13. Index Funds: Get What You Pay For
You might find this shocking: But when you invest, simplicity works best.
So now that you know the general rules of investing, I am going to make life very easy on you. I am going to lead you to the sweetest deal the mutual fund world offers. It is your foolproof way to amass a fortune. Tuck it into your retirement fund, and you should be more successful than many Wall Street stock pickers with years of experience and elaborate strategies.
I’m talking about what are known as “index funds.”
If you have a 401(k) and are overwhelmed with the stock fund choices in it, simply look through the list and try to find the word index on one of the funds. It probably will say something like “Standard & Poor’s 500 Index” or maybe “total stock market index.”
If you spot those words, buy one of those funds. You have found a special kind of mutual fund that has success written all over it. That single fund can be your core investment for life—a no-frills, uncomplicated, cheap mutual fund that invests in 500 of the nation’s largest companies, or what is roughly referred to as the stock market. With an index fund, you can be a stock investor the easy way.
You can put money from every paycheck into one of these index funds and turn your back without giving it a second thought. Because you will have 500 or more stocks, you will be well diversified. Because the fees in index funds usually are very low, you are likely to make more money with it than other funds that invest in large companies.
Likewise, if you are starting an IRA and are overwhelmed by the thousands of choices out there, you can go to a mutual fund company known for its low-cost index funds. Then simply plop your money into a total stock market index fund; hold it forever; feed new money into it every week, every month, or every year; and stop worrying about how to discriminate among all the funds with the wacky names.
If you do this, you have to pay attention to just one thing: getting the proportion right in your portfolio. A total stock market index fund invests exclusively in U.S. stocks—no bonds, no foreign stocks. So if you are in your 20s and feel comfortable with the ups and downs of the stock market, you can simply begin your investing years with 100 percent of your money in this fund. If you are somewhat older, the index fund is fine for your stock money, but you need a bond fund too. I’ll help you with quantities later in this chapter.
Now, I want you to be aware that index funds come in different varieties. The most common two—the ones most often in 401(k) plans—invest in either the Standard & Poor’s 500 or the total stock market. When you see those terms, they mean roughly one thing: the stock market. These are the mutual funds that make sense to buy and hold for life.
If you put your money in either, you will be a stockholder. On the days you turn on the news and hear that the stock market has gone up, you will be able to assume that you made money. On the days you hear that the stock market has gone down, you will assume that you lost money.
If history repeats the way it has for the past 86 years, you will average close to 10 percent annually on your money in that index fund over a lifetime of investing. Remember, I said average. Some years you will lose—maybe 20 percent or more. Some years you will win—maybe 20 percent or more. Over the past 86 years, all the wins and losses in the stock market have blended into a decent gain.
If you had money in a Standard & Poor’s 500 index fund, you would have lost 22 percent of your money in 2002 and gained 28.5 percent the following year. You would have lost 37 percent in 2008 and gained 26.5 percent in 2009. After blending together all the gains and losses over the last decade, you would have averaged about a 4.5 percent return annually for each year of the past 10 years ending June 2012.
You might think, “Earning about 4.5 percent a year is not so good. Those index funds didn’t even grow at 10 percent, the historical average in the stock market.” But the lower return didn’t happen because the fund was a dud. It happened because the stock market itself went through some horrible years. And if you had decided to try to outsmart the market by seeking a fund manager who would excel, you would have likely done worse. The average fund with a professional at the helm, who tried to maneuver skillfully through good and bad times, ended up providing you less—a return of only 4 percent a year on average instead of 4.5 percent in the Standard & Poor’s 500 index fund.
The simple Standard & Poor’s 500 index fund beat 87 percent of all the other funds that hired savvy investing professionals to pick the best large company stocks, according to Morningstar research. In other words, if you had bought an index fund, you would have skipped all the expensive strategies that Wall Street peddles, and you still would have been the winner—a do-it-yourselfer beating the best and the brightest. That’s how you become an extraordinary investor without effort.
