Mutual Fund & ETF Investing Secrets

How to get the most from your mutual funds and ETFs

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Most investors—new and experienced—own mutual funds and/or exchange-traded funds (ETFs).

Investors who tend to be more passive may create portfolios comprising just mutual funds and ETFs. Active investors generally own individual stocks and may seek to increase their portfolio diversification by owning a selection of mutual funds and/or ETFs. This is especially true in areas in which they do not have expertise and need the guidance of a fund manager and analysts to review and select the best investments in that sector, country, or region.

Either way, ETFs and mutual funds have a place in almost every investor’s portfolio. Unfortunately, many investors don’t understand all the ins and outs of these investment strategies, and often get stuck with funds and ETFs that are underperforming, too expensive, too risky, or just aren’t appropriate for their particular investment goals and risk profile.

Let’s remove the confusion from each of these investments and you’ll see that it won’t take you long before you can easily choose the right mutual funds and ETF to suits your needs.

What are Mutual Funds
The first mutual fund was created as a result of a bailout of the British East India Company. After leveraging itself to the hilt, it sought help from the British Treasury. In stepped Dutch merchant, Adriaan van Ketwich, who sought out subscribers in Europe and the American colonies, to pool their money to help the company, thereby forming the first closed-in mutual fund in 1774. The fund survived until 1824, but it set the stage for the growth of closed-end funds throughout the Netherlands, England, and France, spreading to the U.S. in the 1890s.

In the U.S., the first modern-day and open-ended mutual fund was the Massachusetts Investors Trust, which was created in 1924. It started with $50,000 in assets and grew to $392,000 in the first year, going public in 1928, and eventually transforming into today’s MFS Investment Management.

We’ve come a long way. Today, investors around the world pool their money in some 122,528 mutual funds that hold $54.9 trillion in assets, according to Statista.com. And in the U.S. alone, investors have the choice of 7,945 funds with $21.29 trillion in assets.

This chart shows the total number of mutual funds and ETFs (exchange-traded funds) in the U.S. as of the end of last year. I’ll talk about ETFs in just a bit.

Number of Mutual Funds and ETFs

Source: Morningstar Direct

The operation of mutual funds remains pretty much the same as when they were created. The funds pool money from a group of investors and then invest that money in stocks, bonds, and short-term debt (as well as alternative investments like commodities and gold).

Mutual funds appeal to investors as they offer:

  • entry into investments for generally, small amounts of money;
  • easy portfolio diversification; and
  • investments into companies that have been reviewed and vetted by teams of analysts.

Most of us were first introduced to mutual funds when we were offered the opportunity to invest in our employers’ 401(k) plans. For many investors, these accounts add up to the majority of their investment dollars.

Yet, through my years of helping friends, families and associates make sense out of these programs, I have discovered that many people do not have a complete understanding (and sometimes, none at all!) of just what they are being offered. Instead, they just check off boxes, deposit their money every pay day and hope for the best.

But mutual funds are not just for 401(k) plans. As I said, trillions of dollars are being invested in funds. That’s a lot of money going into a vehicle that most people just don’t quite understand.

So, let’s just zap the mystery right out of mutual funds.

Mutual funds offer a number of categories, investing styles and strategies, including:

Equity funds are the most popular. They are just what they sound like: Funds that invest in stocks. They are categorized as follows:

  • Large cap (companies with total market capitalization*  of >$10billion)
  • Mid cap ($2 – $10 billion)
  • Small cap (<$2 billion)

* Market capitalization is the number of outstanding shares multiplied by the current share price.

Additionally, each of these categories may be further divided into:

  • Index funds are for investors who want funds that follow the broader markets, have lower operating expenses, and lower turnover. These funds offer portfolios constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500).
  • Value funds include equities that are priced low, relative to their earnings potential
  • Growth funds consist of companies with high growth, but also are more volatile and riskier than value stocks and generally priced at a higher premium.
  • Blended funds are a combination of both value and growth equities.
  • Sector funds concentrate on one particular sector of the economy. There are sector funds for just about any industry or subsector of any industry. Oil, energy, financial, pharmaceutical, semiconductors, hardware, software—you name it, there’s probably a sector fund for it. While the concentration in one industry can bring fabulous rewards, it can also cause significant losses, making these funds more appropriate for investors who can handle more-than-average risk.

