Mutual Fund Investing Is Not Rocket Science

by Vered DeLeeuw · 13 comments

It drives me crazy to see personal finance articles and blog posts recommending mutual funds that no one should ever buy. You know, those mutual funds that are very lucrative for the broker who sells them (because of sales charges) and for the fund manager (because of high expenses), but are in no way a good deal for you.

It’s especially infuriating, because while I accept that investing in individual stocks requires a fair amount of research and knowledge, the basics of mutual fund investing are not that complicated. Perhaps the concept of asset allocation is a bit more complex (although by no means impossible to learn), but anyone can learn how to pick a good mutual fund. Here are the basics:

Absolutely No Sales Charges!

This is one thing that I feel extremely strongly about. Sales charges – usually called front-end load or back-end load, are something you should never agree to. If you buy through a broker, ask them. If you place your own order, check the fund’s info on Morningstar.com to make sure there’s no load. Studies show that load funds do NOT perform better than no-load funds. Why would you pay 5% of your total investment, often upfront, getting nothing in return? It’s outrageous.

Low Expense Ratio

An expense ratio is the annual fee levied by the fund. You probably know already that statistically speaking, managed funds do worse than cheap index funds, and that the explanation is, most likely, the higher expenses the managed funds charge. Higher expenses erode the profits that investors make. Rare is the managed mutual fund whose manager is so talented that the fund performs so much better than the overall market to justify and balance out its higher expenses.

Just as in the case of loads, why would anyone pay 2% annually, when they can pay half that – or less  – and get the same (or better) results? Personally, I do not own any funds with an expense ratio higher than 1%, regardless of how fabulous they supposedly are.

A Low Turnover

This is not an issue if you hold your investments in a tax-deferred account, but a high turnover – where the fund manager sells the fund’s assets often and replaces them with new ones – means a higher capital gains tax bill for you with taxable accounts, even if you haven’t sold the fund. A good starting point is to aim for a turnover of 50% or less.

An Experienced Manager

You want to buy funds that are managed by seasoned, talented managers. Morningstar.com provides you with information about each funds’ manager, or management team.

Past Performance

Sure, past performance is no indication of future results, but I still like to see how the fund I’m evaluating has performed compared with its peers over the past decade. I’m especially interested in seeing how it did in a bad market (such as 2008) and in a good market (such as 2009). Any fund that consistently under performs its peers is likely not a good choice.

Minimum Cash Holdings

A fund that holds a lot of cash may under perform in a bull market. When I invest in a fund, I expect the manager to invest my money in stocks. Holding money in cash is something I can do by myself, thank you very much.

To sum it up, a no-load, low-cost fund, managed by an experienced manager, that has a low turnover, low cash reserves and consistently outperforms its peers, is a good place to start.

Just as a quick reminder, I am not a financial planner so you should definitely do your own homework prior to making any investment decision.

I would love to hear your own thoughts on mutual fund investing – what do you insist on when picking a mutual fund?

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{ 13 comments… read them below or add one }

marci357 October 7, 2010 at 10:18 am

conservative, stable, no cost, no load, no fee.
good track record, past performance, no big swings.

if one doesn’t understand something, one shouldn’t be investing in it :)

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vered October 7, 2010 at 11:17 am

“if one doesn’t understand something, one shouldn’t be investing in it” – I completely agree Marci.

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Avani Mehta October 7, 2010 at 11:59 am

Hey Vered,

Agree with all your points except the one on cash holding. If the mutual fund manager knows that there is going to be a crash or the market is bad enough to lose money and not make money, I would prefer he sits on cash rather than give me losses. Compulsory investing is one reason why mutual fund averages tend to be equivalent to market averages – since they cannot opt out of a bear run.

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Vered DeLeeuw October 9, 2010 at 12:05 pm

Good point Avani and thanks for you your comment, although personally I would still prefer to make my own decision about whether to pull out of the market or not. I tend to ride out bear markets and for the most part it has served me well.

