The first investments that many investors purchase are the mutual funds their employers offer as part of their 401(k) plans. Mutual 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). And 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 good 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.
Mutual funds are not just for 401(k) plans. As you can see by the following chart (Figure 18), as of mid-2018, there were 7,950 mutual funds in the world (and 2,143 ETFs, but more about those in a moment). 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:
The most popular are equity funds. They are just what they sound like: Funds that invest in stocks. They are categorized as follows:
- Large cap (>$10billion)
- Mid cap ($2 – $10 billion)
- Small cap (<$2 billion)
Additionally, each of these categories may be further divided into the following:
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). And 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: 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:
- 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 reducing returns.
Foreign funds offer investors the opportunity to own stocks and bonds of companies outside the U.S. Selections include:
- Global funds may also encompass U.S. stocks and bonds. Of all the foreign investments, they tend to be some of the safest, since many contain U.S. investments.
- International funds have no U.S. 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 unfortunately).
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, is a very risky plan, as nothing stays constant in the market, and your personal risk tolerance can also change often.
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-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 suggest 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 nine so-so years, the 10-year return might look pretty good, but that would not give you the accurate story of the fund.
As well, 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 websites that offer these statistics, but this is one of the best:
Very importantly, please be aware that—just like any other investment—past performance is not a guarantee of future success.
There are several Costs & Expenses associated with mutual funds:
Loads: Some funds charge front-end loads, ranging from 3.75%-5.75% 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 may range from 4%-5.75% of the funds you redeem or cash out, in the first year of ownership, but then may subsequently decline until they reach zero, in about the sixth year.
Some funds do not have front- or back-end loads, and are called No-load funds.
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, it would be wise to pay attention to the next important item on our list…
Turnover: This refers to the frequency of trading undertaken by fund managers. 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.
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 to 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 but it can happen.
You can find all of this fund information on the Morningstar website. And for additional help in calculating mutual fund fees and expenses and comparing them, try this site:
Here are just a few more helpful hints when deciding on the funds you want in your portfolio:
- You might want to avoid smaller funds, as expenses may be 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.
- Think twice before buying the largest funds, as they may be so unwieldy to manage that their returns may not be as good as similar, smaller funds.
- Take a look at the experience and tenure of the portfolio manager. If he is new to the fund, find out if he came from another fund and what his experience and performance was at his former employment.
- 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.
- 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.
All about Exchange-Traded Funds (ETFs)
First pioneered by the American Stock Exchange in 1993, exchange-traded funds (ETFs) have seen their numbers rise by 10% in the last five years, and as my earlier chart shows, there are now 2,143 ETFs in existence.
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 significantly less than most mutual funds. Unlike mutual funds, you buy ETFs through a broker, so you will have to pay a commission. 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 and mutual funds is 0.518% (down from 0.562% in 2016, according to Morningstar), and for ETFs alone, is 0.44%. Some of the largest indexed ETFs have expense ratios near 0.10%.
- Liquidity and transparency. ETFs can be traded all day long, instead of just once daily 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.
- Fewer capital gains distributions. Investment turnover in ETFs is not as frequent as in mutual funds, lending them to lower capital gain distributions; hence, a smaller tax bite for most investors.
Investors can help themselves to market-, dividend-, earnings- and sales-weighted ETFs. You can also find plenty of commodity, country, and sector exchange-traded funds. 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, investors should pay attention to performance, expenses and risk. As with mutual funds, Morningstar rates ETFs with their 1-5 star system, 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.
Three are plenty of additional sites that evaluate and screen for ETFs, but Morningstar’s is one of the best (and oldest):
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 finetune your investing strategy and goals.