Chapter 8

Mastering Mutual Funds and Exchange-Traded Funds

In This Chapter

Looking at reasons to invest in funds

Uncovering the secrets of successful fund investing

Deciding how to allocate your assets

Finding the best stock, bond, balanced, and money market funds

Good mutual funds, which are big pools of money from investors that a fund manager uses to buy a bunch of stocks, bonds, and other assets that meet the fund’s investment criteria, enable you to have some of the best money managers in the country direct the investment of your money. Because efficient funds take most of the hassle and cost out of deciding which companies to invest in, they’re among the finest investment vehicles available today.

Different types of mutual funds can help you meet various financial goals, which is why investors have more than $15 trillion invested in these funds! You can use money market funds for something most everybody needs: an emergency savings stash of three to six months’ living expenses. Or perhaps you’re thinking about saving for a home purchase, retirement, or future educational costs. If so, you can consider some stock and bond funds.

If you haven’t taken a comprehensive look at your personal finances, read Chapter 3 to begin this important process. Too many people plunge into mutual funds without looking at their overall financial situation and, in their haste, often end up paying more taxes and overlooking other valuable financial strategies.

Discovering the Benefits of the Best Funds

The best mutual funds are superior investment vehicles for people of all economic means, and they can help you accomplish many financial objectives. The following sections go over the main reasons for investing in mutual funds rather than individual securities. (If you wish to invest in individual stocks, I provide information on how best to do so in Chapter 6.)

Professional management

The mutual fund investment company hires a portfolio manager and researchers whose full-time jobs are to analyze and purchase suitable investments for the fund. These people screen the universe of investments for those that meet the fund’s stated objectives.

Typically, fund managers are graduates of the top business and finance schools, where they learned portfolio management and securities valuation and selection. Many have additional investing credentials, such as being a Chartered Financial Analyst (CFA). In addition to their educational training, the best fund managers typically possess ten or more years of experience in analyzing and selecting investments.

For most fund managers and researchers, finding the best investments is more than a full-time job. Fund managers do tons of analysis that you probably lack the time or expertise to perform. For example, fund managers do the following: assess company financial statements; interview a company’s managers to get a sense of the company’s business strategies and vision; examine competitor strategies; speak with company customers, suppliers, and industry consultants; and attend trade shows and read industry periodicals.

In short, a mutual fund management team does more research, number crunching, and due diligence than most people could ever have the energy or expertise to do in what little free time they have. Investing in mutual funds frees up time for friendships, family relationships, and maybe even your sex life — don’t miss the terrific time-saving benefits of fund investing!

Cost efficiency

Mutual funds are a cheaper, more communal way of getting your investment work done. When you invest your money in an efficiently managed mutual fund, it likely costs you less than trading individual securities on your own. Fund managers can buy and sell securities for a fraction of the cost that you pay.

Funds also spread the cost of research over thousands of investors. The most efficiently managed mutual funds cost less than 1 percent per year in fees. (Bonds and money market funds cost much less — in the neighborhood of 0.5 percent per year or less.) Some of the larger and more established funds can charge annual fees of less than 0.2 percent per year — that’s less than a $2 annual charge per $1,000 you invest.

Newer exchange-traded funds (ETFs) are like index mutual funds, except that ETFs trade on a stock exchange and, in the best cases, may have a slightly lower management fee than their sibling index mutual funds. See the later section “Keep exchange-traded funds on your radar” for more information.

Diversification

Diversification is a big attraction for many investors who choose mutual funds. Most funds own stocks or bonds from dozens of companies, thus diversifying against the risk of bad news from any single company or sector. Achieving such diversification on your own is difficult and expensive unless you have a few hundred thousand dollars and a great deal of time to invest.

Mutual funds typically invest in 25 to 100 securities or more. Proper diversification increases the fund’s chances of earning higher returns with less risk.

Although most mutual funds are diversified, some aren’t. For example, some stock funds invest exclusively in stocks of a single industry (for example, healthcare) or country (such as Mexico). I’m not a fan of these funds because of the narrowness of their investments and their typically higher operating fees.

Reasonable investment minimums

Most funds have low minimum investment requirements. Many funds have minimums of $1,000 or less. Retirement account investors can often invest with even less. Some funds even offer monthly investment plans so you can start with as little as $50 per month.

Even if you have lots of money to invest, you should consider mutual funds. Increasing numbers of fund companies offer their higher-balance customers special funds with lower annual operating expenses and thus even better returns. (I provide more information on these funds later in this chapter.)

Different funds for different folks

Some people think that mutual funds = stock market investing = risky. This line of thinking is wrong. The majority of money in funds isn’t in the stock market. You can select the funds that take on the kinds of risks that you’re comfortable with and that meet your financial goals. Following is a list of the three major types of funds:

• Stock funds: If you want your money to grow over a long period of time (and you can handle down as well as up years), choose funds that invest more heavily in stocks.
• Bond funds: If you need current income and don’t want investments that fluctuate as widely in value as stocks do, consider some bond funds.
• Money market funds: If you want to be sure that your invested principal doesn’t decline in value because you may need to use your money in the short term, select a money market fund.

Most investors (myself included) choose a combination of these three types of funds to diversify and help accomplish different financial goals. (I cover each type of fund in depth later in this chapter.)

High financial safety

Thousands of banks and insurance companies have failed in recent decades. Banks and insurers can fail because their liabilities (the money that customers gave them to invest, which may need to be returned on short notice) can exceed their assets (the money that they’ve invested or lent).

For example, when big chunks of a bank’s loans go sour at the same time that its depositors want their money, the bank fails, because banks typically have less than 15 cents on deposit for every dollar that you and I place with them. Likewise, if an insurance company makes several poor investments or underestimates the number of insurance policyholder claims, it, too, can fail.

Such failures can’t happen with a mutual fund because the value of the fund’s shares fluctuates as the securities in the fund rise and fall in value. For every dollar of securities they hold for their customers, mutual funds have a dollar’s worth of securities. The worst that can happen with a fund is that if you want your money, you may get less money than you originally put into the fund due to a market value decline of the fund’s holdings — but you won’t lose all your original investment.

For added security, the specific stocks, bonds, and other securities that a mutual fund buys are held at a custodian, a separate organization independent of the mutual fund company. A custodian ensures that the fund management company can’t embezzle your funds or use assets from a better-performing fund to subsidize a poor performer.

Accessibility

What’s really terrific about dealing with mutual funds is that they’re set up for people who value their time and don’t like going to a local branch office and standing in long lines. With fund investing, you can fill out a simple form (often online, if you want) and write a check in the comfort of your home (or authorize electronic transfers from your bank or other accounts) to make your initial investment. You can then typically make subsequent investments by mailing in a check or zapping in money electronically.

