Understanding the importance of performance and risk

A common and often costly mistake that many investors make when they select a fund is overemphasizing the importance of past performance. The shorter the time period you analyze, the greater the danger that you’ll misuse high past performance as an indicator for a fund’s likely future performance.

High past returns for a fund, relative to its peers, are largely possible only if a fund takes more risk or if a fund manager’s particular investment style happens by luck to come into favor for a few years. The danger of a fund’s taking greater risk in the pursuit of market-beating and peer-beating returns is that it doesn’t always work the way you hope. The odds are great that you won’t be able to pick the next star before it vaults to prominence in the fund universe. You’re more likely to jump into a recently high-performing fund and then be along for the ride when it plummets back to reality.

Some funds make themselves look better by comparing themselves with funds that aren’t really comparable. The most common ploy starts with a manager investing in riskier types of securities; then the fund company, in its marketing, compares its fund’s performance with that of fund companies that invest in less-risky securities. Always examine the types of securities that a fund invests in and then make sure the comparison funds or indexes invest in similar securities.

A fund’s historic rate of return or performance is one of several important factors to examine when you select funds. Keep in mind that — as all fund materials must tell you — past performance is no guarantee of future results. In fact, many former high-return funds achieved their results only by taking on high risk or simply by relying on short-term luck. Funds that assume higher risk should produce higher rates of return, but high-risk funds usually decline in price faster during market declines.

Examining fund management experience

Although the individual fund manager is important, a manager isn’t an island unto himself. The resources and capabilities of the parent company are equally, if not more, important. Managers come and go, but fund companies usually don’t.

Different companies maintain different capabilities and levels of expertise with different types of funds. A fund company gains more or less experience than others not only from the direct management of certain fund types, but also through hiring out. Some fund families contract with private money management firms that possess significant experience. In other cases, private money management firms with long histories in private money management — such as Dodge & Cox and Primecap Management — offer funds to the general public.

Keeping costs down

The charges that you pay to buy or sell a fund, as well as the ongoing fund operating expenses, have a major effect on the return that you ultimately earn on your fund investments. Given the enormous number of choices available for a particular type of fund, there’s no reason to pay high costs.

Fund costs are an important factor in the return that you ultimately earn from a fund because fees are deducted from your investment returns. High fees and other charges depress your returns. Here’s what I recommend you do regarding fees:

• Minimize operating expenses. All funds charge fees as long as you keep your money in the fund. The fees pay for the costs of running a fund, such as employees’ salaries, marketing, toll-free phone lines, and writing and publishing prospectuses (the legal disclosure of the fund’s operations and fees). A fund’s operating expenses are invisible to you because they’re deducted from the fund’s share price on a daily basis. Funds with higher operating expenses tend to produce lower rates of return on average. Conversely, funds with lower operating costs can more easily produce higher returns for you than comparable types of funds with high costs. This effect makes sense because companies deduct operating expenses from the returns that your fund generates.

  Fund companies quote a fund’s operating expenses as a percentage of your investment. The percentage represents an annual fee or charge. You can find this number in the fund expense section of a fund’s prospectus, usually on a line that says “Total Fund Operating Expense.” You also can call the fund’s toll-free phone number and ask a representative, or you can find the information at the fund company’s website. Make sure a fund doesn’t have lower expenses simply because it’s waiving them temporarily. (You can ask the fund representative or look at the fees in the fund’s prospectus to find this information.)

• Use no-load funds. A sales load is a commission paid to brokers and financial planners who work on commission and sell loaded mutual funds. Commissions, or loads, generally are about 5 percent of the amount you invest. Sales loads are additional and unnecessary costs that are deducted from your investment money. You can find plenty of outstanding no-load (commission-free) funds. I recommend a few later in this chapter.

Invest in funds that have low total operating expenses and that don’t charge sales loads. Both types of fees come out of your pocket and reduce your rate of return. Plenty of excellent funds are available at reasonable annual operating-expense ratios (less than 1 percent for stock funds and less than 0.5 percent for bond funds). See my recommendations of specific funds later in this chapter.

Note: Many of the Vanguard funds recommended in this chapter offer Admiral versions that have even lower operating fees for customers who invest at least $50,000, or $10,000 for an index or tax managed fund that offers Admiral shares. Some of Vanguard’s sector-focused Admiral funds have a $100,000 minimum.

