be very difficult to generate sufficient excess returns (returns above and beyond what an index fund will provide) on an after-expense basis.
However, because index fund managers just have to match the market return, they rarely have to buy or sell anything. Certainly, they don’t need to spend money on analysts. It can be very inexpensive to run index funds, often less than 0.1 percent per year ($1 on a $1,000 investment). Index funds are also inherently tax-efficient due to their lower turnover.
If the asset class you are trying to invest in is U.S. stocks, you want the investment that will best capture the return of that market—a passively managed fund that owns all of the publicly traded stocks in the United States or at least a statistical representation of them.
Accepting that market returns are likely the best you are going to get is the counterintuitive first step in becoming a successful long-term investor.
Step 4: Keep Mutual Fund Costs Low
Once you realize that active management is a loser’s game, your focus should shift to those things you can control, like investment expenses. In investing, you get what you don’t pay for.
If you are paying 2 percent per year in advisory and management fees, that 2 percent is subtracted from the market return, and over the long run, expenses that high will transfer more than 50 percent of your eventual wealth from your pocket to Wall Street. A portfolio of index funds can be managed for just 0.05–0.20 percent per year. There is no reason to pay five times that much, much less 40 times.
Expense Ratio
Mutual fund fees come in many flavors. The most visible one is the expense ratio, which is the cost of running the fund divided by the value of the assets in the fund. Every fund has an expense ratio, although they vary from 0.02 percent per year to more than 100 times as much. Many mutual funds also charge an additional marketing, or 12b-1 fee, which is often around 0.25 percent. There is no benefit for you to pay such a fee.
Loads and Commissions
Mutual funds sold by mutual fund salespeople masquerading as financial advisors also have loads or commissions. These range from 3–8 percent of your investment.
Some are front-end loads (A shares), paid when the money is initially invested. If you invest $1,000 in a mutual fund with a 5 percent front load, $950 goes into the mutual fund and $50 goes into the pocket of your advisor.
There are also back-end loads (B shares), where the commission comes out when you sell the investment, and C shares, where the load is ongoing in the form of a higher expense ratio.
However, because the best mutual funds have no load at all, there is really no reason to ever buy a loaded mutual fund. If you need investment assistance, pay a fee-only advisor for advice to minimize conflicts of interest. Be aware that most 401(k)s not only charge additional fees, but they are also often filled with loaded, high expense ratio, actively managed mutual funds.
Do your best to avoid the most expensive options when selecting 401(k) funds. Remember that the very best predictor of future mutual fund performance is low fees.
Step 5: Avoid Performance Chasing
Academic studies have demonstrated time and time again that there is no persistence in performance among active mutual fund managers. Actually, that is not entirely true, as the worst managers do persist in being terrible. Investors are notorious for buying high and selling low, dramatically underperforming the funds they are invested in due to their terrible timing.
The solution is to avoid timing the market at all. Rather than choosing a fund (or an asset class) based on its past performance, simply follow your written investing plan. If your plan says 30 percent of the portfolio should be invested in U.S. stocks and due to recent market changes your portfolio is only 25 percent U.S. stocks, then buy some more to rebalance the portfolio. This forces you to buy low and sell high.
Following these five steps when choosing a mutual fund will help you reach your retirement and other investing goals.
When faced with dozens of mutual funds in your 401(k), how do you choose the right one to use? Comment below!
Hate to be a math nazi, but your 0.1% ER example should be $1 on $1000 investment.
Thanks for the correction. How embarrassing.
Apparently ER docs are not as precise with ER math….da dum cha!
My only consolation is that it slipped by my editor too.
I set up my 403 to reflect a 3-fund portfolio, thankfully I have Vanguard options. Over time I will meld my other accounts (roth’s, taxable brokerage) to get a more appropriate asset allocation concerning reit’s and the like. For now I’m doing 80/20 in the 403. I hope to finish Ferri’s book on AA soon
As of right now, in my 403, I’m going with:
SP 500 index
Total Bond index
Total International index
Extended Market index (just 10% of my 403b allocation)
I would hope physicians could determine an AA on their own. On the other hand, if someone had no idea, they should stick with the fund of funds offered (LifeStyle or LifeFund or whatever).
And if someone is totally clueless, I wonder if investing in one or two of the lowest ER funds would work. They’d probably end up in an sp500 index fund and something else, and would probably end up with more in the end than those of us weighing risks and tilts
Perhaps…
I’m a simpleton, I have only a 401K and a Roth. MY expenses are all under .2 except the Legg Mason (its the only small fund offered) and its at 1.1
401K:
20% Vanguard Bond
35% Vanguard Large
15% Fidelity Medium
10% Legg Mason Small
20% Vanguard International
How do you teach asset allocation? It is such a personal thing. How does someone new to index fund investing learn to understand their own risk tolerance? I think the Age in bonds or Age-10 or Age-20 is OK, but in reality people need to understand why they are doing it and they need to understand their emotions. I have yet to find a good article that explains it in a simple easy way. If anyone can reply with a link if you are aware of it, then please pass it along.
