Chances are if you own investments, some are in mutual funds. Mutual funds are investment opportunities that are made from a group of selected stocks, bonds and/or cash. They offer investors a way of owning diversified securities. If you buy a single stock, that's a share or group of shares in one company. A mutual fund is collection of many different stocks, bonds and/or cash all packaged together in a bundle.
If you are lucky enough to be employed by a company or organization that offers you a 401K savings plan, chances are you'll get to choose from a group of investments offered in the form of mutual funds. Knowing which ones will work best for you? That largely comes down to your time frame (how many years to retirement) and your risk tolerance. But before we even look at that, we need to consider cost. Cost matters and needs your full consideration no matter what kind of investor you are.
Risk tolerance: The teeth on this big blue metal dog look pretty fierce, but we can see Marley has a high tolerance for risk. Plus she knows full well that this dog's just not real.
Over the years I've made my share of mistakes picking mutual funds, without always fully understanding the cost of my choices. As I have learned from my many mistakes, I'd like to share some considerations for anyone starting out.
Fees: they can eat into your investment!
First off, all mutual funds cost YOU, the investor, money. They incur fees. The people who create and manage these funds expect to be paid, and they cleverly build their fees right into the fund. They get paid whether or not you make any money. So it's your job to hunt down funds with low fees that have performed well over time!
As I said, fees are built into your purchase. There's no separate bill. These fees range between 0.1% to over 2.0% yearly. The rate you are charged is completely irrelevant to the quality of management. Yes, you read that right. So when you are presented with a list of funds to choose from by your employer or you're hunting around for yourself, you need to do a little research on what your choices are. And remember--expensive does not always necessarily imply better. It only implies expensive.
So here's the deal: you're looking for a fund that has historically performed well with good managers for the best price you can get.
Step 1: Do NOT fall for a LOAD of-- well, you fill in the blank!!
Now pay attention to this next bit of friendly advice carefully, because I know of what I speak. I learned this the hard and painful way: Do not EVER buy loaded mutual funds. Ever. What is a loaded mutual fund? It's a fund with an extra fee tagged on, usually right up front. It's the sales commission for the alleged professional who's luring you in by offering a cup of coffee in a pretty office. Or maybe they're just so darn nice they come to your home!
These people may have some insight that is valuable, BUT you also need to know some basic facts or you can get sold something that just outright costs too much. Learn what to ask and look for when someone says they have an investment plan for you.
So say you have $1,000 to invest and the front-end load is 5% on the fund you picked. That means you really only have $950 to invest, because that nice cup of coffee in the professional's office just cost you $50. That's the load. That 5% is taken out of your initial investment right at the start. Ouch.
And that's a very expensive cup of coffee. If you even get offered that. Remember-- it doesn't matter how nice the person is who's selling you a loaded fund! These people are NOT always looking out for your best interests, no matter how charming or insistent they are. And loaded funds are only good for the person who's selling them. But loaded funds aren't just offered in fancy offices, you can buy them online too! No coffee for you, unless you make it or buy it yourself. Yes, you can have the honor of paying extra and getting less, right at your fingertips, without ever leaving the comfort of home!
So-- what have we learned? DO. NOT. BUY. LOADED. FUNDS. Ever, ever, EVER!!!
There are also back-end loads on some mutual funds, which in case you're wondering, is comparable to what it sounds like. Not to be crass, but you are going to get screwed in the end buying one of these. I am less familiar with these, but anytime your money is locked up tight and can't be sold until a given amount of time passes without incurring a sales fee, (and we're talking YEARS here) you are getting a bad deal. Don't fall for any sales ploys.
So you are going to buy no load funds only. It's your money, and yours to grow efficiently. But now what?
Step 2: Consider other fees that may eat into your investment
Okay, so it's time to go shopping!! Your new best friend in this adventure is Morningstar. Yep, you can click on that word, it's a link that will take you to this incredible mountain of information. I know I've mentioned this before, but you can find a ton of free info on the Morningstar website which can help you figure out just what might fit into your portfolio.
Your employer may have a relatively small selection of funds for you to choose from for your 401K. You can look these choices up individually on Morningstar. What should you look at first? Fees, of course. Just how much are you going to be forking over to fund managers? You need to know.
We can look at a specific example. A well-known fund that might be offered in a 401K is Vanguard's Wellington Fund (click on the ticker VWELX to open a quote on this fund). This stock and bond fund has been around since 1929, so it's weathered its share of storms. In fact if you had invested $10,000 in 1929 and held all this time, you'd have a bit over $8.7 million in this fund now. And you'd probably be over 100 years old.
As you can see if you opened the Morningstar site, this fund is rated 5 stars and has a gold medal status. The page shows the NAV (net asset value), or price per share. It shows if the price went up or down that day. Now scan to the right of the price, and you will see a lot of data. One of several we are looking for here is "Load." And it says "None." Excellent! That's just what we want to see.
Next scan over to "expenses." Wellington's expenses are 0.26%. Then look at "fee level." It says low. Yep, that's low. But what exactly does this mean? Remember, the expense here is an annual fee that is deducted each year to pay the management. Again--this is not a transaction fee (a buy or sell fee), it's just a fee to run the fund. You will not get a bill for this.
Step 3: Consider How Often the Fund Manager Buys & Sells
There's a lot of other information on this Morningstar page featuring Vanguard's Wellington fund. Another one to consider is turnover. On the Wellington fund, the turnover is 39%. Turnover is important, especially if you are buying a fund that is in a taxable account. According to Morningstar, turnover is "how often a fund manager sells all the stocks in the mutual fund in a given year." That's not the full story, so if you want a more detailed explanation, click on the blue link above. In short, the lower the turnover, the most cost efficient your fund will be.
Who cares about that? Well you might, if you own this fund in a taxable account. The reason the manager traded some stock was his/her attempt to maximize returns. In other words, to make you more money! The whole buy low, sell high! Which is great! Except sometimes you can get a little surprise around tax time on all this manager selling. You may end up paying taxes on your fabulous fund's profits & dividends.
Here we are meeting Herbert the Snowman: he looks & feels great! Healthy, robust and ready for anything! Like a great mutual fund, Herbert looks great until the heat is on...
The after-tax return is something you want to consider when choosing a mutual fund. If you hold a fund with a high turnover in a tax deferred account, like a traditional IRA or 401K, this is not as critical. But high turnover rates even in tax-deferred funds can still cost you money, because the manager of your account pays fees every time a stock is bought or sold. And those fees gets passed on to YOU. Over time they can cost you money. So you want to know the after-tax and after-sale profit a fund has made in previous years to get a better feel for what you can really expect.
Holy heat wave, Batman! Taxes & fees can melt away even the robust investment, so you end up like poor Herbert the Snowman. Yes, that's him behind Rupert. You want to stay cool and hang onto your money!
Step 4: To be continued...
So what are you to do? Look for funds with low turnover. But where are they? Do they even exist? Well as a matter of fact, they do. Index funds have the lowest turnover rates. Index funds are also generally less expensive than actively managed funds. Why is that? And what exactly are index funds? I'll get to that in my next post, in 2 weeks or so!