The past 10 years have not been an aberration. During the last three years, the simple funds crushed 90 percent of the pros, gaining 14.9 percent a year, while the highly paid stock pickers delivered just 12.4 percent. For years, the simple index fund has proven its stuff.
It has triumphed over the majority of stock-pickers who get paid handsomely to try to do better.
What’s an Index Fund?
To understand index funds, you have to first know what other mutual funds do. As I explained in previous chapters, most funds in a 401(k), and almost all the funds brokers sell, employ an investing pro to pick stocks for you. He or she gets paid a lot for helping you make money—about $500,000, on average, and often more than $1 million.
The pro’s goal is to cherry-pick through the stock market for the very best stocks, the ones that will become valuable and make you money in your mutual fund. When investing professionals or fund managers think they see a winner, they buy it. If the fund managers spot a loser, they avoid it. If the fund managers have already bought a stock that has become a dud, they sell it.
All this sounds attractive to the ordinary person. None of us wants a loser; we all want winners. As I explained in the preceding chapter, the investment industry is built around the concept that investors should be willing to pay a pretty penny for the opportunity to have a pro navigate the stock market for them.
The trouble is selecting stocks is difficult. Even the best investment pros let investors down. All the cherry picking usually leaves investors with less money than they’d have if they simply said they’d be willing to accept all the losers along with the winners in the stock market. They’d simply close their eyes and buy the entire stock market, including its shining stars and warts— great stocks, awful stocks, and mediocre stocks.
This is what index funds do. They don’t hire expensive fund managers to navigate through the stock market for you. They just buy everything in the stock market. When you buy a Standard & Poor’s 500 index fund, or a total stock market index fund, you are buying the full array of stocks that make up what’s known as the stock market. The secret to their success: They don’t charge you much—perhaps only 0.17 percent. So you keep more of your money than you would if your fund used a stock picker.
Because this simple, low-cost approach enables investors to repeatedly beat the pros, I think the conclusion is easy: Just invest in the full stock market through an index fund.
A broker might tell you that you can get only mediocre returns that way. They’ve said to me, “A person doesn’t want to be an ordinary student, a mediocre athlete, or an average worker, so why would they want to settle for average as an investor?”
The answer is simple: Mediocre is better than the most highly paid, highly respected fund managers tend to do. People who know a lot more than the novice investor see it this way. Pension funds, which have investment experts at the helm, often use index funds as a core investment in the stock market.
Typically, pension funds use a simple index, like the Standard & Poor’s 500 Index, for close to 50 percent of the money they invest in the stock market. These people have a tremendous responsibility: They must amass enough money to pay retirees’ pensions in the future. That should tell you something: Byron Wien, who spent years at Morgan Stanley, noted in 2004 that using an index fund once would have been considered heresy in his profession, which makes money by selling investors on the value of stock picking. During the past few years, it has simply been considered smart. Index funds have proven themselves in good times and bad. During the last decade, only 13 percent of the brainy, highly paid professional fund managers have been able to beat the simple Vanguard total stock market index fund.
What’s the Stock Market, and What’s a Stock Market Index?
We all have a sense of what the stock market is. Each day, TV and radio news tells us, “The stock market was up today” or “The stock market was down today.”
What most people don’t know is that the stock market isn’t just one thing. There are different stock markets—or, more precisely, different pieces of the full stock market. Each has a name you might recognize. Knowing the names is necessary for picking an index fund because there are various index funds—some that make that perfect all-around investment I mentioned, and some that add spice to the core investment you can buy and hold for life.
The Dow
Most people have heard of the Dow Jones Industrial Average. That’s usually what TV and radio reports are referring to when they say that the stock market is up or down that day. The Dow is simply an index, a collection of stocks used to easily report on the stock market. It is not really the entire stock market. The full stock market actually includes more than 5,000 stocks; the Dow includes just 30.
Why does the Dow get so much attention every day? Because that index contains an array of 30 powerful companies from every industry. The 30 stocks are looked at as a group—through the Dow index—as a means of taking the economy’s temperature or getting a glimpse of how corporate America’s health is perceived.