Additionally, most money market funds offer check-writing privileges. Many mutual fund companies also allow you to electronically transfer money back and forth from your local bank account; you can access your money almost as quickly through a money market fund as you can through your local bank.

Selling shares of your mutual fund is usually simple. Generally, all you need to do is call the fund company’s toll-free number or visit its website. Some companies have representatives available around the clock, year-round. Most fund companies also offer online account access and trading capabilities as well (although some people are prone to overtrading online, so beware).

Reviewing the Keys to Successful Fund Investing

This chapter helps explain why mutual and exchange-traded funds are good investment vehicles to use. However, keep in mind that not all funds are worthy of your investment dollars. Would you, for example, invest in a fund run by an inexperienced and unproven 18-year-old? How about a fund that charges high fees and produces inferior returns in comparison to similar funds? You don’t have to be an investing wizard to know the correct answers to these questions.

When you select a fund, you can use a number of simple, common-sense criteria to greatly increase your chances of investment success. The criteria presented in the following sections have been proven to dramatically increase your fund investing returns. (Visit my website at www.erictyson.com to see the studies and discussion of various investing strategies.)

Minimize costs

The charges that you pay to buy or sell a fund, as well as the ongoing fund operating expenses, can have a big impact on the rate of return that you earn on your investments. So because hundreds of choices are available for a particular type of mutual fund (larger-company U.S. stock funds, for example), you have no reason to put up with inflated costs.

Fund costs are an important factor in the return that you earn from a mutual fund because fees are deducted from your investment returns and can attack a fund from many angles. All other things being equal, high fees and other charges depress your returns.

Stick with funds that maintain low total operating expenses and that don’t charge sales loads (commissions). 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; less than 0.5 percent for bond funds). See my recommendations in the sections on the best stock mutual funds, bond funds, and money market funds, later in this chapter.

Avoid load funds

The first fee you need to minimize is the sales load, which is a commission paid to brokers and “financial planners” who work on commission and sell mutual funds. Commissions, or loads, generally range from 4.0 to 8.5 percent of the amount that you invest. Sales loads are an additional and unnecessary cost that’s deducted from your investment money. You can find plenty of outstanding no-load (commission-free) funds.

Brokers, being brokers, sing the praises of buying a load fund, warn against no-loads, and sometimes even try to obscure the load. For example, brokers may tell you that the commission doesn’t cost you because the mutual fund company pays it. Remember that the commission always comes out of your investment dollars, regardless of how cleverly some load funds and brokers disguise the commission.

Brokers also may say that load funds perform better than no-load funds. One reason, brokers claim, is that load funds supposedly hire better fund managers. Absolutely no relationship exists between paying a sales charge to buy a fund and gaining access to better investment managers. Remember that the sales commission goes to the selling broker, not to the fund managers. Objective studies demonstrate time and again that load funds not only don’t outperform but in fact underperform no-loads. Common sense suggests why: When you factor in the higher commission and the higher average ongoing operating expenses charged on load funds, you pay more to own a load fund, so your returns are less.

Another problem with commission-driven load-fund sellers is the power of self-interest. This issue is rarely talked about, but it’s even more important than the extra costs that you pay with load funds. When you buy a load fund through a salesperson, you miss out on the chance to get holistic advice on other personal finance strategies. For example, you may be better off paying down your debts or investing in something entirely different from a mutual fund. But in my experience, salespeople almost never advise you to pay off your credit cards or your mortgage — or to invest through your company’s retirement plan or in real estate — instead of buying an investment through them.

Some mutual fund companies, such as Fidelity, try to play it both ways. They sell load funds (through brokers) as well as no-load funds (direct to investors). Be aware of this when a “financial advisor” says he can get you into funds from the leading companies, such as Fidelity, because what he really may be telling you is that he’s pitching load funds.

Beware of high operating expenses

In addition to loads, the other costs of owning funds are the ongoing 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, printing and mailing prospectuses (legal disclosure of the fund’s operations and fees), and so on.

A fund’s operating expenses are essentially invisible to you because they’re deducted from the fund’s share price. Companies charge operating expenses on a daily basis, so you don’t need to worry about trying to get out of a fund at a particular time of the year before the company deducts these fees.

Although operating expenses are invisible to you, their impact on your returns is quite real. Studying the expenses of various money market mutual funds and bond funds is critical; these funds buy securities that are so similar and so efficiently priced in the financial markets that most fund managers in a given type of money market or bond fund earn quite similar returns before expenses.

With stock funds, expenses may play less of an important role in your fund decision. However, don’t forget that, over time, stocks have averaged returns of about 9 to 10 percent per year. So if one stock fund charges 1.5 percent more in operating expenses than another and your expected long-term return is about 10 percent per year, you give up an extra 15 percent of your expected (pre-tax) annual returns (and an even greater portion of your after-tax returns).

All types of 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 a comparable type of fund with high costs. This effect makes sense because companies deduct operating expenses from the returns that your fund generates. Higher expenses mean a lower return to you.

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 a fund’s prospectus, in the fund expenses section, usually in a line that says something like “Total Fund Operating Expenses.” 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 that a fund doesn’t appear to have low expenses simply because it’s temporarily waiving them. (You can ask the fund representative or look at the fees in the fund’s prospectus to find this information.)

Reflect on performance and risk

A fund’s historic rate of return or performance is another important factor to weigh when you select a mutual fund. However, 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 major market declines. Thus, a good fund should consistently deliver a favorable rate of return given the level of risk that it takes.

A big mistake that many investors make when they choose a fund is overemphasizing the importance of past performance numbers. The shorter the time period you analyze, the greater the danger that you’ll misuse high performance as an indicator for a good future fund.

Although past performance can be a good sign, high 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 to come into favor for a few years). The danger of taking more risk is that it doesn’t always work the way you’d like. The odds are high that you won’t be able to pick the next star before it vaults to prominence in the investing sky. You have a far greater chance of getting on board when a recently high-performing fund is ready to plummet back to Earth.

One clever way that fund managers make their funds look better is to compare them to funds that aren’t really comparable. The most common ploy is for a manager to invest a fund in riskier types of securities and then compare its performance to funds that invest in less risky securities. Examine the types of securities that a fund invests in, and then make sure that the comparison funds or indexes invest in similar securities.

