By Dr. Jim Dahle, WCI Founder

Given how much of my portfolio (85%) is invested in publicly traded traditional mutual funds and exchange traded funds (ETFs), we spend way too little time around here talking about them. While I've written many posts about mutual funds over the years, it might only average out to one per year. There isn't that much to say, and it rarely changes.

But today, I want to talk about how you can evaluate and compare those mutual funds and ETFs if you have questions about where to put your money.

 

Building a Mutual Fund-Based Portfolio

Mutual funds make up the majority of my investment portfolio, and I think that should be the case for most investors out there. There are other ways to invest successfully, but they will require significantly more time and effort. A mutual fund is simply a large number of investors pooling their money together to hire professional management and benefit from some economies of scale.

 

Upsides and Downsides

Mutual funds have a number of sweet benefits you can't get by buying individual stocks, bonds, and properties. These include:

  1. Diversification: Buy thousands of securities in 10 seconds
  2. Pooled Costs: Share the costs of the fund with thousands of others
  3. Daily Liquidity: Buy or sell the entire investment any day the market is open
  4. Professional Management: Don't know what you're doing? No problem. Hire someone for cheap who does
  5. Automatic Reinvestment: While stocks often have dividend reinvestment plan (DRIP) programs, try doing that with a municipal bond or a duplex

Mutual funds have a few downsides as well, and in full disclosure, they ought to be mentioned.

  1. Diversification: It works both ways, your (or the manager's) best ideas get diluted
  2. No Capital Loss Pass Through: While capital losses in the fund can be used to reduce the capital gains passed through, those tax losses that occur on individual securities in the fund won't find their way onto your tax return. You still may get a capital gains distribution whether the fund makes money or not
  3. Management Fees: While they can be very low, they often are not
  4. Loads and 12b-1 Fees: While you don't have to buy a fund with these fees, lots of investors mistakenly do
  5. Manager Risk: The reason you hire a professional manager is because you recognize that you're an idiot. But what if the manager is too?

 

 

Which Is Better: ETF or Index Fund? 

A traditional mutual fund is only traded once per market day at 4pm ET. An ETF can be traded all day long while the markets are open. It is slightly more complex to invest with ETFs than traditional funds, but due to their underlying structure, they can be slightly more tax-efficient than a traditional mutual fund—at least once you step away from the Vanguard mutual funds with their patented ETF share class.

There are good mutual funds and bad mutual funds, and there are good ETFs and bad ETFs. You should not make a decision between them solely based on whether it is a traditional fund or an ETF. I find mutual funds more convenient but tend to use ETFs in a taxable account. I also tend to use Vanguard ETFs when I am investing in a 401(k) or another account at Fidelity or Schwab.

Index funds are a subtype of mutual funds and ETFs. While most ETFs are some kind of an index fund, many of them are just actively managed funds masquerading as index funds. The kind of index fund you want follows a broad-based, capitalization-weighted index in a passive manner, and it's typically very low cost. Index funds are more tax-efficient than actively managed funds, and in the long run, they are likely to outperform the vast majority of actively managed mutual funds. Thinly traded ETFs may have significant bid-ask spreads and market impact costs when traded, but this should not be a factor when using the ETFs typically recommended on this site from providers such as Vanguard, BlackRock (iShares), State Street (SPYDERS), Schwab, and Fidelity.

Learn more about mutual funds vs. ETFs here. For the remainder of this post, I will treat traditional mutual funds and ETFs identically. When I say “fund” or “mutual fund” from here on out, I'm talking about both flavors of mutual funds.

 

Key Factors for Evaluating Funds

When evaluating and choosing funds to invest in, you want to make sure you understand the following factors:

    • What Does the Fund Invest in and How Does It Fit in with Your Other Investments?
    • What Is the Fund Strategy?
    • Who Is Managing the Fund?
    • What Is the Cost of the Fund?
    • What Is the Fund Doing About Taxes?
    • How Has the Fund Performed?

Don't invest in something you don't understand. Know the above, and you'll understand what you are investing in.