If investors think companies will be delivering strong profits in the near future, they will buy stocks, the prices on the stocks will rise, and the Dow will be up that day. If investors are worried about the health of all or part of the economy, investors will sell stocks, the prices on stocks will fall, and the Dow will be down.
If you invested in a Dow index fund, the fund manager wouldn’t try to pick the winners from 30 stocks and avoid the losers. The fund would buy all 30 stocks so that your fund mimicked the Dow index. Consequently, you would own a tiny piece of all 30 industrial giants, everything from ExxonMobil to General Electric. You would have the winning stocks that would become more valuable investments and the losing stocks that might become less valuable—or even ghastly investments. But the individual stocks wouldn’t matter to you. You would make money based on the average value of the full array of 30 stocks in the Dow index.
The Standard & Poor’s 500
If you buy an index fund in your 401(k), it’s likely to be a different index from the Dow, but the concept is the same as I just described. The most common index fund in 401(k)s is what’s called a Standard & Poor’s 500 index fund.
Instead of containing just 30 stocks, the Standard & Poor’s 500 includes 500 stocks from the largest American companies. So a fund manager for a Standard & Poor’s 500 index fund would buy all 500 stocks, paying no attention to winners and losers. If you owned a share of a Standard & Poor’s 500 index fund, you would own a tiny piece of everything from Exxon and Johnson & Johnson to Wal-Mart and Microsoft. When you heard that the stock market was up one day, you could assume that you made money.
Generally, when you hear Wall Street experts talking about the stock market, they are not talking about the Dow. They are usually referring to the Standard & Poor’s 500. When you hear that the stock market has averaged a 9.8 percent return a year over the past 86 years, people are referring to the Standard & Poor’s 500. (It is sometimes called the “S&P” for short.) It is Wall Street’s favorite shorthand way of taking the temperature of all the stocks bought and sold day in and day out.
Because the stocks in the Standard & Poor’s 500 index are so large, the index represents about 70 percent of the value of all stocks that are available. But even though Wall Street repeatedly calls the Standard & Poor’s 500 “the stock market,” it is not really the full market. It’s missing the smaller stocks that make up approximately 30 percent of the stock market.
The Total Stock Market
A handful of other indexes represent roughly the full stock market. One, called the Wilshire 5000, includes more than 5,000 different stocks—large ones such as General Electric and Johnson & Johnson, but also smaller ones such as H&R Block, Expedia, Cheesecake Factory, Hyatt Hotels, Aeropostale, and hundreds of small companies with names you probably wouldn’t recognize. The smaller companies and the huge quantity of companies differentiate this index from the Standard & Poor’s 500 index.
If your 401(k) plan has a fund that contains words such as total stock market index, the fund is about the most diverse one you can find. It is probably designed to mimic the Wilshire 5000 or perhaps a somewhat smaller index known as the MSCI Broad Market Index or the Russell 3000 index.
A total stock market index fund is an easy one-stop pick. If you select it, you will have large stocks and small stocks. You will be a long way toward doing what every investor should do: You will have a diverse mixture of stocks. Your fund will always contain some winners and some losers. Despite the losers, the average annual return for the 15 years ending June 30, 2012, has been about 5 percent. Meanwhile, funds that tried to beat that number by employing savvy stock pickers had less to show for their efforts. They averaged just 4.4 percent a year over the same period. In other word, investors who relied on the savvy fund managers paid more to get less.
Again, the beauty of an index fund and the reason it beats many other funds is that it’s cheap. For the privilege of investing in the entire stock market, the investor in the Vanguard Total Stock Market Index (VTSMX) pays only 0.17 percent of his or her assets—a lot less than the 1.4 percent on a fund employing a professional stock picker to find winners and avoid losers.
If you had two funds that had the same return before you were charged fees—a traditional one with a professional stock picker and average fees, plus an index fund—you would end up with a lot more money in the index fund. That’s because you give up only 0.17 percent of your money to have the index fund. You give up 1.4 percent to have the stock picker.