Stick with experience

A great deal of emphasis is placed on who manages a specific mutual fund. 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. Vanguard, for example, is terrific at money market, bond, and conservative stock funds, thanks to its low operating expenses. Fidelity has significant experience with investing in U.S. stocks.

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. For example, 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 PIMCO and Dodge & Cox, offer mutual funds.

Consider index funds

Index funds are funds that are mostly managed by a computer. Unlike other mutual funds, in which the portfolio manager and a team of analysts scour the market for the best securities, an index fund manager simply invests to match the makeup, and thus also the performance, of an index (such as the Standard & Poor’s 500 index of 500 large U.S. company stocks). Most exchange-traded funds (ETFs), which I discuss in the next section, are simply index funds that trade on a stock exchange.

Index funds deliver relatively good returns by keeping expenses low, staying invested, and not trying to jump around. 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. Index funds can run with far lower operating expenses because significant ongoing research isn’t needed to identify companies to invest in.

The average U.S. stock mutual fund, for example, has an operating expense ratio of 1.4 percent per year. (Some funds charge expenses as high as 2 percent or more per year.) That being the case, a U.S. stock index fund with an expense ratio of just 0.2 percent per year has an advantage of 1.2 percent per year over the average fund. A 1.2 percent difference may not seem like much, but in fact it’s a significant difference. Because stocks tend to return about 10 percent per year, you end up throwing away about 12 percent of your expected (pre-tax) stock fund returns with an “average fund” in terms of expenses (and an even greater portion of your post-tax returns).

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.

Don’t try to pick in advance one of the few elite money managers who manage to beat the market averages by a few percentage points per year. Also, don’t overestimate the pros’ ability to consistently pick the right stocks. Index funds make sense for a portion of your investments, especially when you invest in bonds and larger, more conservative stocks, where beating the market is difficult for portfolio managers.

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

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

Keep exchange-traded funds on your radar

Exchange-traded funds (ETFs) are relatively new. The first one was created in 1993. They’ve gained some traction in recent years and now hold about 10 percent of the total assets of the fund industry.

ETFs are similar to mutual funds. The most significant difference is that in order to invest, you must buy an ETF through a stock exchange where ETFs trade, just as individual stocks trade. Thus, you need a brokerage account to invest in ETFs. (See Chapter 9 for general information on selecting a brokerage firm.)

Most ETFs are also like index mutual funds in that each ETF generally tracks a major market index. (Beware that more and more companies are issuing ETFs that are actively traded or that track narrowly focused indexes such as an industry group or small country.) The best ETFs may also have slightly lower operating expenses than the lowest-cost index funds. However, you must pay a brokerage fee to buy and sell an ETF, and the current market price of the ETF may deviate slightly from the underlying market value of the securities in its portfolio.

Steer clear of leveraged and inverse exchange-traded funds

Since their introduction in 2006, leveraged and inverse exchange-traded funds have taken in tens of billions in assets. Here’s the lowdown on these funds:

• Leveraged ETFs: These funds claim to magnify the move of a particular index, such as the Standard & Poor’s (S&P) 500 stock index, by double or even triple in some cases. So a double-leveraged S&P 500 ETF is supposed to increase by 2 percent for a 1 percent increase in the S&P 500 index.
• Inverse ETFs: These funds are supposed to move in the opposite direction of a given index. For example, an inverse S&P 500 ETF is supposed to increase by 1 percent for a 1 percent decrease in the S&P 500 index.

The steep 2008 decline in stock market indexes around the globe and the increasing volatility in that year created the perfect environment for leveraged and inverse ETFs. With these new vehicles, you could easily make money from major stock market indexes when they were falling. Or if you were convinced a particular index or industry group was about to zoom higher, you could buy a leveraged ETF that would magnify market moves by double or even triple.

Suppose that back in early 2008, when the Dow Jones Industrial Average had declined about 10 percent from its then-recent peak above 14,000, you were starting to get nervous and wanted to protect your portfolio from a major market decline. So you bought some of the ProShares UltraShort Dow 30 ETF (trading symbol DXD), which is an inverse ETF designed to move twice as much in the opposite direction of the Dow. So if the Dow goes down, DXD goes up twice as much, and you make money.

Now consider what happened when you held on to the ETF through early 2010 — two years after you bought the fund in early 2008. Over this entire two-year period, the Dow was down about 20 percent. So your original thinking that the market was going to fall proved to be correct. If the ETF did what it was supposed to do and moved twice as much in the other direction, it should’ve increased 40 percent in value over this period, thus giving you a tidy return. But it didn’t. It wasn’t even close. The ETF actually plummeted nearly 50 percent in value over this two-year period!

My overall investigations of whether the leveraged (and inverse) ETFs actually deliver on their objectives show that they don’t. In recent years, ETF issuers have come out with increasingly risky and costly ETFs. Leveraged and inverse ETFs are especially problematic in that regard. And now the issuers of these leveraged and inverse ETFs are in trouble for their poor disclosure and misleading marketing. Buried in the fine print of the prospectuses of these ETFs, you usually see notes that these ETFs are designed to accomplish their stated objectives for only one trading day. As a result, they’re really suitable only for day traders! Of course, few investors read (and understand) the dozens of pages of legal boilerplate in a prospectus.

Brokerage firms and industry regulators are taking notice of these problems. The Financial Industry Regulatory Authority (FINRA), the largest independent regulator for U.S. securities firms, issued a lengthy warning to brokers and financial advisors that “inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

Retail investors pumped billions of dollars into leveraged and inverse ETFs without FINRA’s clear explanation and disclosure. If they had, and if they had known how poorly these ETFs actually do over extended periods of time, they wouldn’t have invested.

A number of brokerage firms have suspended trading in these ETFs. They’re worried about their legal exposure as well about what will happen if their customers invest in leveraged and inverse ETFs and get burned.

Leveraged and inverse ETFs aren’t investments. They’re gambling instruments for day traders. As an individual investor, if you happen to guess correctly before a short-term major market move, you may do well over a short period of time (longer than one day but no more than a few months). However, the odds are heavily stacked against you. You can reduce risk and hedge yourself through sensible diversification. If, for example, you don’t want 80 percent of your portfolio exposed to stock market risk, invest a percentage you’re comfortable with and don’t waste your time and money with leveraged and inverse ETFs.

Creating Your Fund Portfolio with Asset Allocation

Asset allocation simply means that you decide what percentage of your investments you place — or allocate — into bonds versus stocks and into international stocks versus U.S. stocks. (Asset allocation can also include other assets, such as real estate and small business, which are discussed throughout this book.)