Bond funds, which invest in fixed-income securities, are also very popular, especially for investors who are more conservative with their money. These funds are available in short-term (< 5 years), long-term (>10 years) or intermediate-term (5 – 10 years). Bond funds come in a few varieties also:

  • Government and government agency: The ‘safest’ (in terms of recouping your principal), but generally pay the least amount of interest.
  • Municipal: Often referred to as “munis”, these bonds issued by state and local governments and their agencies, in the form of general or revenue issues. Tend to be fairly safe, but investors should pay attention to their bond ratings before investing. For easy access to the major bond rating firms’ rankings, go to: https://www.sec.gov/ocr/ocr-current-nrsros.html
  • Corporate: Bonds issued by corporations and tend to pay higher interest than governments or munis. May be safe or risky; ratings should be checked.
  • High-yield: Pay higher returns, but also tend to be much riskier than investing in regular corporate, government or municipal bonds. Investors should pay heed to their ratings.

Balanced funds may include a combination of equities and fixed income investments, ‘balancing’ out risk, but also balancing the returns.

Foreign funds offer investors the opportunity to own stocks and bonds of companies outside the US. Selections include:

  • Global funds may also encompass US stocks and bonds. Of all the foreign investments, they tend to be some of the safest since many contain US investments.
  • International funds have no US investments, and they run the gamut from safe to risky
  • Country-specific funds will generally invest in one specific country or region and can be very volatile.
  • Emerging market funds invest in undeveloped regions of the world. They can offer tremendous growth, but also significant risk.

Money market funds tend to be very safe since they invest in very short-term securities, but also offer fairly low returns (there have been some notable exceptions to this primarily due to fraud so be wary of any money market fund claiming high rates of return).

 Alternative funds (alt funds) invest in non-traditional investments, such as global real estate, start-up companies, or commodities such as gold or oil.

Additionally, more mutual fund categories have evolved in recent years, including:

Target-date funds in which you choose one fund to diversify your investments in stocks, bonds, and cash (the allocation) throughout your working life. The fund’s name includes a date—your targeted date for retirement. And it is managed by a professional manager who has the discretion to buy and sell, according to your age (younger folks get more aggressive investments). But be aware, these funds often come with higher fees, and sometimes, more risk than you desire.

Lifestyle funds also have a targeted date, but your allocation to different investments is based on your risk tolerance and remains constant throughout your time frame. This, of course, in my opinion, would be a very risky plan, as nothing stays constant in the market, and your personal risk tolerance can also change often.

Ok, now you have a handle on the major categories of funds. To prepare for your selection, you will need to consider your time frame for investing (i.e., how long before your retirement) and then make a decision as to just how risk-tolerant or risk-averse you are, so you can determine the types of funds and strategies with which you would be most comfortable, and also consider the parameters for evaluating your funds.

Evaluating Your Mutual Funds
As with any investment, several critical factors must be examined:

Performance: The funds’ actual returns (investment appreciation + dividends) are key comparison measures. In a great market, a large percentage of mutual funds will do well; that’s why it is extremely important to look at a fund’s returns over a multi-year period. I would suggest that you compare returns on a 3-year, 5-year and 10-year basis. And it is best to look at the annual numbers, not the cumulative figures, as they will disguise the true fund returns and won’t tell you a thing about the consistency of the performance. For example, if the fund had one really great year, but 9 so-so years, the 10-year return might look pretty good, but that would not give you the accurate story of the fund.

Morningstar.com offers ratings (1 to 5 stars) on mutual funds, based on how well they’ve performed (after adjusting for risk and accounting for sales charges).  There are many web sites that offer these statistics, but Morningstar is one of the best:  morningstar.com/funds.html

Very importantly, please be aware that—just like any other investment—past performance is not a guarantee of future success. Funds can have changes in management, philosophy, or just make some bad judgements.

Costs & Expenses: there are several associated with mutual funds:

Loads:

  • Some funds charge front-end loads, ranging from 5.0%-8.5% of the monies you initially invest. Note that funds may also charge a front-end load for reinvesting your dividends back into the fund.
  •  Back-end loads range from 5% (and up) of the funds you redeem or cash out, in the 1st year of ownership, but then may subsequently decline until they reach zero, in about the 6thyear.
  • Some funds do not have front- or back-end loads, and are called No-load funds.
  • Level Loads are ongoing “level” percentages”, such as 1.00%, that the investor pays to the mutual fund company. Like front-end loads and back-end loads, level loads are not fees paid directly out of the investor’s pocket to the investor. Instead, this fee actually comes out of your gains, reducing your net returns.

