All about mutual funds (repost)

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This is a repost from a January 2005 article I wrote about mutual funds. Read this, ask questions, and we’ll continue on with the financial makeover.

Most adults in America invest in some kind of mutual fund. They’re an easy, hands-off way to buy and diversify part of your portfolio. But there are costs to handing off your investment decisions to someone else. Here I’ll cover the basics of mutual funds, the secret most investors don’t know, and what fund I invest in. I will also make fun of stupid things people do with mutual funds.

What a mutual fund is and how it works
A mutual fund is a collection of some kind of investment, usually stocks. They’re extremely popular. Your parents own at least one mutual fund if they’ve ever worked at a company. Mutual funds work like this: You pick a fund you like (e.g., growth, value, technology, international…), buy shares of the fund, and let a money manager pick the stocks he thinks will yield the best return. In exchange for this diversification and his expertise, you pay an annual fee.

Advantages: Hands-off approach means an expert money manager makes investment decisions for you. Mutual fund (ostensibly) holds many varied stocks, so if one company tanks, your fund doesn’t go down with it (i.e., it’s “diversified”).

Disadvantages: Annual fees can equal tens of thousands of dollars or more (!) over the lifetime of an investment. If you invest in two mutual funds, they may overlap in investments, yielding a less-diversified portfolio than you really think. In other words, if both funds hold Microsoft and Microsoft tanks, you get hit twice. Although you’re paying an expert to manage your money, they rarely beat the market—the mutual fund industry’s dirty secret!

The fund manager
Each mutual fund has a fund manager overseeing all investments. He’s usually a talented financial expert whose bonus is based on the fund’s performance, so he’ll get (say) a $2 million bonus if the fund returns X%. Because they actively manage your money, you’ll sometimes hear mutual funds called “actively managed funds.”

Fund managers are highly compensated but also subject to being fired if the fund performs poorly. The main reason you should care about the fund manager is that you’re basically investing in him—by putting your money in his fund, you’re betting he’ll make you money.

The different types of mutual funds
If you want to buy a mutual fund, you have some choices to make. It’s kind of like the 50 kinds of toothpaste you can choose at Target. Except there are thousands of funds and we’re talking about your life savings. Anyway, you can pick a mutual fund of almost any imaginable type, based on many factors (e.g., risk, return, sector, geographic area of investment, etc). For example, you could invest in a value fund, an emerging-markets fund, or a medical-device fund.

The key is to invest in what you understand. If I were going to buy a mutual fund, I’d get a technology fund because that’s what I know. Even though biotech sounds sexy, I don’t know enough about biotech to choose a “good” vs. “bad” fund, so I’d steer clear. You can sort through funds using ETrade or MorningStar.

By the way, one of my most popular questions is this: How exactly do you “buy” into a mutual fund? Mutual funds have ticker symbols just like stocks. Just browse the links above and you’ll see that buying shares of a mutual fund is almost exactly the same as buying shares of stock.

Mutual-fund costs
Your fund manager doesn’t come cheap. Actually, investing in mutual funds is damn expensive. Remember, you have to pay an annual fee in exchange for his expertise and the fund’s hands-off diversification.

The main fee you’re charged is called an expense ratio, which consists of the management fee (goes to your fund manager), administrative costs, and the 12b-1 distribution fee, which is used to advertise your fund. How ridiculous. Most funds charge somewhere around a 1.5% expense ratio.

Also, when you buy a mutual fund, you may be asked for a commission; this is also known as a front-end load or back-end load. Avoid commissions! You want a no-load fund. If your broker tries to convince you that a loaded fund is better, he is lying. You shouldn’t even be talking to a broker, anyway. Use a discount online broker like ETrade, Datek, Schwab, anything.

Why am I so against loaded funds? Easy: Loads cut into your profits and there’s no evidence that they produce better results. In fact, look at this data I ripped off of Yahoo Finance:

“Assuming a $10,000 investment with a conservative nine percent annual net return rate (after annual fund operating expenses) over three years…

Total Return Comparison
Start Year 1 Year 2 Year 3
100% No-Load $10,000 $10,900 $11,881 $12,950
5% Front-End Load $ 9,500 $10,303 $11,174 $12,119
3% Back-End Load $10,000 $10,845 $11,762 $12,374

Cumulative ROI Comparison
Year 1 Year 2 Year 3
100% No-Load 9.0% 18.8% 29.5%
5% Front-End Load 3.0% 11.7% 21.2%
3% Back-End Load 8.4% 17.6% 23.7%

In cumulative ROI after three years in this illustration, the 100 percent no-load fund outperforms the five percent front-end load fund by 39.3 percent and the back-end load fund by 24.4 percent — even though a nine percent annual return rate is ident ical for all three funds!”

