All about mutual funds

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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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16 Comments

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  1. Hi Ramit

    Excellent discussion above on index funds. One question is – what if you don’t have enough to meet the min. investment needed to get into more than a few funds (so you want to access different index funds – not just the SP 500) . Say I have 10,000 dollars to invest. I can definitely do VFINX (Vanguard 500), and add one or two more. In contrast we have the fidelity 2040, which is an asset allocation fund. The expense ratio is 0.79, and i did not find any other expenses in the prospectus. The expense ratio is of course way higher than the SP (0.18), but I get more diversifcation. (BTW – it’s interesting to note that if you buy from fidelity, there is an extra 0.16% mgmt fee. I didn’t see that at Ameritrade). Maybe one could invest in the Fidelity 2040 to begin with, and then once we have enough $$ to diversify (and i mean diversify beyond the SP; Will Bernstein, Four Pillars of Investing – pg 272 shows a very diversified portfolio), one can make one’s own portfilio of different index funds. Would appreciate your thoughts on this.
    thanks!
    c

  2. Hi Ramit
    Mistake in the previous comment – the expense ratio is 0.79%, not 0.79. My bad there. Also, The SP 500 is 0.18%. Pls also ignore the comment on the management fee at fidelity. But given the low expense ratio and the extent of the diversification, it looks very attractive, and SIMPLE.

    thanks
    c

  3. Thanks for this article. It inspired me to actually take a look at the performance and prospectus information of the available investment options in my company’s 401k. Lo-and-behold, found an S&P 500 index fund. After checking out the cost ratio of the mutual funds in the program and then realizing that by using the goal-directed investment model provided, I was probably spending even more than the 1.6-2% cost ratio of the individual funds, decided it was time to take more control of my investment direction and stop being lazy. One of these days I’ll figure out how to get more control of the money in that 401k, but until then at least I can waste less of it on fund managers.

  4. Ramit,

    I don’t disagree that index funds are better than 85% of mutual funds. But since the performance of mutual funds is so easy to find, why not invest in the 15% that actually beat the market at a reasonable cost? I have been investing in Selected American Shares for many years and they’ve been beating the market in every time horizon, without charging exorbitant fees.

  5. Because you don’t know which ones will beat the market until you look backwards in time.

  6. Just in case Ramit’s case wasn’t already convincing enough:
    http://www.sanfran.com/home/view_story/1507/

  7. I disagree with you, Funds are a great investment if have a moderate ammount of knowledge. I didn’t see you talk about the risk of the funds (debt vs. stocks), if you study the funds you want to invest in and you know the risk you can tolerate, you can make a pretty good investment. For example I invested in a couple of funds three months ago and I have managed to get a 16% return, already having paid all the operational costs. I think it’s a great way of saving money, if you¡re willing to leave your money in there for 3 to 5 years and spend some time studying the funds you are going to invest in

  8. Good article. I will now actually look at the performance of index funds in India after reading your article. I was under impression that actively managed mutual funds are the best bet.

  9. While index funds are superior to actively managed funds, there is a strange paradox in that the more popular index funds become, the less likely they are to outperform actively managed funds. Index funds work on the premise that the value of all stocks is accurately reflected in their market prices – that there is no advantage to searching for mispriced stocks, something that goes on all the time with actively managed funds. As more money flows into index funds and out of active funds, the chance of finding mispriced stocks in the market increases. Eventually, the more mispricings a fund manager can capitalize on, the more likely he/she is to earn a return in excess of the market return. Bottom line is, index funds work best only when there is more money in actively managed funds.

  10. I am being actively sold on hedge funds. I imagine that index funds will do poorly if the market takes a downturn. So too will Mutuals? I wonder what Ramit’s opinion is?

  11. the problem with index fund is you can’t really mimic the index fund. Since all the index fund will try to buy in and buy out at the same time and that’s probably several % right there lost to other mutual fund. Or they have to wait which means they are not true index fund. What’s you take on this? Some financial planners suggested just opposite of what you said here.

  12. Strangely the vast majority of people are financial illiterate, (basically a pet peeve, the reason our primary education system is so poor is that the worst enemy of a politician is an educated voter, few politicians desire an educated consumer) and trust without verification, and sadly do not want to spend even sixteen hours per year investigating the numbers and what they actually mean, and compare them to the alternatives. They just turn it over to there broker, and let him decide. That is the sole reason the bottom 85% of the mutual funds exist coupled with fads that one can talk about in social settings. Just like all investments, including Mutual Funds (MFs)– Each investment has to be audited periodically. I been quite successful with MFs, my main screen points are: 1) No loads, I always been able to find a equal to or better mutual fund with without a load (excluding 12b-1 fees, which I do try to minimize). This I believe has been widely documented one rarely gets anything for paying a load. 2) Small Mutual funds on total assets, basically it is easier to turn a row boat than a aircraft carrier, and typically the manager more hungry. 3) Low turn over rate. Basically if there is typical above average turnover, in the portfolio that tell me the manager did not do his homework. They are constantly chasing the next fad 4) Pick out the mutual fund families which close to new investors, more purchases of shares from existing investors when they have a superior year, and then everybody want to get into that specific fund. 4) Just like other investments, when it performance is below average for too long of a period for no valid reason – it is time to find a new investment, but find where you going to invest prior to selling. 6) I prefer small companies MF, and mid cap MF, and overseas MF. These investments are typically harder to investigate than large companies. If I invested in large company MF’s then I would consider buying stocks directly; but, probably would use mutual fund literature to select individual small and mid cap companies for both stock and to screen employment opportunities 5) I will probably never get out of MF unless something changes dramatically in that area., The better MF managers visit the plants, talk to the manager’s, talk to the competition, and go to the trade shows etc. That don’t just look at the written data provide by the news services.

  13. Who is a good brick+mortar/online stock investment company if you are interested in investing in ETFs like the S&P 500 and QQQQ?

  14. Hello Ramit, I was wondering what your thoughts are on ING’s IRA and how they invest in their mutual funds? I normally wouldn’t invest in mutual funds, but I do want to have an IRA. It’s just that ING’s IRA invests in mutual funds and not index funds. Do you think that is okay? Thanks for reading!

  15. index funds also, at least where i live, have much less marketing/advertising. the actively managed ones use often very clever tactits to persiade you to buy them. probably for a reason.

  16. The reason people invest in regular mutual funds instead of index funds is because they just don’t know the difference. There is no press about it or it’s not on the front page of the newspaper.

    Also, most people have a 401k from their job and if it is not offered in there than they will never invest in one. It would be a disadvantage to mutual fund companies to include it in retirement accounts because they would make less money per year on it.