Expense ratios: These expenses are the cost of doing business, and include administrative and management fees. They are calculated as a percentage of net assets managed. And while they have been declining (mostly due to the proliferation of less expensive ETFs), the current average for actively-managed funds is 0.5%-1.0%, but may go as high as 2.5%.

12b-1 fees: These fees are marketing and distribution expenses. They are included in the fund’s expense ratio, but often separated out as a point of comparison. They are charged in addition to loads, and even no-load funds may have them.

Taxes: When a fund manager sells a stock from the fund at a profit, the gain is taxable. Short-term gains (for investments held less than one year) are taxed higher, at your individual income tax rate, while long-term gains (for investments held more than one year) are currently taxed at an approximate 15%-20% rate, depending on your income. Many investors tend to forget about taxes on funds since they aren’t privy to the fund manager’s everyday buying and selling of investments and the losses and gains accrued and are often surprised by the tax bite at the end of the year. Consequently, pay attention to the next important item on our list…

Turnover: This refers to the frequency of trading undertaken by the fund manager. The more buying and selling they do, the higher the turnover, and the greater the potential tax bite. This is another area in which index funds are advantageous, as their managers generally trade less than actively-managed funds, so they usually accrue lower tax bills. And one more thing you need to know about mutual funds that can really bite into your returns is this:

  • If you hold shares in a taxable account, you are required to pay taxes on mutual fund distributions, whether the distributions are paid out in cash or reinvested in additional shares. The funds report distributions to shareholders on IRS Form 1099-DIV after the end of each calendar year.

For any time during the year you bought or sold shares in a mutual fund, you must report the transaction on your tax return and pay tax on any gains and dividends. Additionally, as an owner of the shares in the fund, you must report and potentially pay taxes on transactions conducted by the fund, that is, whenever the fund sells securities. And because funds will often ‘clean up’ their portfolios at the end of the year, you can end up paying taxes on the sale of any securities in the fund that they dispose of, which can increase your tax liability.

Portfolio Strategy is of utmost importance when comparing funds. It will do you no good to compare the returns and expenses of a growth equity fund with that of a bond fund; you must compare apples with apples.

And one warning: It would be to your benefit to double-check the funds’ holdings and see if they are in line with the stated portfolio strategy. I’m rarely surprised to find the majority of holdings in something other than what the fund’s prospectus dictates.

You can find all of this information on the Morningstar web site. And for additional help in calculating mutual fund fees and expenses and comparing them, try this site:  sec.gov/investor/tools/mfcc/get-started.htm

Finding Potential Funds
If you’re not sure where to start, these sites can help you screen for the types of funds you might want in your portfolio. You can enter the parameters that you are seeking (low expenses, loads, high returns, etc.) and you’ll get a choice of funds to consider:

finance.yahoo.com/screener/mutualfund/new/

personal.vanguard.com/us/FundsMFSBasicSearch?FROM=VAN

Finally, just a few more helpful hints when deciding on the funds you want in your portfolio:

  1. You might want to avoid smaller funds, as expenses may be too high. For the same reason, steer clear of new funds unless they are part of an established fund family, as investors often find themselves subsidizing a new fund’s startup costs.
  2. Think twice before buying the largest funds, as their sheer size may make them so unwieldy to manage that their returns may not be as good as similar, smaller funds.
  3. Take a look at the experience and tenure of the portfolio manager. If he or she is new to the fund, find out if they came from another fund and what their experience and performance was at their former employment.
  4. Compare the holdings in the fund’s portfolio with similar funds, as well as with the other funds you are considering. I have often found that many funds overlap their holdings and investors are frequently investing in very similar funds although their stated strategies may be very different. Here are a couple of sites that allows you to compare your funds:
    personal.vanguard.com/us/faces/JSP/Funds/Compare/CompareEntryContent.jsp and fidelity.com/calculators-tools/investing/search-compare-investments
  5. Beware of funds that rationalize their high costs just because of the type of funds they are. For example, the expenses at some growth funds are higher than value funds, for no reason that I can come up with. Similarly, sector funds often cost an investor more than diversified funds, which, since they must take fewer experts to run them than a fund covering more industries, absolutely makes no sense.
5 Sites for Mutual Fund Research
Refinitiv Lipper: refinity.com
Morningstar: Morningstar.com
Kiplinger: kiplinger.com/kiplinger-tools/investing/t041-s001-top-performing-mutual-funds/index.php?table_select=intlsm
Max Funds: maxfunds.com/
MarketWatch: marketwatch.com/investing/mutual-funds

What are ETFs (Exchange-Traded Funds)?
The first ETF—the S&P Depository Receipts Trust Series 1 or “SPDRs” was pioneered in 1993, by the American Stock Exchange (Amex)”, with the symbol SPY’. As you can see from the graph below, in the last 15 years, the growth of ETFs has really taken off, and today, there are 7,058 ETFs in existence around the world.