Understanding and using index funds

In some funds, the portfolio manager and a team of analysts scour the market for the best securities. These funds are generally known as actively managed funds. An index fund, however, simply invests to match the makeup — and, thus, the performance — of an index such as the Standard & Poor’s 500 index of 500 large U.S.-company stocks. Index funds, also known as passively managed funds, operate with far lower operating expenses because ongoing research isn’t needed to identify companies in which to invest.

Index funds deliver relatively solid returns by keeping expenses low, staying invested, and not changing investments (unless changes occur to the securities in the underlying index). With actively managed stock funds, a fund manager can make costly mistakes, such as not being invested when the market goes up, being too aggressive when the market plummets, or just being in the wrong stocks. An actively managed fund can easily underperform the overall market index that it’s competing against. Over ten years or more, index funds typically outperform about three-quarters of their peers. Most so-called actively managed funds can’t overcome the handicap of high operating expenses that pull down their rates of return.

In addition to lower operating expenses, which help boost your returns, index funds are usually tax-friendlier to invest in when you invest outside retirement accounts. Fund managers of actively managed portfolios, in their attempts to increase returns, buy and sell securities more frequently. This trading, however, increases a fund’s taxable capital gains distributions and reduces a fund’s after-tax return.

Vanguard is the largest and most successful provider of index funds because it generally maintains the lowest annual operating fees in the business. Vanguard has all types of bond and stock (both U.S. and international) index funds. See my recommended-fund sections later in this chapter.

Understanding exchange-traded funds: Index funds that trade

Index mutual funds, which track particular market indexes and the best of which feature low costs, have been around for decades. Exchange-traded funds (ETFs) represent a twist on index funds. ETFs trade as stocks do and offer some potential advantages over traditional mutual funds, but they also have some potential drawbacks.

As with index funds, the promise of ETFs is low management fees. I say promise because the vast majority of ETFs actually have expense ratios far higher than those of the best index funds.

In addition to slightly lower expenses, the best ETFs have one possible advantage over traditional index funds: Because ETFs may not be forced to redeem shares to cash and recognize taxable gains (which can happen with an index fund), they may be tax-friendlier for non-retirement-account investors.

If you can’t meet the minimum investment amounts for index funds (typically, several thousand dollars), you face no minimums when buying an ETF, but you must factor in the brokerage costs of buying and selling ETF shares through your favorite brokerage firm. Suppose you pay a $10 transaction fee through an online broker to buy $1,000 worth of an ETF. That $10 may not sound like much, but it represents 1 percent of your investment and wipes out the supposed cost advantage of investing in an ETF. Because of the brokerage costs, ETFs aren’t good vehicles for investors who seek to make regular monthly investments. (Note: Some brokers waive brokerage fees for trading their own ETFs and selected other ETFs.)

Here are some drawbacks of ETFs:

• The perils of market timing: Being able to trade in and out of an ETF during the trading day presents challenges. In my experience working with individual investors, most people find it both nerve-racking and futile to try to time their moves in and out of stocks with the inevitable fluctuations that take place during the trading day. In theory, traders want to believe that they can buy at relatively low prices and sell at relatively high prices, but that’s far easier said than done.
• Brokerage commission every time you trade: With no-load index funds, you generally don’t pay fees to buy and sell. With ETFs, however, because you’re actually placing a trade on a stock exchange, you generally pay a brokerage commission every time you trade. (Note: Some brokers offer certain ETFs without brokerage charges in the hope of getting your account and making money on other investments.)
• Fluctuating prices: Because ETFs fluctuate in price based on supply and demand, when you place a trade during the trading day, you face the complication of trying to determine whether the current price on an ETF is above or below the actual value. With an index fund, you know that the price at which your trade was executed equals the exact market value of the securities it holds.
• Poorly diversified investments: Many ETFs (that don’t invest in an index) invest in narrow segments, such as one specific industry or one foreign country. Such funds undermine the diversification value of fund investing and tend to have relatively high fees.
• Excessive risks and costs with leverage: ETF issuers have come out with increasingly risky and costly ETFs. One particular class of ETFs I especially dislike consists of so-called leveraged ETFs. These ETFs claim to magnify the move of a particular index, such as the Standard & Poor’s 500 stock index, by double or triple. So a double-leveraged S&P 500 ETF is supposed to increase by 2 percent for every 1 percent increase in the S&P 500 index. My investigations of whether the leveraged ETFs actually deliver on their objectives show that they don’t — in fact, they don’t even come close. Leveraged ETFs aren’t investments; they’re gambling instruments for day traders.