 

What Does the Fund Invest In?

The most important thing to understand about a fund is its contents. What are the underlying securities in the fund? You can get this from the mutual fund prospectus and website. I recommend you actually read (or at least skim) the fund prospectus and the annual report for the funds you invest in. The first section of a prospectus usually tells you what the fund objective is. Here is an example from the prospectus of the Vanguard Real Estate Index Fund (VGSLX):

“The Fund seeks to provide a high level of income and moderate long-term capital appreciation by tracking the performance of a benchmark index that measures the performance of publicly traded equity REITs and other real estate-related investments.”

What does the fund invest in? US REITS and other real estate stocks. If you want to add US REITs to your portfolio, this is a good choice. If you are trying to invest in international energy stocks, this is a bad choice.

Rather than going to each mutual fund company website and reading prospectuses, an easier method that is far more standardized is to search the name of the fund (or ticker symbol) and “morningstar.” The first link will take you to Morningstar.com and, specifically, to the page where Morningstar (a mutual fund database company) has compiled a ton of information about that fund in a standardized manner. It might look something like this:

 

Morningstar

 

This first page provides a broad overview. It includes the fund name and ticker, the size of the fund, the expense ratio, the yield, a current price (Net Asset Value-NAV), and a “category” that tells you how Morningstar characterizes the fund. That might tell you all you need to know about the contents of the fund. In this case, it is mostly composed of foreign large blend stocks. To learn more about the fund, click on the “Portfolio” link. It will take you to a page that looks like this:

 

Portfolio 1Portfolio 3

As you can see, this page contains a ton of information, some of which is useful and some of which is not. Some information also requires you to buy a subscription to Morningstar, but in my experience, that's not really the important information. I'm on this page because I want to know what's in the fund, and this page tells me that. In the case of this fund (VXUS), it is a broadly diversified foreign stock fund, owning stocks from all over the world (including Canada but not the US). The fund is dominated by large stocks, and it has no particular “tilt” to small, value, or other factors. The P/E ratio on this fund is relatively low compared to a US stock fund at 12.3. After you compare and contrast a few funds using this Morningstar “Portfolio” page, it becomes second nature to quickly determine what is in a fund.

 

How Well Do Your Investments Work Together?

When building a portfolio of funds, you want to have a plan. Some people think they are diversified because they own four mutual funds. But if those four mutual funds all own the same stocks, it's false diversification. It is complexity without any benefit. If your plan calls for a certain amount in international stocks, it may be that you can use a single mutual fund for that entire asset class. The idea behind portfolio construction is to pick a mix of investment asset classes (US stocks, international stocks, REITs, bonds, etc.) with good returns but low correlation with each other. You want some investments to be zigging while others zag. This will provide higher long-term returns with less volatility and risk. You cannot just pick a fund in isolation. It needs to be part of an overall written investment plan.

If you need help putting one together, consider hiring a real financial advisor or taking our online course entitled Fire Your Financial Advisor.

 

What Is the Fund Strategy?

The name of a fund will often reveal its strategy. Index funds are trying to track an index while actively managed funds are usually trying to beat the market index.  You're usually better off with an index fund. If you can't figure out its strategy from the name of the fund, check the Fund Objective in the Prospectus. If you still can't figure it out, it's an actively managed fund and you can skip it. The cost of the fund is another clue as to its strategy. Good index funds tend to have an expense ratio under 0.20% (often under 0.10%), while most actively managed funds have an expense ratio higher than 0.2%.

comparing mutual funds etfs

 

Who Is Managing the Fund?

When choosing between actively managed funds, the manager matters a lot. You should know who it is and who it would be if that person were hit by a bus tomorrow. This matters much less for an index fund. But I still want to know what company is managing it because, let's be honest, some companies are better at tracking an index, keeping costs down, and minimizing your taxes than others.

