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.
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
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.
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!