Investing in the best ETFs

Like the vast majority of investors, you don’t need to complicate your life by investing in ETFs. Use them only if you’re an advanced investor who understands index funds and you’ve found a superior ETF for a given index fund that you’re interested in.

I strongly encourage you to employ the buy-and-hold mentality that I advocate throughout this book. Don’t hop in and out of ETFs. Also, you should buy only the ETFs that track the broader market indexes and that have the lowest expense ratios. Avoid those that track narrow industry groups or single small countries.

Check whether the ETF you’re considering is selling at a premium or discount to its net asset value. You can find this information on the ETF provider’s website after the market’s close each business day.

The best ETFs, like the best index funds, have low expense ratios. My top picks among the leading providers of ETFs include the following:

• Vanguard: Historically, Vanguard has been the low-cost leader with index funds, and now it has low-cost ETFs as well. If you’re interested in finding out more about ETFs, be sure to examine Vanguard’s ETFs. Vanguard also offers the Admiral Share class for bigger-balance customers (more than $100,000) of its index funds that match the low expense ratio on its ETFs. (https://personal.vanguard.com/us/home; 800-662-7447)
• WisdomTree: This family of indexes is weighted toward stocks paying higher dividends. These ETFs have higher fees but offer a broad family of index choices for investors seeking stocks that pay higher dividends. Note: Other ETF providers offer several value-oriented and high-dividend-paying stock funds. (www.wisdomtree.com; 866-909-9473)

Three additional and larger providers of ETFs include the following firms (beware that some of their ETFs are pricey or too narrowly focused):

• iShares: BlackRock has competitive expense ratios on some domestic ETFs based on quality indexes, such as Russell, Morningstar, S&P, Lehman, Dow Jones, and so on. Fidelity offers dozens of iShare ETFs free of brokerage charges. (www.ishares.com; 800-474-2737)
• Schwab: The investment brokerage firm Charles Schwab, which revolutionized the discount brokerage business, offers many very low cost ETFs. (www.schwab.com; 800-435-4000)
• State Street Global Advisors SPDRs: This group uses indexes from Dow Jones, S&P, Russell, and MSCI, among others. (www.ssgafunds.com; 866-787-2257)

Picking the best stock funds

Stock funds differ from one another in several dimensions. The following characteristics are what you should pay the most attention to:

• Company location: Stocks and the companies that issue that stock are classified based on the location of their main operations and headquarters. Funds that specialize in U.S. stocks are, not surprisingly, called U.S. stock funds; those that focus overseas typically are called international or overseas funds.
• Growth stocks versus value stocks: Stock fund managers and their funds are categorized by whether they invest in growth or value stocks.
  • Growth stocks have high prices in relation to the company’s assets, profits, and potential profits. Growth companies typically experience rapidly expanding revenue and profits. These companies tend to reinvest most of their earnings in the company to fuel future expansion; thus, these stocks pay no or low dividends.
  • Value stocks are priced cheaply in relation to the company’s assets, profits, and potential profits. Value stocks tend to pay higher dividends than growth stocks and historically have produced higher total returns.
• Company size: Another dimension on which a stock fund’s stock selection differs is based on the size of the company in which the fund invests: small, medium, or large. The total market value — capitalization, or cap for short — of a company’s outstanding stock defines the categories of the stocks that the fund invests in. Small-capitalization stocks are usually defined as stocks of companies that possess total market capitalization of less than $2 billion. Medium-capitalization stocks have market values of $2 billion to $10 billion. Large-capitalization stocks are those of companies with market values greater than $10 billion. (Note: These definitions can change over time.)

Putting together two or three of these major classifications, you can start to comprehend those lengthy names that are given to various stock funds. You can have funds that focus on large-company value stocks or small-company growth stocks. You can add U.S., international, and worldwide funds to further subdivide these categories into more fund types. So you can have international stock funds that focus on small-company stocks or growth stocks.