10 Year ETF ETP CAGR

Source: ETFGI.com

An ETF is a basket of investments that track a stock index, a commodity, bonds, or a diverse group of assets. For the most part, ETFs offer the same type of diversity as mutual funds, allowing you to choose different investment strategies and goals.

But there are some significant differences between ETFs and mutual funds, including:

  • ETF expenses are usually significantly less than most mutual funds. Trading in ETFs does require a broker. However, the total expenses (unless you are an active trader—and if that’s the case—you shouldn’t be in ETFs), are, on average, much lower than the expenses of mutual funds investing in similar asset categories. The average annual expense ratio for ETFs is 0.44%, compared to 0.55% for mutual funds. But they generally range from 0.5%-0.75%.
  • Liquidity and transparency. ETFs can be traded all day long like a stock, instead of just once daily as is the case for mutual funds. You buy and sell them just like stocks. And unlike mutual funds, with ETFs, you can use limit orders; you can sell them short; and you can trade options on them.
  • Less capital gains distributions. Investment turnover in ETFs is not as frequent as in mutual funds, lending themselves to lower capital gain distributions; hence, a smaller tax bite for most investors.

Investors can help themselves to market (index)-, dividend-, earnings- and sales-weighted ETFs. You can also find plenty of growth, value, conservative, aggressive, balanced, or income funds. And if you are looking to diversify into commodities, countries, regions of the world, or by sectors or industries, there’s an ETF ready for your money.

One advantage of buying a foreign-based ETF instead of the individual shares of a company in a different county is that the ETF managers will have ‘boots on the ground’, analysts who live and work in that region or country, who are well-versed on the economics, geopolitical, and accounting of that country or region. As for sector-based, investors can easily find ETFs for virtually any sector or industry, including technology, financial, consumer cyclical, consumer staples, utilities, energy, natural resources, healthcare, real estate, and precious metals. And note that each of these can be subdivided into even smaller sectors. For example, technology ETFs could be found for companies generating their income from the cloud, software, internet, or mobile communications.

Actively-managed ETFs are growing in popularity, and during the economic woes of the recession—with sectors like housing and financials under fire—short ETFs grew considerably.

To evaluate an ETF, as with mutual funds, investors should pay attention to performance, expenses, and risk. And like mutual funds, Morningstar rates ETFs with their 1-5 star system (with 5 being the best), based on the fund’s past performance, the fund manager’s skill, risk- and cost-adjusted returns, and performance consistency. The ETFs are evaluated for up to three time periods: three, five and 10 years, and then combined to create an overall rating for the fund. Morningstar does not evaluate funds with less than three years of history.

There are plenty of sites that evaluate and screen for ETFs, including these favorites:

morningstar.com/etfs.html?TID=1
seekingalpha.com/etfs-and-funds/etf-screener
screener.fidelity.com/ftgw/etf/evaluator/gotoBL/research#/home

Additionally—just as with mutual funds—the same investigation as to portfolio manager tenure and the composition of the fund should be analyzed.

Mutual funds or ETFs—it’s up to you, whichever you prefer. Many investors have both. And with mutual fund fees declining (to make them more competitive with those of ETFs), you have a very wide choice of funds and ETFs in which to fine tune your investing strategy and goals.

To help get you started, I did a search for funds and ETFs with low expenses/loads, good multi-year returns, and 5-star Morningstar ratings. These include broad-based index funds, sector funds, and international funds. I hope you find something here to your liking!

Broad-based (index funds)
Both of these funds/ETFs seek to emulate the returns of the S&P 500 Index.

  • S&P 500 ETF Vanguard (VOO), seeks to replicate the stocks in the S&P 500 index, has an expense ratio of 0.03%, and a 3-year average return of 10.4%.
  • Schwab S&P 500 Index Fund- Select Shares (SWPPX), seeks to replicate the stocks in the S&P 500 index, with an expense ratio of .02%, and a 3-year return of 10.39%.