You'd better have a very good reason to invest in a fund from a company that is not Vanguard, Fidelity, Schwab, BlackRock (iShares), State Street, Avantis, or DFA. That reason might very well be that you have a crummy 401(k) and don't have the option to invest in funds from those companies. However, a common reason why you might be looking at funds from other companies is that you have mistaken a commissioned salesperson for a financial advisor and that person is showing you the funds that generate the largest commissions for the salesperson rather than the best returns for you.

 

How Do You Evaluate a Fund Manager's Performance?

If you are looking at an active fund manager, you need to compare their performance to an appropriate benchmark index. If they're investing mostly in US large cap stocks, you should compare their performance to a US large cap stock index such as the S&P 500 (with dividends reinvested.) It might be easier to just use a solid index fund for comparison. If they're investing in international small value stocks, you should choose an international small cap index to compare with. The longer the time period you can compare their performance to, the better. You are likely to find that almost all active managers underperform an appropriately chosen index over the long run, especially after-tax. While it isn't too hard to find a manager that beat the index in the past, that performance doesn't tend to persist. Picking a manager that will beat the index in the future is your goal, but as Han Solo says, “That's the real trick, isn't it?”

With an index fund, all you should care about is how well that manager is tracking the index. They should track it VERY closely, within just a few basis points. If they are not, they either suck at their job (less likely since it isn't that hard) or are simply taking too much of the return in fees.

 

What Is the Cost of the Fund?

Costs matter in investing. Unlike most things in life, you get (to keep) what you don't pay for. You're looking for “no-load” funds with low “expense ratios.” If you click on the “Price” tab at Morningstar, you'll see something like this:

 

Cost of Fund

This shows you the expense ratio (0.07% in this case) and an illustration of how much you will pay in fees on a $10,000 investment over one, five, and 10 years. It also tells you how many basis points (a basis point is 0.01%) you will spend on fees over one, five, and 10 years. This particular fund is a very inexpensive one. My portfolio is filled with funds like these. An expensive (i.e. terrible) mutual fund might look like this one:

 

Lousy Expensive Mutual Fund

You're going to pay half your initial investment in fees over 10 years, but I would avoid one that looked even like this:

 

Active mutual fund costs

Why spend $800 in fees when you could spend $80? Watch those costs.

 

What Is the Fund Doing About Taxes?

If you are investing in a taxable account instead of a tax-protected account like a 401(k) or Roth IRA, you really need to pay attention to taxes. That same page at Morningstar (“Price”) gives some tax information. Let's compare two funds that invest in the same kinds of stocks. One is very tax-efficient and one is not.

VTI Tax Cost

BRAGX Tax Cost

You can get more tax information from the “Performance” page at Morningstar if you then click on “Distributions.” For these two funds, you see the following information:

 

VTI Distributions

BRAGX Distributions

I wouldn't necessarily call this second fund a “bad” fund, but if I had to put one into a taxable account and one into a retirement account, it would be an easy decision. Taxes are going to reduce your three-year return by 0.56% in the first case but by 1.06% in the second case. Lower is better. While you may worry about a fund that has a large potential capital gains exposure distributing those gains to you, I actually view it more as the ability of management to avoid distributing gains to me. In fact, the first fund above has not distributed capital gains to investors in more than 20 years. That's very tax-efficient. The second fund has had distributions as high as 10% of the value of the fund twice in the last five years. That's not good.

Mutual funds are also required to report returns in both pre-tax and after-tax (at least for the highest federal tax brackets) returns in their prospectuses. For example, for our first fund, that data looks like this:

VTI tax efficiency

This is a very tax-efficient fund, but it still had its returns reduced by 0.5% per year over the last 10 years even if you never sold it. If you did sell it, the returns were reduced by 2.13% per year. That's the real benefit of investing in a tax-protected account. For the second fund, it looks like this:

BRGAX Tax-efficiency

As you can see, the returns aren't bad (better pre-tax than the first fund actually), but you lose more of them to taxes each year, 1.13% per year vs. 0.45% per year over the last five years.

 

How Has the Fund Performed?

Fund performance matters, but I really only care about the fund performance AFTER I buy a fund, not before I buy it. And there is a reason that every mutual fund prospectus says something like:

“Past performance is no indication of future performance.”