You can purchase several stock funds, each focusing on a different type of stock, to diversify into various types of stocks. Two potential advantages result from doing so:

• Not all your money rides in one stock fund and with one fund manager.
• Each of the different fund managers can look at and track particular stock investment possibilities.

The following sections describe the best stock funds that are worthy of your consideration.

Balancing your act: Funds that combine stocks and bonds

Some funds — generally known as balanced funds — invest in both bonds and stocks. These funds are usually less risky and less volatile than funds that invest exclusively in stocks. In an economic downturn, bonds usually hold value better than stocks do.

Balanced funds make it easier for investors who are skittish about investing in stocks to hold stocks because they reduce the volatility that normally comes with pure stock funds. Because of their extensive diversification, balanced funds are also excellent choices for an investor who doesn’t have much money to start with.

Balanced funds aren’t appropriate for some investors who purchase funds outside tax-sheltered retirement accounts because these funds pay decent dividends from the bonds that they hold. With the exception of the Vanguard Tax-Managed Balanced Fund, which holds federal-tax-free bonds, you should avoid balanced funds if you’re in a higher tax bracket. Consider buying separate tax-friendly stock funds and tax-free bond funds to create your own balanced portfolio.

Here’s my short list of great balanced funds:

• Dodge & Cox Balanced (800-621-3979; www.dodgeandcox.com)
• Fidelity Freedom Funds and Fidelity Puritan (800-343-3548; www.fidelity.com)
• T. Rowe Price Balanced, Personal Strategy Balanced, and Retirement Funds (800-638-5660; www.troweprice.com)
• Vanguard LifeStrategy Funds, Wellesley Income, and Wellington (800-662-7447; www.vanguard.com)

Finding the best bond funds

Although there are thousands of bond fund choices, not many remain after you eliminate high-cost funds, low-performance funds, and funds managed by fund companies and fund managers with minimal experience investing in bonds (all key points that I address in “Maximizing Your Chances for Fund Investing Success” earlier in this chapter).

Among the key considerations when choosing bond funds are

• Years to maturity: Bond-fund objectives and names usually fit one of three maturity categories: short-, intermediate-, and long-term. You can generally earn a higher yield from investing in a bond fund that holds longer-term bonds, but such bond prices are more sensitive to changes in interest rates. (Duration, which quantifies a bond fund’s sensitivity to changes in interest rates, is another term you may come across. A fund with a duration of eight years means that if interest rates rise by 1 percent, the fund should decline by 8 percent.)
• Bond credit quality: The lower the issuer’s credit rating, the riskier the bond. As with the risk associated with longer maturities, a fund that holds lower-quality bonds should provide higher returns for the increased risk you take. A higher yield is the bond market’s way of compensating you for taking greater risk. Funds holding higher-quality bonds provide lower returns but more security.
• Fees and costs: After you settle on the type of bonds you want, you must consider a bond fund’s costs, including its sales commissions and annual operating fees. Stick with no-load funds that maintain lower annual operating expenses.
• Taxability: Pay attention to the taxability of the dividends that bonds pay. If you’re investing in bonds inside retirement accounts, you want taxable bonds. If you invest in bonds outside retirement accounts, the choice between taxable and tax-free depends on your tax bracket.
• Type of bond issuer: Bonds can be issued by corporations, state and local governments, the federal government, and foreign entities (corporate and governments). Although some bond funds hold an eclectic mix, many focus on specific types of bonds (such as corporate bonds).

Because bond funds fluctuate in value, invest in them only if you have sufficient money in an emergency reserve. If you invest money for longer-term purposes, particularly retirement, you need to come up with an overall plan for allocating your money among a variety of funds, including bond funds.

Your own online fund

On some websites, various services claim that you can invest in a chosen basket of stocks for a low fee and without the high taxes and high fees that come with mutual fund investing.

These “create your own funds” services pitch their investment products as superior alternatives to mutual funds. One such service calls its investment vehicles folios, charging you $29 per month ($290 per year paid in advance) to invest in folios, each of which can hold a few dozen stocks that are selected from the universe of stocks that this service makes available. The fee covers trading in your folios that may occur only during two time windows each day that the stock market is open. Thus, in addition to the burden of managing your own portfolio of stocks, you have virtually no control of the timing of your trades during the trading day.