In my experience, the best way to read a few books, pick a relatively conservative asset allocation, and then go through a bear market with it. If it was too conservative, you can take on more risk after the bear market. Better to guess too conservative than too aggressive. Any reasonable asset allocation that you can stick with is fine.
https://www.whitecoatinvestor.com/150-portfolios-better-than-yours/
Read anything by John Bogle. Start with Common Sense on Mutual Funds. For more basic, start with The New Coffeehouse Investor.
Asset allocation is not something I would ‘teach’. Typically, what is done to come up with asset allocation is a lot of research on the underlying asset classes. What I typically do to design asset allocation is
1) Come up with a design framework.
a) Decide on how to allocate domestic vs. global vs. emerging markets
b) Decide on the tilts, such as ‘value’/dividends and small-cap stocks
c) Decide how to allocate small cap vs. large cap/mid-cap
d) Decide how much to allocate to fixed income vs. stocks
2) Select actual asset classes. This is based on many factors such as the type of index, cost, tax-efficiency, liquidity.
3) Decide on whether you want to invest in mutual funds vs. ETFs (depending on the type of account/cost, etc). One reason to do one vs. the other is the ease of rebalancing.
4) Create a balanced portfolio, depending on what asset classes are available (inside a 401k plan vs. inside an IRA).
5) When doing a particular asset allocation design, I typically do a very thorough analysis with Morningstar tools to determine such things as the dividend yield, volatility vs. S&P500, historical returns, investment overlap (stocks that overlap), etc.
So I have to say, doing asset allocation is not an art – it is a science. While one can start with a particular philosophy (for example, US is 50% of the world’s stock market, so we allocate 50% to US stocks), or have a preference for a particular tilt (such as dividends or small caps), everything else is more like engineering. The idea is to be as diversified as possible without too much overlap, so that this diversification can help capture market returns across the globe, at the lowest possible cost and with the best efficiency.
I agree it’s more an engineering problem than an art or science.
How should the novice investor know if the mutual funds in your 401k are actively or passively managed? This isn’t a listed category in Morningstar. Is this just an assumption you should make based on expense ratio and turnover?
The fund prospectus will give an idea. The ER can weed out a lot: anything over 0.8 is -likely- active managed (caveat emptor)
Then if you read the prospectus, you will see the goal of the fund. Anytime “benchmark” is mentioned, look to see if it is an index of some sort
I agree with Nate. Take a quick look at the prospectus, especially the investment strategy/investment policy of the fund, the expense ratio, and the turnover ratio. Here’s an example of an investment strategy from the Vanguard Total Stock Market Index Fund:
The fund employs an indexing investment approach designed to track the performance of the CRSP US Total Market Index, which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq. The fund invests by sampling the index, meaning that it holds a broadly diversified collection of securities that, in the aggregate, approximates the full Index in terms of key characteristics. These key characteristics include industry weightings and market capitalization, as well as certain financial measures, such as price/earnings ratio and dividend yield.
Here’s an example of an actively managed fund, the Vanguard Windsor Fund:
The fund invests mainly in large- and mid-capitalization companies whose stocks are considered by an advisor to be undervalued. Undervalued stocks are generally those that are out of favor with investors and that the advisor feels are trading at prices that are below average in relation to measures such as earnings and book value. The fund uses multiple investment advisors.
Which one sounds like an index fund to you?
Or:
The investment seeks to provide long-term capital appreciation through investments in common stocks of growth companies. In taking a growth approach to investment selection, the fund will normally invest at least 80% of its net assets (including any borrowings for investment purposes) in the common stocks of large-cap companies.
Vs:
The investment seeks to track the performance of a benchmark index that measures the investment return of large-capitalization stocks. The fund employs an indexing investment approach designed to track the performance of the Standard & Poor’s 500 Index, a widely recognized benchmark of U.S. stock market performance that is dominated by the stocks of large U.S. companies. It attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.
One clue is the high expense ratio. All index funds are passively managed (some bond indexes are actually actively managed, which is OK). An index fund should cost less than 0.2%, whether Vanguard or Fidelity. There are some gimmicky index funds that charge more inside some expensive 401k plans (usually an S&P500 index). But really, there are only a handful of index funds that are used inside 401k plans. Fidelity’s plans always have some Spartan funds, other plans typically use Vanguard indexes. By the way, even some Vanguard funds are actively managed. The word ‘INDEX’ should be prominent in the title to make sure it is an index fund.
Talking about asset allocation and choosing funds. I have a question about bond funds, I currently use a mix of Vanguard total bond market and some Spartan bond funds (since they are in my 403b options). I read an excerpt from Bernstein’s new book where he talks about bond funds and ETFs and basically says the average investor shouldn’t use either and focus on actual government bonds and CDs. Do most of you use bond funds or actually try and hold treasuries etc…? I find the latter far to cumbersome…
I use bond funds. The convenience factor is worth the tiny ERs. Plus I have access to the G Fund via my old TSP.