Not only is it a law to put that in there, but it is a true statement. It's a total rookie move to look at your 401(k) and select your portfolio from the two or three funds that did the best last year. That kind of performance chasing almost always results in poor long-term returns.

Thus, I put checking the performance below all of the other factors when I'm choosing between funds. Frankly, since I invest almost entirely in index funds, my goal is for the fund to do as good of a job as possible at matching the index it is trying to match. I'm not looking for it to beat the performance of some other randomly selected fund. That sort of thing is usually just a result of what the fund invests in and its expenses. With an index fund, the following is what matters:

  1. What index does it follow?
  2. How well does it follow it?

That's it. Some indices are better than others, and some companies/managers are better at tracking indices than others. But using index funds really simplifies this whole performance thing. If you really want to see how many angels can dance on the head of a pin, you can compare two good index funds in this matter, and that might help you make a decision between the two. For example, here is VTI vs. FSKAX:

 

VTI Performance

 

FSKAX Performance

Over the last 15 years, VTI has outperformed FSKAX by 7 basis points a year, 8.72% to 8.65%. That's essentially identical, but if you have to choose between the two, why not choose the one that did better? Well, I would actually look a little deeper. If you look at the Vanguard fund on the Vanguard website under its “Performance” tab, you'll see a comparison of how it did compared to what it was trying to do, which according to the prospectus is the CRSP Total Stock Market Index.

VTI Tracking

How'd Vanguard do tracking its benchmark? Basically, Vanguard killed it. Over 10 years, it was within one basis point of the benchmark each year on average. That's awesome, especially considering that benchmark doesn't include any taxes or fees. Fidelity did just as well at following the Dow Jones Total Stock Market Index.

 

FSKAX Tracking

Note that these two comparisons are not the exact same time period. These two funds have performed nearly identically over the last decade despite following slightly different indices.

 

What Measure Is Used to Evaluate and Compare Mutual Fund Performance?

Mutual funds are required to show a standardized time-weighted internal rate of return to their investors. Note that “investor returns”—i.e. “dollar-weighted returns”—are generally lower as investors invest money over time, especially after a period of good performance. In fact, a sign of good investor behavior is when dollar-weighted returns for all of the investors approach the time-weighted returns.

 

Free Mutual Fund Comparison Tools

Morningstar and the mutual fund websites and prospectuses are all available for free. Most brokerage websites also offer a “mutual fund screener” that allows you to compare and contrast funds.

 

Portfolio Comparison Tool

If you would really like to understand what you own, you can analyze your entire portfolio using the Morningstar Instant X-ray Tool. While this is behind a paywall at Morningstar, it is not at TD Ameritrade. It can tell you a lot about your portfolio, such as this X-ray of the classic 3-Fund Portfolio:

Morningstar Instant X-ray 1

Morningstar Instant X-ray 2Morningstar Instant X-ray 3

 

Any investor who hasn't put their portfolio into this tool should do that soon.

 

How the Morningstar Style Box Works

While I have blogged about this before, every investor should also understand how the Morningstar “style” boxes work. You may have noticed them above. On the stock side, it divides the market into large cap, mid cap, and small cap stocks and into value, blend, and growth styles. Three sizes by three styles = nine boxes. On the bond side, it divides the bond market into three categories for quality of bonds and three categories for maturity of bonds. Again, nine boxes. This offers a very quick comparison of mutual funds.

 

Morningstar Style Box Equities

Morningstar Style Box Bonds

 

Top Funds Compared

WCI contributors have compared and contrasted a number of top mutual funds and ETFs. In most of these cases, both funds are excellent choices. When you make similar comparisons in your 401(k), you are far more likely to find stark differences.

Given publicly available, free data that funds are required to provide to you, it is relatively easy to compare and evaluate both traditional mutual funds and ETFs these days.

What do you think? What tools do you use to evaluate mutual funds? Which ones do you invest in? Do you have any favorites? Comment below!