When you invest money for the longer term, such as for retirement, you can choose among the various types of funds that I discuss in this chapter. Most people get a big headache when they try to decide how to spread their money among the choices. This section helps you begin cutting through the clutter. (I discuss recommended funds for shorter-term goals later in this chapter as well.)

Allocating for the long term

Many working folks have time on their side, and they need to use that time to make their money grow. You may have two or more decades before you need to draw on some portion of your retirement account assets. If some of your investments drop a bit over a year or two — or even over five years — the value of your investments has plenty of time to recover before you spend the money in retirement.

Your current age and the number of years until you retire are the biggest factors in your allocation decision. The younger you are and the more years you have before retirement, the more comfortable you should be with volatile, growth-oriented investments, such as stock funds. (See Chapter 2 for the risks and historic returns of different investments.)

Table 8-1 lists guidelines for allocating fund money that you’ve earmarked for long-term purposes, such as retirement. You don’t need an MBA or PhD to decide your asset allocation — all you need to know is how old you are and the level of risk that you desire!

Table 8-1 Asset Allocation for the Long Haul

What’s it all mean, you ask? Consider this example: If you’re a conservative sort who doesn’t like a lot of risk, but you recognize the value of striving for some growth to make your money work harder, you’re a middle-of-the-road type. Using Table 8-1, if you’re 35 years old, you may consider putting 25 percent (35 – 10) into bond funds and 75 percent (110 – 35) into stock funds.

Now divvy up your stock investment money between U.S. and international funds. Here’s what portion of your stock allocation I recommend investing in overseas stocks:

• 20 percent (for a play-it-safe attitude)
• 35 percent (for a middle-of-the-road attitude)
• 50 percent (for an aggressive attitude)

Using Table 8-1, if a 35-year-old, middle-of-the-road investor puts 75 percent in stocks, she can then invest about 35 percent of the stock fund investments (which works out to be around 25 percent of the total) in international stock funds. So here’s what the 35-year-old, middle-of-the-road investor’s portfolio asset allocation looks like:

Diversifying your stock fund investments

Suppose that your investment allocation decisions suggest that you invest 50 percent in U.S. stock funds. Which ones do you choose? As I explain in the later section “Exploring different types of stock funds,” stock funds differ on a number of levels. You can choose from growth-oriented stocks and funds and those that focus on value stocks as well as from funds that focus on small-, medium-, or large-company stocks. I explain these types of stocks and funds later in this chapter. You also need to decide what portion you want to invest in index funds (which I discuss earlier in “Consider index funds”) versus actively managed funds that try to beat the market.

Generally, it’s a good idea to diversify using different types of funds. You can diversify in one of two ways:

• Purchase several individual funds, each of which focuses on a different style. For example, you can invest in a large-company value stock fund and in a small-company growth fund. I find this approach somewhat tedious. Granted, it does allow a fund manager to specialize and gain greater knowledge about a particular type of stock. But many of the best managers invest in more than one narrow range of security.
• Invest in a handful of funds (five to ten), each of which covers several bases and that together cover them all. Remember, the investment delineations are somewhat arbitrary, and most funds focus on more than just one type of investment. For example, a fund may focus on small-company value stocks but may also invest in medium-company stocks. It may also invest in some that are more growth oriented.

Deciding how much you should use index versus actively managed funds is really a matter of personal taste. If you’re satisfied knowing that you’ll get the market rate of return and that you can’t underperform the market (after accounting for your costs), index your entire portfolio. On the other hand, if you enjoy the challenge of trying to pick the better managers and want the potential to earn better than the market level of returns, don’t use index funds at all. Investing in a happy medium of both, like I do, is always a safe bet.

If you haven’t experienced the sometimes significant plummets in stock prices that occur, you may feel queasy the next time it happens and you’ve got a chunk of your nest egg in stocks. Be sure to read Chapters 2 and 5 to understand the risk in stocks and what you can and can’t do to reduce the volatility of your stock holdings.

The Best Stock Funds

Stock mutual and exchange-traded funds are excellent investment vehicles that reduce your risk, compared to purchasing individual stocks, because they

• Invest in dozens of stocks: Unless you possess a lot of money to invest, you’re likely to buy only a handful of stocks. If you end up with a lemon in your portfolio, it can devastate your other good choices. If such a stock represents 20 percent of your holdings, the rest of your stock selections need to increase about 25 percent in value just to get you back to even. Stock funds mitigate this risk.

  For example, if a fund holds equal amounts of 50 stocks and one goes to zero, you lose only 2 percent of the fund value if the stock was an average holding. Similarly, if the fund holds 100 stocks, you lose just 1 percent. Remember that a good fund manager is more likely than you to sidestep disasters (see the earlier section “Professional management” for details).

• Invest in different types of stocks: Some funds invest in stocks of different sizes of companies in a variety of industries. Others may hold U.S. and international stocks. Different types of stocks (which I explain in the upcoming section titled “Exploring different types of stock funds”) generally don’t move in tandem. So if smaller-company stocks get beat up, larger-company stocks may fare better. If U.S. stocks are in the tank, international stocks may be on an upswing.

In Chapters 2 and 5, I make the case for investing in stocks (also known as equities) to make your money grow. However, stocks sometimes plummet or otherwise remain depressed for a few years. Thus, stock funds (also known as equity funds), which, as their name suggests, invest in stocks, aren’t a place for money that you know you may need to protect in the next few years.

Making money with stock funds

When you invest in stock funds, you can make money in three ways:

• Dividends: As a mutual fund investor, you can choose to receive your share of the dividends paid out to the fund as cash or to reinvest them in purchasing more shares in the fund. Higher-growth companies tend to pay lower dividends.

  Unless you need the income to live on (if, for example, you’re already retired), reinvest your dividends into buying more shares in the fund. If you reinvest outside of a retirement account, keep a record of those reinvestments because you need to factor those additional purchases into the tax calculations that you make when you sell your shares. (Most brokers will allow you to reinvest dividends paid on ETFs without a fee.)

• Capital gains distributions: When a fund manager sells stocks for more than he paid, the resulting profits, known as capital gains, must be netted against losses and paid out to the fund’s shareholders. Just as with dividends, you can reinvest your capital gains distributions in the fund.
• Appreciation: The fund manager isn’t going to sell all the stocks that have gone up in value. Thus, the price per share of the fund increases to reflect the gains in its stock holdings. For you, these profits are on paper until you sell the fund and lock them in. Of course, if a fund’s stocks decline in value, the share price depreciates.

If you add together dividends, capital gains distributions, and appreciation, you arrive at the total return of a fund.