Sector Funds
Two of the best-performing sectors this year are technology and healthcare. Here are two ideas to consider:

  • Fidelity Select Communication Services Portfolio (FBMPX) seeks capital appreciation. The fund normally invests at least 80% of assets in securities of companies principally engaged in the development, production, or distribution of communication services, expense ratio of 0.78% and a 3-year return of 15.62%. Top five holdings include: Alphabet Inc A (GOOGL), Facebook Inc A (FB), T-Mobile US Inc (TMUS), Liberty Broadband Corp A (LBRDA), and Netflix Inc (NFLX).
  • SPDR S&P Health Care Equipment ETF (XHE), seeks to include investments that correspond generally to the total return performance of an index derived from the health care equipment and supplies segment of a U.S. total market composite index. Its expense ratio is 0.35% and its 3-year return is 15.27%. Its top five holdings include: Quidel Corp (QDEL), Staar Surgical Co (STAA), Align Technology Inc (ALGN), OraSure Technologies Inc (OSUR), and Penumbra Inc (PEN).

International Funds
The best returns this year, internationally speaking, include the Pacific region of the world. These funds/ETFs are region-based funds from the Far East.

  • Fidelity Pacific Basin Fund (FPBFX) seeks growth of capital over the long term. The fund normally invests at least 80% of assets in securities of Pacific Basin issuers and other investments that are tied economically to the Pacific Basin. Its expense ratio is 0.97% and its 3-year return is 9.58%. Its top five holdings include: Alibaba Group Holding Ltd ADR (BABA), Tencent Holdings Ltd (00700), Taiwan Semiconductor Manufacturing Co Ltd (2330.TW), Fidelity Revere Str Tr (N/A), and AIA Group Ltd (01299.HK).
  • Invesco Golden Dragon China ETF (PGJ) seeks to track the investment results (before fees and expenses) of the NASDAQ Golden Dragon China Index. The fund generally will invest at least 90% of its total assets in the securities that comprise the underlying index. The fund’s expense ratio is 70% and its 3-year return is 8.91%. Its top five holdings include: Baidu Inc ADR (BIDU), Alibaba Group Holding Ltd ADR (BABA), JD.com Inc ADR (JD), TAL Education Group ADR (TAL), and NetEase Inc ADR (NTES).
5 Sites for ETF Research
ETF.com: etf.com
ETF Database: etfdb.com/
Morningstar: Morningstar.com
Vanguard: vanguard.com/etf
Yahoo Finance: finance.yahoo.com/etfs?ltr=1

Summary of Best Online Brokers for ETF Investing 2020

Broker NerdWallet Rating  Commissions Promotion Account Minimum
Merrill Edge 4.5/5

Best for Hands-On Investors

$0

per trade

Up to $600

cash credit with qualifying deposit

$0
E*TRADE 5.0/5

Best for Hands-On Investors

$0

per trade

None

no promotion available at this time

$0
TD Ameritrade 5.0/5

Best for Hands-On Investors

$0

per trade

None

no promotion available at this time

$0
Wealthfront 5.0/5

Best for Hands-Off Investors

0.25%

management fee

$5,000

amount of assets managed for free

$500
SoFi Automated Investing 4.5/5

Best for Hands-Off Investors

0%

management fee

Free

career counseling plus loan discounts with qualifying deposit

$0

Source: Nerdwallet.com

Summary of Best Brokers and Robo-Advisors for Mutual Funds 2020

Broker NerdWallet Rating  Commissions Promotion Account Minimum
Merrill Edge 4.5/5

Best for Hands-On
Investors

$0

per trade

Up to $600

cash credit
with
qualifying
deposit

$0
E*TRADE 5.0/5

Best for Hands-On
Investors

$0

per trade

None

no
promotion
available at
this time

$0
TD Ameritrade 5.0/5

Best for Hands-On
Investors

$0

per trade

None

no
promotion
available at
this time

$0
Vanguard Personal
Advisor Services
5.0/5

Best for
Robo-Advisors
for Hands-Off
Investors

0.30%

management fee

None

no
promotion
available at
this time

$50,000
Ellevest 5.0/5

Best for
Robo-Advisors
for Hands-Off
Investors

$1 – $9

per month

2 months free

with promo
code
“nerdwallet”

$0

Source: Nerdwallet.com

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