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Jenna October 7, 2010 at 12:15 pm

Loving the title. I’m definitely someone who thinks mutual funds and investing is rocket science so I’m glad to have the opportunities to read awesome blogs to help give me some encouragement and understanding around these topics. Thanks for the insight on what to look for.

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Kevin Cimring October 7, 2010 at 3:18 pm

Hi Vered,

This is good general advice that will serve your readers well.

I would also add risk/return trade-off to your list. Generally, in order to achieve higher returns investors need to accept more risk – the question is, how much more risk is the investor willing to take?

Therefore, when looking at past performance, investors should also look at factors such as sharpe ratio and standard deviation, which measure volatility and risk. A fund may have performed very well, but may have taken great risks to achieve its returns. More risk averse investors would do well to look at funds with less volatility. Perhaps a good topic for a future post?

Regards,
Kevin

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Vered DeLeeuw October 9, 2010 at 12:10 pm

Thanks Kevin. Yes, this is imporant to factor in. As a lay investor, I tend to be lazy and just look at the morningstar.com risk measures – they have this handy graph that shows you each fund’s risk and return compared with its category.

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Tony DuBon October 8, 2010 at 9:35 am

The advice in the article is excellent. It seems to boil down to educate yourself and be mindful of the risks inherent in each investment you make. Don’t invest in anything you don’t understand… Spend some time with some key books. I like a couple of books by John Bogle, the founder of Vanguard: Common Sense on Mutual Funds, and The Little Book of Common Sense Investing. As the creator of the first index fund, Bogle presents the case for them. One should include them as part of a portfolio of mutual funds.

I want to make the case for actively managed funds as well. There is a very good rationale for positing that past performance can identify funds likely to outperform in the future. Actively managed mutual funds are decision-making machines. Their decision-making capability is the bottom line result of people, processes, approaches, and tools that they use every day to make decisions. Good machines are more likely to make good decisions than bad machines. This capability to make consistently good decisions can be inferred from past risk, return and persistence behavior. Persistence is the tendency of a fund to exceed S&P500 return at lower than S&P500 risk.

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Nick D. October 8, 2010 at 9:48 am

You have to be very careful when looking at past performance. You also have to consider what kind of taxes you’ll have to pay on your gains. Some people rely to heavily on names like Dave Ramsey who say you can go out and get a 12% mutual fund, put in X amount of money each month and eventually you’ll be so rich you won’t even be able to spend all the money you have. The problem is he never calculates in taxes (all the sudden 12% goes to 8%) and it’s never mentioned for example that a mutual fund that has 20% gains one year and 20% losses the next year actually losses you money. (please do the math, it’s true) I would argue that the new “fad” in financial planning is to NEVER LOSE MONEY.

And by the way, have you ever heard of a mutual fund millionaire? or someone who got rich investing in mutual funds. Me neither.

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Vered DeLeeuw October 9, 2010 at 12:13 pm

Hi Nick, I agree – and I also think that the goal with mutual fund investing is not to make a fortune, but to slowly grow your money in a way that would keep up with inflation, while not taking too much risk with the principal. This is were asset allocation becomes important. I might write a post about that at some future point.

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Mark October 22, 2010 at 2:12 pm

Size is very important to me. A fund that is bloated with a large market capitalization will have a difficult time delivering market beating returns. I prefer smaller funds that have greater capital appreciation potential.

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Louis October 23, 2010 at 5:39 pm

My strategy is to avoid mutual funds. Instead I own a diverse portfolio of dividend paying stocks, balanced across all sectors and which emphasize reasonable payout ratios and good dividend growth. No management fees here, and when the dividends roll in, I get to choose how the cash will be reinvested. Research is not troublesome to me – I select quality blue chip companies, and put no more than 2% of my money into any one stock. So I don’t care if I pick a “bad” stock. I sleep like a baby, have great diversification, and best of all my portfolio outperforms the Wilshire 5000. If I can do it, so can you.

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Thomas June 20, 2013 at 5:59 am

You have made some very interesting points there. It’s hard to find a good fund manager who keeps your interest before his. To have an experienced manager to manage your fund is worth his weight in gold. I believe it’s the fear of losing that keeps people from investing.

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