Exploring different types of stock funds

Stock funds and the stocks that they invest in are usually pigeonholed into particular categories based on the types of stocks that they focus on. Categorizing stock funds is often tidier in theory than in practice, though, because some funds invest in an eclectic mix of stocks. So don’t get bogged down with the names of funds — they sometimes have misleading names and don’t necessarily do what those names imply. The investment strategies of the fund and the fund’s typical investments are what matter. The following characteristics are what you need to pay attention to:

• Company size: The first dimension on which a stock fund’s stock selection differs is based on the size of the companies in which the fund invests — small, medium, or large. The total market value (capitalization) of a company’s outstanding stock defines the categories that define the stocks that the fund invests in. (The term capitalization is often shortened to “cap,” so you may hear financial folks tossing around terms like large cap and small cap.) The dollar amounts are arbitrary, and as stock prices increase over time, investment market analysts have moved up their cutoffs. Here’s the latest:
  • 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 between $2 billion and $10 billion.
  • Large-capitalization stocks are those of companies with market values greater than $10 billion.
• Growth versus value: Stock fund managers and their funds are further 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 revenues and profits. These companies tend to reinvest most of their earnings in the company to fuel future expansion; thus, these stocks pay low dividends. For example, eBay pays no dividends and reinvests most of its profits in its business.
  • Value stocks are priced cheaply in relation to the company’s assets, profits, and potential profits. Value stocks tend to pay higher dividends and historically have produced higher total returns than growth stocks.

  Fund companies sometimes use other terms to describe other types of stock funds. Aggressive growth funds tend to invest in the most growth-oriented companies and may undertake riskier investment practices, such as frequent trading. Growth and income funds tend to invest in stocks that pay higher-than-average dividends, thus offering the investor the potential for growth and income. Income funds tend to invest more in higher-yielding stocks. Bonds usually make up the other portion of income funds.

• Company location: Stocks and the companies that issue them are also divvied up 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 focusing in overseas stocks are typically called international or overseas funds.

Putting together two or three of these major classifications, you can start to comprehend all those silly, lengthy names that fund companies give their stock funds. You can have funds that focus on large-company value stocks or small-company growth stocks. You can add in 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.

Using the selection criteria I outline in the earlier section “Reviewing the Keys to Successful Fund Investing,” the following sections describe the best stock funds that are worthy of your consideration. The funds differ primarily in terms of the types of stocks that they invest in. Keep in mind as you read through these funds that they also differ in their tax-friendliness (see Chapter 3). However, if you invest inside a retirement account, you don’t need to worry about tax-friendliness.

U.S. stock funds

Of all the different types of funds offered, U.S. stock funds are the largest category. Stock funds differ mainly in terms of the size of the companies that they invest in and in whether the funds focus on growth or value companies. Some funds hold all these characteristics, and some funds may even invest a bit overseas.

The only way to know for sure where a fund currently invests (or where the fund may invest in the future) is to ask. You can call the fund company that you’re interested in to start your information search, or you can visit the company’s website. You can also read the fund’s annual report (just a little light reading before heading off to the land of Nod). Don’t waste your time looking for this information in the fund’s prospectus, because it doesn’t give you anything beyond general parameters that guide the range of investments. The prospectus generally doesn’t tell you what the fund currently invests in or has invested in.

For funds that you hold outside of retirement accounts, you owe current income tax on distributed dividends and capital gains. As I discuss in Chapter 3, long-term capital gains and stock dividends are taxed at lower rates than ordinary income and other investment income.

Here’s my short list of U.S. stock funds:

• Dodge & Cox Stock
• Fairholme Fund
• Fidelity Low-Priced Stock
• Sequoia
• T. Rowe Price Spectrum Growth (holds some foreign stocks)
• Vanguard Total Stock Market Index, PRIMECAP, Selected Value, Tax-Managed Capital Appreciation, Tax-Managed Small Cap, and Total Stock Market (ETF)

International stock funds

For diversification and growth potential, you should include in your portfolio stock funds that invest overseas. Normally, you can tell that you’re looking at a fund that focuses its investments overseas if its name contains words such as international (foreign only), global (foreign and U.S.), or worldwide (foreign and U.S.).

As a general rule, avoid foreign funds that invest in just one country, regardless of whether that country is Australia, Zimbabwe, or anywhere in between. As with investing in a sector fund that specializes in a particular industry (see the following section), this lack of diversification defeats the whole purpose of investing in funds. Funds that focus on specific regions, such as Southeast Asia, are better but still generally problematic because of poor diversification and higher expenses than other, more-diversified international funds.

If you want to invest in more geographically limiting international funds, take a look at T. Rowe Price’s and Vanguard’s offerings, which invest in broader regions, such as just Europe, Asia, and the volatile but higher-growth-potential emerging markets in Southeast Asia and Latin America.

In addition to the risks normally inherent with stock fund investing, changes in the value of foreign currencies relative to the U.S. dollar cause price changes in the international securities. A decline in the value of the U.S. dollar helps the value of foreign stock funds (and conversely, a rising dollar versus other currencies can reduce the value of foreign stocks). Some foreign stock funds hedge against currency changes. Although this hedging helps reduce volatility a bit, it does cost money.

Here are my picks for diversified international funds:

• Dodge & Cox International
• Harbor International
• Litman Gregory Masters’ International
• Oakmark International and Oakmark Global (holds some U.S. stocks)
• Tweedy, Browne Global Value (invests in the U.S. as well)
• Vanguard Global Equity (invests in the U.S., too), International Growth, Tax-Managed International, Total International Stock Index, FTSE All-World ex-US (ETF), and Total International Stock (ETF)

Sector funds

Sector funds invest in securities in specific industries. In most cases, you should avoid sector funds for a number of reasons, including the following:

• Lack of diversification: Investing in stocks of a single industry defeats a major purpose of investing in mutual funds — you give up the benefits of diversification. Also, even if you’re lucky enough to jump into a sector fund just before it becomes “hot,” you can’t assume that the fund will pick the right securities within that sector.
• High fees: They tend to carry much higher fees than other mutual funds.
• Taxable distributions: Many sector funds have high rates of trading or turnover of their investment holdings. Investors who use these funds outside of retirement accounts have to pay the tax man for the likely greater taxable distributions that this trading produces.