The decision is easy: For your core large-cap stock fund, simply buy an index fund full of large company stocks. Two of the lowest-cost funds are the Vanguard Total Stock Market Index and the Fidelity Spartan Total Market Index.
Using Index Funds in a 401(k)
When you have a 401(k), your choices are limited. Your employer gives you only a few mutual fund options. You might not have an index fund among them, but chances are, you do have one. About 60 percent of 401(k) plans offer an index fund, and if you work for a large company, an index fund is probably embedded somewhere in the midst of your fund list.
Usually, the choice would be a Standard & Poor’s 500 index fund. If you find this index fund, select it for your exposure to large cap stocks. You won’t need any additional large-cap stock funds.
Then, of course, return to your 401(k) list to complete your selections for all the other categories you need. You should sign up for a small-cap stock fund, an international fund, and a bond fund to complete the mixture of investments you need. If you are confused about the right proportions of all of these, go back to Chapter 11, “Do This.”
If your 401(k) plan also includes a total stock market index fund, you can make life even easier on yourself. Instead of choosing a large-cap and small-cap fund, you can simply choose that one total stock market index fund. With that one fund, you will invest roughly 75 percent of your money in large company stocks and 25 percent in small ones. This gives you your complete U.S. stock portfolio. It’s an all-in-one choice. So if you select it, do not also choose a Standard & Poor’s 500 index fund because you’d be doubling up— your total stock market index fund includes virtually the same large stocks as the Standard & Poor’s.
If you are debating between the Standard & Poor’s index and the total stock market index, the total stock market makes investing easiest for you. After picking it, all you need to do for a simple portfolio is to select an international fund and a bond fund, and you’re set.
Your portfolio might look like this if you’re about 30:
60 percent in the total stock market index
30 percent in an international stock fund
10 percent in an intermediate-term bond fund
In your late 50s, it might look like this:
40 percent in the total stock market index
20 percent in an international stock fund
40 percent in an intermediate-term bond fund
If your 401(k) gives you the choice of a total stock market index fund or a total bond market index fund, you have hit the busy person’s jackpot. Simply divide your money between those two index funds, hold the appropriate proportions throughout your lifetime, and don’t worry about sorting through the hodgepodge of other funds.
Let’s say that you are in your 40s, and you want 70 percent of your money in stocks and 30 percent in bonds. You would put 70 percent from each paycheck into the total stock market index and 30 percent in the total bond market index. You’d be done.
Over time, your stock index fund would help your money grow, and your bond index fund would insulate you from sharp downturns in the market. You’d be missing just one extra piece, international stocks, which probably isn’t the best move. If you are willing to tweak a little more, put about a third of your stock money into a diversified international stock fund that invests throughout the world. You might even be lucky enough to find an index fund that invests in international stocks. It would likely have a name like the total international stock index, and the description would likely say that it mimics either the MSCI EAFE index or the MSCI ACWI Ex U.S. index.
The last index is the broadest way to invest in the full world and to take advantage of fast-growing emerging market countries. AC stands for “all country.” It means that you will invest in developed parts of the world such as Europe and Japan, as well as emerging markets such as China, Indonesia, and Argentina. The “Ex U.S.” in the name tells you that the fund invests virtually everywhere in the world except the United States. That, of course, makes it a sensible selection because you already get all the U.S. exposure you need from your total stock market index.
Among international selections, the MSCI EAFE has been a tamer index than the “all country” index because EAFE stands for the more established developed countries of the world—everything from Europe to Japan. On the other hand, the emerging markets in the “all country” index give you an opportunity to take part in the fast-growing economies. If you are offered either of these index funds for foreign stocks, you can save yourself money by buying a broad range of stocks cheaply with a single fund.
As with the other index funds, no professional is at the helm trying to buy winning stocks or winning countries. No one is looking to avoid losers. The goal is simple: Just provide stock exposure worldwide.
Now look at how this complete portfolio would look for a person in his or her 30s. This is similar to the previous portfolio for a 30-year-old but includes the names of the indexes. Also notice the ranges for fund quantities. The idea is to adjust portions based on your stomach for risk.