According to my analysis, you’d need to invest more than $150,000 through this folio service to come out ahead in terms of the explicit fees. You also need to be aware of additional fees, which you usually have to search the fine print to find. You may get whacked $30 to wire money out of your account or even $100 to close an account and have it transferred elsewhere!

Evaluating the performance of self-created funds is difficult. Also, unlike mutual funds, these funds have no standards or easily accessible services that report and track the performance of your customized folio.

Unit investment trusts

Unit investment trusts (UITs) have much in common with both mutual funds and exchange-traded funds. UITs take a fixed initial amount of money and buy securities that meet the objectives of the UIT. Unlike a mutual fund, however, a UIT doesn’t make any changes in its holdings over time. This holding of a diversified portfolio can be advantageous because it reduces trading costs and possible tax bills.

With that said, UITs do suffer from the following major flaws:

• High commissions: Brokers like to sell UITs for the same reason they like to pitch load mutual funds: the commissions paid out of your investment. Commissions usually are around 5 percent, so for every $10,000 that you invest in a UIT, $500 comes out of your investment and goes into the broker’s pocket. (Although UITs do have ongoing fees, their fees tend to be lower than those of most actively managed mutual funds — typically, in the neighborhood of 0.2 percent per year. The best no-load funds also have reasonable management fees, and some charge even less than UITs charge.)
• Lack of liquidity: Especially in the first few years after a particular UIT is issued, you won’t readily find an active market in which you can easily sell your UIT. In the event that you can find someone who’s interested in buying a UIT that you want to sell, you’ll likely have to sell the UIT at a discount from its actual market value at the time.
• Lack of ongoing management oversight: Because UITs buy and hold a fixed set of securities until the UITs are liquidated (years down the road), they’re more likely to get stuck holding some securities that end up worthless. Compared with the best bond funds, bond UITs are more likely to end up holding bonds in companies that go bankrupt.

Brokerage managed accounts

Brokerage firms offer investment management services for an ongoing fee rather than commissions. (Merrill Lynch is one common example of a brokerage firm.) Wrap accounts, or managed accounts, go by a variety of names, but they’re the same in one crucial way: For the privilege of investing your money through their chosen money managers, they charge you a percentage of the assets that they’re managing for you. These accounts are quite similar to mutual funds except that the accounts don’t have the same regulatory and reporting requirements.

These managed accounts tend to have relatively high fees — upward of 2 percent per year of assets under management. No-load mutual funds and ETFs offer investors access to the nation’s best investment managers for a fraction of the cost of brokerage managed accounts. Many excellent funds are available for 0.5 percent or less annually.

Hedge funds for the wealthier

Hedge funds, historically investments reserved for big-ticket investors, seem to be like mutual funds in that they typically invest in stocks and bonds. They have the added glamour and allure, however, of taking significant risks and gambles with their investments. Here’s how they stack up compared with mutual funds and ETFs:

• Hedge funds are often much higher-risk. When a hedge fund manager bets right, he can produce high returns. When he doesn’t, however, his fund can get clobbered. With short selling, because the value of the security that was sold short can rise an unlimited amount, the potential loss from buying it back at a much higher price can be horrendous. Hedge fund managers have also been clobbered when a previously fast-rising commodity, such as natural gas or copper futures, plunges in value or an investment they make with leverage goes the wrong direction. Several hedge funds went belly-up when their managers guessed wrong. In other words, their investments did so poorly that investors in the fund lost everything. This won’t occur with a mutual fund or an ETF.
• Hedge funds have much higher fees. Hedge funds charge an annual management fee of about 1 percent to 2 percent and a performance fee, which typically amounts to a whopping 20 percent of a fund’s profits.
• Hedge funds have had problems with fraud and lousy returns. During the severe stock market decline in the late 2000s, many hedge funds did poorly. Some funds went under or were exposed to be Ponzi schemes, the most notorious being the fund run by the now-jailed Bernie Madoff. According to Forbes magazine, “Hedge funds exist in a lawless and risky realm… . Hedge funds aren’t even required to keep audited books — and many don’t.” They’re often “guilty of inadequate disclosure of costs, overvaluation of holdings to goose reported performance and manager pay, and cozy ties between funds and brokers that often shortchange investors.” Objective studies of all hedge fund returns show that they underperform funds, which makes sense, because hedge funds have the burden of much higher fees.