Financial Freedom: All About Mutual Funds
Mutual funds are professionally managed pools of money gathered from a variety of investors. The manager of that mutual fund then takes that collective capital and invests it in investment securities and does so for an annual fee. The manager will buy and sell securities and manage the investment funds according to the fund’s investment objectives as delineated in that mutual fund’s prospectus.
Mutual funds are, for the average individual, far and away the best investment vehicles for stock and bond investing. Purchasing a handful of individual stocks or bonds on one’s own is risky because the average individual often lacks the investment capital and the knowledge, experience, and interest necessary to select a diversified stock or bond portfolio that will be successful over the long term. The keys to active stock and bond investing over the long term are diversification and quality selection backed by professional research and experience. Mutual funds provide both of these keys with a minimal amount of investment capital required.
There are mutual funds available for virtually every asset class and every niche within each and every asset class. Wading through the universe of mutual funds is taxing and attempting to include every single asset class and a multitude of mutual funds in one’s investment portfolio for the sake of broad and expansive diversification is cumbersome and, in my opinion, the burden of such a stratagem far outweighs the diminutive benefits. There are a number of individuals who own a dozen or more mutual funds and a number of bizarre and exotic investment securities which simply serve to add layers of complexity without any additional benefit of any lasting significance. I wanted a portfolio that was simple, but effective without the added burden of constant monitoring and constant adjustment.
In relationships, some of us have made the mistake of dating tremendously good looking and high maintenance men and women only to find them needy, self-absorbed, and in need of constant attention. We loved to look at them the first week or two, and having them on our arms was a point of pride and we couldn’t wait to take them out to social functions and discuss them with friends and family. We loved to talk about how we came to be in the company of such beauty and doling out tips on how others may likewise find such good fortune served to fuel the hubris. But, eventually the constant attention and the neediness dulled the radiance and what we were once enamored with ultimately became a tremendous burden that sucked the joy out of dating. With the passage of time, the burden outpaced the diminishing returns.
Many of us however have also had the good fortune of finding men and women who were low-maintenance. Their beauty may not have been as obvious and ostentatious as the high-maintenance variety, but the fact that they were not extracting from us so much energy and attention added to their beauty. They were not necessarily points of pride or topics of conversation, but they were partners in something deeper and more fundamental in stark contrast to the superficial and shallow relationships we had entered into previously on a whim or an intuition. With the passage of time, the compounding returns outpaced the diminishing burden.
Likewise, there are those who follow the hot tip and commit the mental folly of equating complexity with efficacy. I am of the opinion that for most average individuals the time and energy devoted to complex portfolios and investment products and schemes are resources wasted without any concrete benefit to justify the squander. What I did and what I outline here is not sexy. This is not a portfolio you will want to brag about at parties and it may not generate short-term returns that you’ll want to staple to your face. But, in the long run, this is a stratagem that will beat the high-maintenance variety nine times out of ten with a fraction of the time and energy input. An individual’s time and energy as it relates to their finances is best devoted to eliminating or drastically reducing their expenses and making efforts to maximize their income. Their investment portfolio should be stable, simple and effective so that the time and energy spent on increasing investment outlay will prove to be time well spent. If an individual’s investment portfolio becomes a source of consternation, resentment or confusion, more likely than not, it is because they have succumbed to the siren song of short-term greed only to be disillusioned in the long run.
Two Mutual Funds
1) S&P 500 Index Fund
2) Intermediate-Term US Bond Market Index Fund
I chose to place 100% of my investment capital into stocks. I have not invested any of my investment capital into bonds as of yet. Again, I intend to do so the closer I get to retirement and by the time I do retire I anticipate having close to 100% of my investment portfolio in bonds.
Actively Managed Mutual Funds v. Index Funds
Mutual funds that invest in stocks and bonds fall under two broad categories generally: actively managed funds and index funds.
Actively managed mutual funds have a fund manager who invests selectively in the stocks or bonds he or she believes will achieve the highest returns for their shareholders. For actively managed mutual funds, the manager’s expertise, judgment, and long-term historical record are important. Because the returns of that actively managed mutual fund are determined entirely by the fund manager’s selection, he or she better be good at picking stocks and bonds.
Index funds likewise have a fund manager, but that manager’s job is simply to buy a representative basket of stocks and bonds to mimic the returns of whatever index or benchmark they are meant to follow. So, for example, if one were to buy shares in an S&P 500 index fund the objective of that index fund is to match the returns of the S&P 500. Because the returns of the index fund are determined entirely by the performance of the index, the manager’s judgment and selection are not nearly as critical as the performance of the underlying index.
Why Index Funds are Better
First, they are far cheaper than their actively managed brethren. For the most part, actively managed mutual funds charge upwards of ten times more than what index funds charge to manage investment capital. That’s not surprising as running an index fund is far less capital intensive than running an actively managed mutual fund.
Second, research has found that two-thirds of all actively managed US stock mutual funds fail to beat the S&P 500. What does that mean practically? The odds are that the actively managed US stock mutual funds most people are currently investing in do not do as well as an index fund and yet they charge their shareholders ten times as much in annual fees.