The only types of specialty funds that may make sense for a small portion (10 percent or less) of your entire investment portfolio are funds that invest in real estate or precious metals. These funds can help diversify your portfolio because they can perform better during times of higher inflation — which often depresses bond and stock prices. (However, you can comfortably skip these funds because diversified stock funds tend to hold some of the same stocks as these specialty funds.) Here are some details about these two specialty fund types:

• Real estate funds: Real estate investment trusts (REITs) are stocks of companies that invest in real estate. REITs typically invest in properties such as apartment buildings, shopping centers, and other rental properties. REITs allow you to invest in real estate without the hassle of being a landlord. Evaluating REIT stocks is a hassle, but you can always invest in a fund of REITs.

  REITs usually pay healthy levels of dividends, which, unlike stock dividends, are taxed at ordinary income tax rates. As such, they’re less appropriate for people in a higher tax bracket who invest money outside of retirement accounts. Some good no-load REIT funds include Fidelity Real Estate, T. Rowe Price Real Estate, and Vanguard REIT Index.

• Precious metals: If you expect higher inflation, consider a gold fund. But know that these funds swing wildly in value and aren’t for the faint of heart. A good precious-metals fund is the Vanguard Precious Metals and Mining Fund.

  Don’t buy bullion itself; storage costs and the concerns over whether you’re dealing with a reputable company make buying gold bars a pain. Also avoid futures and options, which are gambles on short-term price movements (see Chapter 1 for information).

The Best Bond Funds

Bond funds can make you money in the same three ways that a stock fund can: dividends, capital gains distributions, and appreciation. (See the earlier section “Making money with stock funds” for more on these ways of making money.) However, most of the time, the bulk of your return in a bond fund comes from dividends.

Although an overwhelming number of bond fund choices exists (thousands, in fact), not that many remain after you eliminate high-cost funds (those with loads and high ongoing fees), low-performance funds (which are often the high-cost funds), and funds managed by fund companies and fund managers with minimal experience investing in bonds. Here are the aspects to consider when choosing bond funds:

• Length to maturity: Bond fund objectives and names usually fit one of three maturity categories — short-, intermediate-, and long-term. You can earn a higher yield from investing in a bond fund that holds longer-term bonds, but as I explain in Chapter 7, such bond prices are more sensitive to changes in interest rates.
• Quality: Generally speaking, the lower their 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.
• Loads and fees: After you settle on the type of bonds that 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.
• Tax implications: Pay attention to the taxability of the dividends that bonds pay. If you’re investing in bonds inside of retirement accounts, you want taxable bonds. If you invest in bonds outside of retirement accounts, the choice between taxable versus tax-free depends on your tax bracket (see Chapter 3).

Bond funds fluctuate in value, so 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 different funds, including bond funds. (See the section “Allocating for the long term” earlier in this chapter.)

Avoiding yield-related missteps

When selecting bond funds to invest in, investors are often led astray as to how much they can expect to make. The first mistake is to look at recent performance and assume that you’ll get that return in the future. Investing in bond funds based on recent performance is particularly tempting immediately after a period where interest rates have declined (as in the 1990s and the early and late 2000s), because declines in interest rates pump up bond prices and therefore bond fund total returns. Remember that an equal but opposite force waits to counteract pumped-up bond returns: Bond prices fall when interest rates rise.

Don’t get me wrong: Past performance is an important issue to consider. In order for performance numbers to be meaningful and useful, you must compare bond funds that are comparable (such as intermediate-term funds that invest exclusively in high-grade corporate bonds).

Bond funds calculate their yield after subtracting their operating expenses. When you contact a fund company seeking a fund’s current yield, make sure you understand what time period the yield covers. Fund companies are supposed to give you the SEC yield, which is a standard yield calculation that allows for fairer comparisons among bond funds. The SEC yield, which reflects the bond fund’s yield to maturity, is the best yield to use when you compare funds because it captures the effective rate of interest that an investor can receive in the future.

Unfortunately, if you select bond funds based on advertised yield, you’re quite likely to purchase the wrong bond funds. Bond funds and the fund companies that sell them can play more than a few games to fatten a fund’s yield. Such sleights of hand make a fund’s marketing and advertising departments happy because higher yields make it easier for salespeople and funds to hawk their bond funds. But remember that yield-enhancing shenanigans can leave you poorer. Here’s what you need to watch out for:

• Lower quality: When comparing one short-term bond fund to another, you may discover that one pays 0.5 percentage points more and decide that it looks better. However, you may find out later that the higher-yielding fund invests 20 percent of its money in junk (non-investment grade) bonds, whereas the other fund fully invests in high-quality bonds.
• Longer maturities: Bond funds can usually increase their yield just by increasing their maturity a bit. So if one long-term bond fund invests in bonds that mature in an average of 17 years and another fund has an average maturity of 12 years, comparing the two is a classic case of comparing apples and oranges.
• Giving your money back without your knowing it: Some funds return a portion of your principal in the form of dividends. This move artificially pumps up a fund’s yield but depresses its total return. When you compare bond funds, make sure you compare their total return over time (in addition to making sure that the funds have comparable portfolios of bonds).
• Waiving of expenses: Some bond funds, particularly newer ones, waive a portion or even all of their operating expenses to temporarily inflate the fund’s yield. Yes, you can invest in a fund that has a sale on its operating fees, but you’d also buy yourself the bother of monitoring things to determine when the sale is over. Bond funds that engage in this practice often end sales quietly when the bond market is performing well. Don’t forget that if you sell a bond fund (held outside of a retirement account) that has appreciated in value, you owe taxes on your profits.

Treading carefully with actively managed bond funds

Some bond funds are aggressively managed. Managers of these funds possess a fair degree of latitude to purchase and trade bonds that they think will perform best in the future. For example, if a fund manager thinks interest rates will rise, she usually buys shorter-term bonds and keeps more of a fund’s assets in cash. The fund manager may invest more in lower-credit-quality bonds if she thinks that the economy is improving and that more companies will prosper and improve their credit standing.

Aggressively managed funds are a gamble. If interest rates fall instead of rise, the fund manager who moved into shorter-term bonds and cash experiences worse performance. If interest rates fall because the economy sinks into recession, the lower-credit-quality bonds will likely suffer from a higher default rate and depress the fund’s performance even further.

Some people think the “experts” have no trouble predicting which way interest rates or the economy is heading. The truth is that economic predictions are always difficult, and the experts are often wrong. Few bond fund managers have been able to beat a buy-and-hold approach. However, William Gross, who manages the PIMCO and Harbor bond funds, is one fund manager who has pretty consistently beaten the market averages.

But remember that trying to beat the market can lead to getting beaten! Recent years have shown an increasing number of examples of bond funds falling on their faces after risky investing strategies backfire. Interestingly, bond funds that charge sales commissions (loads) and higher ongoing operating fees are the ones that are more likely to blow up, perhaps because these fund managers are under more pressure to pump up returns to make up for higher operating fees.