See. Always get a no-load fund.

One more reason mutual funds are expensive: Your manager is constantly buying and selling stocks, which incurs trading fees and HUGE amounts of taxes. This is part of why you can expect at least 2% of your returns to be eaten up by mutual-fund-related fees.

The dirty secret of mutual funds
Earlier I told you how most adults in America have mutual funds. Now let me explain why they are pretty stupid. Ok, you are paying for expert advice and a Very Smart Person to invest your money.

Stay with me. Remember when I told you that The Market returns about 11% per year?

Now, with all your Smart Money Manager’s tools and resources, you’d of course expect him to beat that. But…

Over 85% of mutual funds fail to beat the market.

shocked.jpg

Woah. Why would anyone invest in a mutual fund, which costs you tremendous amounts of money just for maintenance when you won’t even beat the market? Could it just be because people are lazy and don’t know what to do? What if there were a way to invest directly in the market?

How to invest directly in The Market: Index funds
I’m glad you asked. Index funds are a special type of mutual fund. Instead of being actively managed by a fund manager, a computer simply matches the stocks in The Market. So the Vanguard S&P 500 index fund has every stock that the actual S&P 500 has—the Vanguard index fund is an index of The Market.

There are index funds for the S&P 500, NASDAQ, and more.

The advantages are simple: YOU MAKE A LOT MORE MONEY AND SAVE ON DUMB COSTS. Because index funds don’t have money managers and other BS costs, your expense ratio is vastly lower. Compared to usual mutual funds (whose expense ratios average around 1.5%), index funds are routinely lower than 0.2%.

The differences are serious. In yet another scenario I ripped off—this time from Vanguard—let’s say you invest $10,000. You put half of it in a mutual fund with a 1.3% expense ratio. The other half goes in a fund with an 0.3% expense ratio. In 20 years, the expensive fund would cost you over $28,000. See details here.

The first and biggest advocate of index funds was Vanguard, which now has the most popular funds out there. I invest part of my portfolio in the Vanguard Index Funds 500 Index (VFINX), which has an expense ratio of 0.18%.

I’m in august company:

  • “[Most investors would] be better off in an index fund.” Peter Lynch, famous stock picker, Barron’s, p. 15, April 2, 1990
  • “The deeper one delves, the worse things look for actively managed funds.” – William Bernstein, The Intelligent Asset Allocator
  • “..the best way to own common stocks is through an index fund…”
    -Warren Buffett, Berkshire Hathaway, Inc. 1996 Shareholder Letter
  • I was an analyst at a well known financial advisory firm. I have no idea why they advise people to buy actively managed funds. It is a scam and mathematically stupid. – John Foxworthy, July, 2002

More quotes: http://www.ifa.com/12steps/Step1/

Mutual funds sound dumb compared to index funds. Why do people like my parents still have them?
I ask myself this a lot. There are no clear advantages to an actively managed mutual fund vs. an index fund. Yes, if you happen to have a mutual fund that beats the market, you’re better off investing in a mutual fund—-but fewer than 15% of all funds do that.

The basic answer is sad but revealing. First, most Americans just don’t know how mutual funds work. Fees sound small per year (2%! So what?) but over 20 years, they add up to tens of thousands of dollars or even more. Second, nobody knows what an index fund is. In fact, when was the last time you heard of one? Finally, buying and holding an index fund isn’t as sexy as thinking of a smart New York fund manager barking instructions to his minions.

Give me a break. When my butler Jeeves is helping me recline on gold sheets and reaching for my jewel-encrusted remote control, I will be just fine with “boring” index funds.

Good reading:
http://www.fool.com/school/basics/basics04.htm

http://www.indexfunds.com

Now what?

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14 Comments

 
  1. I’ll be the first to state the obvious: the entry was posted twice.
    The site is somewhat difficult to navigate because of how many entries there are. Maybe you could have an index on the right linked to separate pages for each year.

    Another observation: you first posted the entry in Jan. 2005, and that reminds me of an investment I began at the same time — in my girlfriend. Now, a year and a half later, I’ve gotten no return. Isn’t that how stocks are? You put all your eggs in one basket and if it crashes, you’re SOL. Maybe I should have “diversified” and dated many girls at one time…

    OK, I really am looking at index funds, so sorry for not commenting on that. I’ll keep tuning in to the discussion so I don’t repeat the same mistakes with my life savings.