It is very difficult to beat the market. There is so much readily available information and the market has become so efficient at converging all of that information to generate a stock’s price that attempting to gain an edge on the market by searching for some piece of esoteric information the market has overlooked is often an exercise in futility. More often than not, the only way to obtain such esoteric information is to get it from those on the inside, but trading on that information is illegal. Unfortunately, for those who desire to pick individual stocks or select money managers who will, the market is only getting more efficient with the internet and the growing transparency of a company’s financial information. The best bet for the vast majority of average investors is to stop kicking against the goads and simply bet on the market and not on a fund manager.
But, you say, there are money managers who have beaten the market over the long term. Why can’t I just find them and give them my money? First, money managers who have beaten the market over the long term are exceedingly rare. Money managers who will continue to beat the market over the long term are rarer still. Second, if you do find a money manager who has a long-term record of beating the stock market time and time again and do decide to invest your money with him or her you have to stay vigilant because if they ever lose their “edge” or leave the mutual fund you have to be ready to pull out all of the money. Moreover, the more success this money manager has the more popular the mutual fund becomes and the more money it attracts. It becomes increasingly difficult for a money manager, no matter how talented, to continue to beat the market with an asset base that continues to grow. There are only a limited number of stocks that give this money manager an edge and a limited percentage of capital, by law, that he or she can invest in those companies. Thus, having to generate more stock picks with an ever-expanding asset base is dilutive to the fund’s returns. The larger the mutual fund becomes, the more stocks it has to buy. Thus, the greater the asset base the more likely this actively managed mutual fund becomes like an index fund. If a mutual fund’s asset base continues to grow unchecked, it matters very little how talented a money manager is, because you can’t deviate from the mean if you are the mean.
Finally, not only do these money managers have to beat the market, which is incredibly difficult, but they have to beat the market handily. Again, actively managed mutual funds charge upwards of ten times as much as index funds do. Thus, not only must this manager beat the market over the long term, but they have to beat the market by the spread – which is represented by the difference between what he or she charges you to invest with him or her and what an index fund would charge to invest your capital. In many cases the spread is 1% or more. If beating the market is incredibly difficult over the long term, beating it by 1% or more over the long term is virtually impossible.
How to Select Actively Managed Mutual Funds
If you insist on selecting actively managed mutual funds or you have no choice because your employer sponsored retirement plan does not have an index fund option then here is how I evaluate actively managed mutual funds.
First, I go to www.morningstar.com. In my opinion, this is far and away the best resource on the internet for mutual fund selection. The website also has a list of the top performing mutual funds over a 10-year period. They can screen the top performing funds for a variety of asset classes.
Second, there are several criteria I evaluate in selecting an actively managed mutual fund. In order of priority:
1) 10-year annualized returns
2) Expenses and Fees
3) Turnover Ratio
10-year annualized returns
The 10-year annualized return for any mutual fund is available on the Morningstar website. For most US stock funds they also provide a comparison of how this stock fund did relative to the S&P 500 over that same 10 year period. Obviously, you want to select a stock fund that beat the S&P 500 over the long term and you want to make sure the fund actually beat the spread based on the fund’s expenses.
Expenses and Fees
Every mutual fund has annual expenses. The mutual fund company takes their annual expenses from the mutual fund’s assets. I never buy into a mutual fund that has an expense ratio of 1% or higher. There are also mutual funds that charge fees above and beyond the expense ratio. Some charge “load fees” which are fees charged to the investor every time they purchase shares in the mutual fund. There are some mutual funds that also charge a redemption or withdrawal fee every time an investor withdraws money or redeems their shares in the mutual fund. There are still others that charge sales loads, 12b-1 fees etc. I never buy any mutual fund that charges a “load fee” or any other fee beyond the expense ratio. Index funds typically have the lowest expense ratios and I am unaware of any index fund that charges fees beyond the expense ratio.
Turnover Ratio
The turnover ratio is generally only important for those mutual funds you invest in for taxable accounts. If you invest in mutual funds within a tax-sheltered account you typically need not worry about the turnover ratio. The turnover ratio is the percentage of a mutual fund’s assets that have changed over the course of a period of time, usually a year. Why is this important? When a mutual fund sells a stock for profit it has to return that profit to the investor by way of capital appreciation every year and the investor has to pay taxes on that money. If a mutual fund simply holds on to the stock and never sells it that stock gain is reflected on the investor’s scorecard but never actually realized, so the government cannot take their cut. When a fund’s turnover ratio is high (i.e. 50% or more) this means that this mutual fund is selling and buying stocks at a relatively rapid pace and therefore the investor can expect to receive capital appreciation or profit from the sale, and therefore the investor will have to pay taxes on that money. Ideally, I want a mutual fund that has long-term conviction in the stocks it purchases for the shareholders and I want gains that cannot be touched by the government until I decide to pull the money out. Index funds, as you can imagine, have a very low turnover ratio.