It’s fine to invest some of your bond fund money in funds that try to hold the best position for changes in the economy and interest rates, but remember that if these fund managers are wrong, you can lose more money. Over the long term, you’ll probably do best with efficiently managed funds that stick with an investment objective and that don’t try to time and predict the bond market. Index funds (and their companion exchange-traded funds) that invest in a relatively fixed basket of bonds so as to track a market index of bond prices are a good example of this passive approach.

Stabilizing your portfolio by investing in short-term bond funds

Of all bond funds, short-term bond funds are the least sensitive to interest rate fluctuations. The stability of short-term bond funds makes them appropriate investments for money that you seek a better rate of return on than a money market fund can produce for you. But with short-term bond funds, you also have to tolerate the risk of losing a percent or two in principal value if interest rates rise.

Short-term bonds work well for money that you earmark for use in a few years, such as the purchase of a home or a car, or for money that you plan to withdraw from your retirement account in the near future.

Taxable short-term bond funds

Consider bond funds that pay taxable dividends when you’re not in a high tax bracket and for investing inside of retirement accounts. With yields generally low for shorter-term bonds, expenses are ultra-important with this type of fund. My picks in this category are the Vanguard Short-Term Investment-Grade fund and Vanguard Short-Term Corporate Bond ETF.

Important note: Many of the Vanguard funds recommended in this chapter offer “Admiral” versions that have even lower operating fees for customers investing at least $10,000 for an index fund that offers Admiral shares, $50,000 for an actively managed fund, and $100,000 for certain sector-specific index funds and tax-managed funds.

U.S. Treasury short-term bond funds

U.S. Treasury bond funds may be appropriate if you prefer a bond fund that invests in U.S. Treasuries (which possess the safety of government backing; see Chapter 7 for details). They’re also a fine choice if you’re not in a high federal tax bracket but you’re in a high state tax bracket (5 percent or higher). Vanguard Short-Term Treasury is a good choice, but with short-term yields as low as they’ve been in recent years, consider buying short-term bonds directly from the Treasury Department.

I don’t recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds.

Federally tax-free short-term bond funds

State and federally tax-free short-term bond funds are scarce. If you want shorter-term bonds, and if you’re in a high federal bracket but in a low state bracket (less than 5 percent), consider investing in these federally tax-free bond funds (whose dividends are state taxable):

• Vanguard Short-Term Tax-Exempt
• Vanguard Limited-Term Tax-Exempt

If you live in a state with high taxes, consider checking out the state and federally tax-free intermediate-term bond funds (which I discuss in the next section) — if you can withstand their somewhat higher volatility. Another option is to use a state money market fund, which is covered later in this chapter in “The Best Money Market Funds.”

Earning higher returns with intermediate-term bond funds

Intermediate-term bond funds hold bonds that typically mature in a decade or so. They’re more volatile than shorter-term bonds but can also prove more rewarding. The longer you own an intermediate-term bond fund, the more likely you are to earn a higher return on it than on a short-term fund, unless interest rates continue to rise over many years.

As an absolute minimum, don’t purchase an intermediate-term fund unless you expect to hold it for three to five years — or even longer, if you can. You need to make sure that the money you put into an intermediate-term fund is money that you don’t expect to use in the near future.

Taxable intermediate-term bond funds

Taxable intermediate-term bond funds to consider include the following:

• Dodge & Cox Income
• Harbor Bond
• PIMCO Total Return (ETF)
• Vanguard GNMA, High-Yield Corporate, Total Bond Market Index, and Intermediate-Term Corporate Bond (ETF)

U.S. Treasury intermediate-term bond funds

Consider U.S. Treasury bond funds if you prefer a bond fund that invests in U.S. Treasuries (which maintain the safety of government backing). You can also invest in them if you’re not in a high federal tax bracket but you’re in a high state tax bracket (5 percent or higher). I don’t recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds.

A couple of my favorites are Vanguard Inflation-Protected Securities and Vanguard Intermediate-Term Treasury.

Federally tax-free intermediate-term bond funds

You should consider federally tax-free bond funds if you’re in a high federal bracket but in a relatively low state bracket (less than 5 percent).

Good federally tax-free bond funds include the following:

• T. Rowe Price Summit Municipal Intermediate
• Vanguard Intermediate-Term Tax-Exempt

If you’re in high federal and state tax brackets, refer to the state and federally tax-free bonds that I mention later in this chapter.

Using long-term bond funds to invest aggressively

Long-term bond funds are the most aggressive and volatile bond funds around. If interest rates on long-term bonds increase substantially, you can easily see the principal value of your investment decline 10 percent or more. (See Chapter 7 for a discussion of how interest rate changes impact bond prices.)

Long-term bond funds are generally used for retirement investing in one of two situations:

• Investors don’t expect to tap their investment money for a decade or more.
• Investors want to maximize current dividend income and are willing to tolerate volatility.

Remember: Don’t use these funds to invest money that you plan to use within the next five years, because a bond market drop can leave your portfolio short of your monetary goal.

Taxable long-term bond funds

Be careful with longer-term bond funds, as they’re generally much more volatile than most bond funds. My recommendations in this category are the Vanguard Long-Term Investment-Grade fund and the Vanguard Long-Term Corporate Bond ETF.

U.S. Treasury long-term bond funds

U.S. Treasury bond funds may be advantageous if you want a bond fund that invests in U.S. Treasuries. They’re also great if you’re not in a high federal tax bracket but you’re in a high state tax bracket (5 percent or higher). I recommend Treasuries for non-retirement accounts only, because Treasuries pay less interest than fully taxable bond funds.

I recommend the Vanguard Long-Term Treasury fund.

Federally tax-free long-term bond funds

Municipal (federally tax-free) long-term bond funds that I recommend are Fidelity Municipal Income and Vanguard Long-Term Tax-Exempt.

State and federally tax-free long-term bond funds

State and federally tax-free bond funds may be appropriate when you’re in high federal and high state (5 percent or higher) tax brackets. Fidelity, T. Rowe Price, and Vanguard offer good funds for a number of states. If you can’t find a good, state-specific fund for where you live or if you’re only in a high federal tax bracket, you can use the nationwide Vanguard Municipal bond funds.

Balanced and Asset Allocation Funds: The Best Hybrid Funds

Hybrid funds invest in a mixture of different types of securities. Most commonly, they 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.

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

Hybrid funds come in two forms:

• Balanced funds generally try to maintain a fairly constant percentage of investment in stocks and bonds.
• Asset allocation funds, by contrast, normally adjust the mix of different investments according to the portfolio manager’s expectations.