  2. Read The Four Pillars of Investing by William Bernstein.

    It’s all about index funds, asset allocation, rebalancing, investing passively, avoiding common investing mistakes.

    Your article is a good summary, but the numbers examples are a little unfair. Most funds do not have such huge front or back end loads. 1 or 2% are much more common for load funds.

    The bottom line is that the best you can reasonably do to predict fund returns is The expected Return minus the fee. Therefore, the lower the fee, the better the net return to you. Even a small .5 or 1.0% difference makes a big deal after a while.

  3. Picking mutual funds (or any investment for that matter) is like picking stocks. You have to know which mutual fund to buy, and that’s why people need brokers. If they want to be conservative, they can go for an index fund, but you generally won’t beat the market because you’re essentially getting “the market” by investing in the index, which is, in itself, the market. I have seen some mutual funds (front-end load) that are yielding a consistent average of 20-25% per year. Also, yes; no-load funds don’t charge a load commission, and back-end loads charge at the end (so you have more to invest in the beginning), but you also have to take a look at the investment situation: in a back-end load situation, you are essentially taking out a loan from the fund because you’re not paying right away. Because of this, the costs are higher than if you were to invest in a front-end load fund. Is your initial investment enough to warrant this added cost? I don’t know, it depends on your financial situation. Front-end load funds are good for some people, and bad for others…just like any other investment.

  4. Great post Ramit.

    I have been trying to move my money into Index funds over the past few years. This information and the links helped solidify that this is the right thing to do.

    what do you think the net effect would be if the majority of mutual fund investors switched to index funds?

    eric n.

  5. I’ve always figured that an actively managed fund is better when the market is going down – when it’s going up, everyone wins (more or less), but when it’s going down, a good fund manager could help limit the damage. I have no data to back that up, just something in my head. Thoughts?

  6. Very thorough review Ramit! Jack Bogle (Vanguard founder) believes there are very few things an investor can control with respect to the markets… but one of those things you can control for is expenses. Keep expenses low, returns will be higher. But Bogle doesn’t practice a strict asset allocation strategy….check out my comments (archived) on his portfolio if interested.

  7. RP: The problem is that nobody knows how far something will go up or down until much later. People who try to time the market are usually wrong, and I mean that in a very real, statistical sense.

  8. Do you know anything about so-called “socially conscious” mutual funds/indexes? The idea of investing in companies that have been screened to be not involved in say, tobacco or land-mine production, sounds appealing to me… Feel free to mock me if I’m being hopelessly idealistic/naive

  9. First of all, let me say that I love the idea of inviting me to mock you. Unfortunately, you have a pretty good question so I will reserve it for someone who asks something dumb. I’ve written about socially responsible investing before, and you can also do a search for “socially responsible investing” on Google.

  10. Ramit’s comments on Socially Responsible funds are accurate, from my experience. My IRA includes a Socially Responsible Fund, and it generally underperforms my other investments in the same category (large cap domestic) by a few percentage points. This has been consistent since I purchased it.

  11. Also, no-load funds have no load (duh ;) ), but sometimes the operating costs can be pricey. I wish I had included that in my original comment.

  12. I’m a big fan of index funds and have seen great returns with them as long as I’ve followed them. I think the reason more people don’t invest in them is a)they don’t know about them – a broker’s not going to tell you about an option with lower fees and b)people are lazy – they’d rather give their money to someone else and let them worry about it when in reality an index fund takes care of itself. I’ve told many people that if they’ve got some money to invest and they really want to invest in the stock market, that index funds are the way to go – it’s a great way to get your foot in the door.

  13. Hi. Dude! It seems like you have some really negative visitors come to this page expecially that first comment I would re-comment on saying its attitude not his girlfriend that his going to make his life more rich.

    I was going to comment that Mutual Funds are not the best investment for young people and Fund Managers basically take your money. I am pro online discount brokerage service and educate yourself about the Options market and Covered Calls. I got started seriously as a business buying and selling options at age 23 when I went to a party and someone referenced me to meet this multi-millionaire options and stock investor. Boy was that the best decision I ever made. The market is starting to get bearish and mutual funds don’t make money for you when the market goes does, but Options DO.

    Cheers,
    Paul

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