Inside retirement plans, bond funds are just fine. While you can lose principal, the idea is that a bond fund acts as a diversifier, so that if stocks go down, bonds go up. Because you are holding your portfolio for a long time, this is acceptable.
As far as using individual bonds, that can be a good idea inside an IRA.
Another point is that many employers who don’t have Vanguard use Fidelity for their 401K. While Fidelity often has higher ERs on the individual side, their Spartan (especially Spartan Institutional Shares) are ofter very competitive (and sometimes even have a lower ER) than Vanguard shares.
Schwab also has some great index funds.
http://www.vanguard.com/pdf/s356.pdf
Dear WCI and fellow bloggers,
Take a look at the attached article by Vanguard regarding low-cost active management. I am particularly impressed by Figure 4, which illustrates that a low cost portfolio of actively managed Vanguard funds can outperform the benchmark portfolio (the indexes) at 15 years. Notably, these are the surviving funds only. But I think my conclusion is that if you select that Vanguard Windsor fund for large value, which has survived long term, you’re not worse off, especially in a qualified plan where the index alternative does not exist, and where you get the cheaper admiral share class.
That’s a good demonstration of the low cost hypothesis. It isn’t so much the indexing, as the fact that keeping costs low matters. However, in order to keep things honest, two things about this study should be pointed out:
#1 The survivorship bias you mention. I would bet that’s good for at least the 0.5% difference being shown for a 15 year period. Remember the longer the period, the more significant survivorship bias becomes.
#2 The active funds are more likely to have a small/value tilt, so they’re not necessarily comparing apples to oranges.
I think I take a different conclusion from this than you may. My conclusion is that there is no point in taking active manager risk when even at ultra-low cost Vanguard, the benefit over 10 years is at best 2 basis points. That said, if someone holds Wellington or Wellesley, (especially with low basis in a taxable account) I probably shouldn’t try to spend a lot of time talking them out of it in favor of “magical” index funds. It just doesn’t matter that much.
The period selection is interesting – you can see that over 10 years there was no difference and over 5 years they underperformed. Also, 0.5% isn’t something I’d be impressed about – this is what I’d call a statistical error. Even if we knew for sure that some Vanguard active funds outperform, there is absolutely no way we can predict which ones will continuously do so over the long term.
Let’s not take more out of this study than the data suggests – we can not form a conclusion based on this data that active Vanguard will benchmarks in the future. I’d stick to a good rule of thumb that over the long term (not 15 years, but more like 20-40 years), index funds will beat most managed funds (statistically, we know that a handful of managed funds will survive and some will outperform index funds, but never in hindsight).
We can talk about Asset Allocation for days.
With Benrstein’s Investors Manifest, he recommends Age=Bond Percentage.
Vanguard’s TDFs recommendations are more aggressive.
For example, someone close to 50:
Bernstein recommends 50% Bonds (average risk tolerance), Vanguard 30% bonds.
WCI investor, for an average investor with average risk tolerance, would you recommend allocations closer to Bernstein or Vanguard?
Is Vanguard being too aggressive?
As a general rule, the key is to choose the most aggressive asset allocation you can tolerate in a massive downturn without going over (like the Price is Right.) That’ll be different for everyone.
https://www.whitecoatinvestor.com/150-portfolios-better-than-yours/
When times are good, more aggressive will look good. When times are bad, more aggressive will look bad.
In the accumulation phase up to 5yrs before retirement my philosophy is, can you tolerate losing 50% of your equity portfolio and sleep well
Near or at retirement you need to be much more conservative to avoid SEQUENCE OF RISK
Hey Jim, are you familiar with Paul Merriman’s “best in class” blog post where he shows the most recommended funds for each asset class? do you have something similar on your site? If you take a look Paul will actually recommend, for example, some small cap value funds that are more small and valuey despite having higher ER’s in the 50-60bps range, over say VBR or FSVIX which have rock bottom ER’s of 7 and 3 bps, respectively. Should docs just keep it simple and choose the funds with the lowest ER’s? Or do you believe Paul is right where the fund that is more pure to the asset class/factor is worth the extra 50bps in ER?
I myself stick with Jack Bogle- fees matter, and I am not spending anymore than 10bps to have my fund/factor fund be more pure, seeing that we don’t know if factors really do have a premium going forward.
also, any total stock market or total international funds in your experience that you should stay away from because they hold too much in cash but fool docs into buying because of low ER’s?
Yes, I’m familiar with that page. I have a post coming up on SV ETFs and which ones I like.
You can have more of a cheaper less valuey/less small fund and get to the same weighting.
Obviously there is a tradeoff between more factors investing and higher costs. The costs are guaranteed and maybe the factors pay off/maybe they don’t. No right answer to your question.
No, I think the TSM/TISM funds from Vanguard, Fidelity, Schwab, and iShares are all fine. I think one of the TISM funds is actually a developed market fund though. Schwab’s I think. So watch out for that.