  Some asset allocation funds, however, tend to keep more of a fixed mix of stocks and bonds, whereas some balanced funds shift the mix around quite frequently. (Although the concept of a manager being in the right place at the right time and beating the market averages sounds good in theory, most funds that shift assets fail to outperform a buy-and-hold approach.)

Because hybrid funds pay decent dividends from the bonds that they hold, they’re not appropriate for some investors who purchase funds outside tax-sheltered retirement accounts. With the exception of the Vanguard Tax-Managed Balanced Fund, which holds federally tax-free bonds, avoid hybrid funds if you’re in a higher tax bracket. (Chapter 7 has details on tax-free bonds.) You should consider buying separate tax-friendly stock funds and tax-free bond funds (both discussed earlier in this chapter) to create your own hybrid portfolio.

Here’s my recommended short list of great balanced-type mutual funds:

• Dodge & Cox Balanced
• Fidelity Freedom funds and Fidelity Puritan
• FPA Crescent
• T. Rowe Price Balanced and T. Rowe Price Retirement funds
• Vanguard LifeStrategy funds, Wellesley Income, and Wellington

The Best Money Market Funds

As I explain in Chapter 7, money market funds are a safe, higher-yielding alternative to bank accounts. (If you’re in a higher tax bracket, money market funds have even more appeal because you can get tax-free versions of money market funds.) Under Securities and Exchange Commission regulations, money market funds can invest only in the highest-credit-rated securities, and their investments must have an average maturity of less than 60 days. The short-term nature of these securities effectively eliminates the risk of money market funds being sensitive to changes in interest rates.

The securities that money market funds use are extremely safe. General-purpose money market funds invest in government-backed securities, bank certificates of deposit, and short-term corporate debt that the largest and most creditworthy companies and the U.S. government issue.

When shopping for a money market fund, consider these factors:

• Expenses: Within a given category of money market funds (general, Treasury, municipal, and so on), fund managers invest in the same basic securities. The market for these securities is pretty darn efficient, so “superstar” money market fund managers may eke out an extra 0.1 percent per year in yield but not much more.

  Select a money market fund that does a good job controlling its expenses. The operating expenses that the fund deducts before payment of dividends are the biggest determinant of yield. All other things being equal (which they usually are with different money market funds), lower operating expenses translate into higher yields for you.

  You have no need or reason to tolerate annual operating expenses of greater than 0.5 percent. Some top-quality funds charge 0.3 percent or less annually. Remember, lower expenses don’t mean that a fund company cuts corners or provides poor service. Lower expenses are possible in most cases because a fund company is successful in attracting a lot of money to invest. (Note that many money market funds have been waiving a portion of their management fee in recent years due to ultra-low interest rates. Otherwise, the yield on their funds would be negative.)

• Tax consequences: With money market funds, all your return comes from dividends. What you actually get to keep of these returns (on non-retirement account investments) is what’s left over after the federal and state governments take their cut of your investment income. If you invest money that’s held outside of a retirement account and you’re in a high tax bracket, you may come out ahead if you invest in tax-free money market funds. If you’re in a high-tax state, then a state money market fund, if good ones exist for your state, may be a sound move.

  Tax-free refers to the taxability of the dividends that the fund pays. You don’t get a tax deduction for money that you put into the fund, as you do with 401(k) or other retirement-type accounts.

• Location of other funds: Consider what other investing you plan to do at the fund company where you establish a money market fund. Suppose that you decide to make fund investments in stocks and bonds at T. Rowe Price. In that case, keeping a money market fund at a different firm that offers a slightly higher yield may not be worth the time and administrative hassle, especially if you don’t plan on holding much cash in your money market fund.
• Associated services: Good money market funds offer other useful services, such as free check writing, telephone exchange and redemptions, and automated electronic exchange services with your bank account.

Most fund companies don’t have many local branch offices. Generally, this fact helps these companies keep their expenses low so they can pay you greater money market fund yields. You may open and maintain your mutual fund account via the fund’s toll-free phone lines, the mail, or the company’s website. You don’t really get much benefit, except psychological, if you select a fund company with an office in your area. However, having said that, I don’t want to diminish the importance of your emotional comfort level.

In the following sections, using the criteria that I just discussed, I recommend the best money market funds — those that offer competitive yields, check-writing, access to other excellent mutual funds, and other commonly needed money market services.

Taxable money market funds

Money market funds that pay taxable dividends may be appropriate for retirement account funds that await investment as well as for non-retirement account money when you’re not in a high federal tax bracket and aren’t in a high state tax bracket (less than 5 percent).

Here are the best taxable money market funds to consider:

• Fidelity Cash Reserves
• T. Rowe Price Summit Cash Reserves (higher yields if you invest $25,000)
• Vanguard’s Prime Money Market

U.S. Treasury money market funds

Consider U.S. Treasury money market funds if you prefer a money market fund that invests in U.S. Treasuries, which maintain the safety of government backing, or if you’re not in a high federal tax bracket but are in a high state tax bracket (5 percent or higher).

The following lists U.S. Treasury funds that I recommend:

• Fidelity’s Government Money Market ($25,000 minimum)
• USAA’s Treasury Money Market
• Vanguard Admiral Treasury Money Market

Municipal money market funds

Municipal (also known as muni) money market funds invest in short-term debt that state and local governments issue. A municipal money market fund, which pays you federally tax-free dividends, invests in munis issued by state and local governments throughout the country. A state-specific municipal fund invests in state and local government-issued munis for one state, such as New York. So if you live in New York and buy a New York municipal fund, the dividends on that fund are federal and New York state-tax-free.

So how do you decide whether to buy a nationwide or state-specific municipal money market fund? Money market funds that are only federally tax-free may be appropriate when you’re in a high federal tax bracket but not in a high state bracket (less than 5 percent). State-tax-free municipal money market funds are worth considering when you’re in a high federal and a high state tax bracket (5 percent or higher).

If you’re in a higher state tax bracket, your state may not have good (or any) state-tax-free municipal money market funds available. If you live in any of those states, you’re likely best off with one of the following national municipal money market funds:

• T. Rowe Price Summit Municipal Money Market ($25,000 minimum)
• USAA Tax-Exempt Money Market
• Vanguard Tax-Exempt Money Market

Fidelity, USAA, and Vanguard have good funds for a number of states. If you can’t find a good, state-specific fund for your state or you’re only in a high federal tax bracket, use one of the nationwide muni money markets that I describe in the preceding list.