10 to 20 percent in a total bond market index fund (identified as the Barclays Aggregate Bond Index)
25 to 30 percent in a total international stock market index (identified as the MSCI EAFE index the MSCI All Country World Index Ex-U.S.)
55 to 60 percent in the total U.S. stock market index (identified as maybe the Wilshire 5000 or MSCI Broad Market Index or Russell 3000 index)
Some Index Fund Ideas
Here are some fine low-cost index funds: Vanguard 500 (VFINX), Vanguard Total Stock Market Index (VTSMX), Vanguard Total International Index (VGTSX), Vanguard Total Bond Market Index (VBMFX), Fidelity Spartan 500 Index (FSMKX), Fidelity Spartan Total Market Index (FSTMX), Fidelity Spartan International Index (FSIIX), and T. Rowe Price Equity Index 500 (PREIX). Many low-cost index funds also exist for midsize and small companies. Among them are Vanguard Small Cap Index (NAESX) and Fidelity Extended Market (FSEMX).
Tweak Your Portfolio Once a Year: Rebalance
Just one word of warning: After awhile, the proportions that you are supposed to keep constant in your portfolio—or your recipe for investment success—get skewed without your noticing it.
So remember to revisit your 401(k) or IRA at the end of each year: Look over the portions in each fund and make sure they still fit the model you chose in Chapter 11. You will recall that this year-end process is called rebalancing.
For example, if you are 35 and you want 20 percent of your money in the bond index fund, 25 percent in the international stock fund, and 55 percent in the total stock market fund, your intent should be to keep those proportions roughly intact until you purposefully change them as you age. Yet if international markets have been soaring and the U.S. has languished, you could find 35 percent invested in your international fund and only 45 percent in the United States. This, of course, is not your intent. Your model has been distorted. You would move some money out of the international fund and into the U.S. fund, following the model you preselected. That way, you will be prepared for the next cycle.
Using Index Funds in an IRA
Remember the reason for using index funds: They give you broad exposure to stocks, and they are cheap. Because they are cheap, you tend to get a better return from them than you would with a traditional mutual fund that employs an investing pro.
Index funds are perfect for an IRA as well as a 401(k). With an IRA, you are in the driver’s seat because you are not constrained by funds someone else selects for you.
My advice: Make life easy on yourself. Go to a firm such as Vanguard or Fidelity, known for low-cost index funds, and start building your nest egg with the simple funds.
Say you’re in your 20s and have $3,000 to invest in your first IRA. You could start the first year by putting your full IRA contribution into the Vanguard Total Stock Market Index. Eventually, you will add some extra funds to your IRA over the years so that you will be exposed to all the investments you need. (If you are confused about this, go back and review asset allocation in Chapter 10, “The Only Way That Works: Asset Allocation.”)
But you don’t have to move into two or three funds immediately. Just focus on that first index fund for a while. Maybe the second year you contribute to your IRA again. Simply put some more money into the Vanguard Total Stock Market Index. After that, start filling in the slot for another type of investment. If you are young and aren’t squeamish about losing money in stocks, you can make your next IRA contribution to the Vanguard Total International Stock Market Index.
As the years go by and you continue to invest in your IRA, you would eventually put some money into a bond market index fund. Let’s say that you have reached your mid-30s; your IRA might look approximately like this:
20 percent in the Vanguard Total Bond Market Index (VBMFX), which mimics the Barclays U.S. Bond Index.
26 percent in the Vanguard Total International Market Index (VGTSX), which mimics the MSCI ACWI Ex U.S. Index.
54 percent in the Vanguard Total Stock Market Index (VTSMX), which mimics the MSCI U.S. Broad Market Index.
You can continue to keep investing money in those three index funds throughout your retirement saving years, simply changing the proportions a little year after year to be safer as you approach retirement.
Let’s say that you are in your mid-40s. At this point, your portfolio might look about like this:
30 percent in the Vanguard Total Bond Market Index
23 percent in the Vanguard Total International Market Index
47 percent in the Vanguard Total Stock Market Index
When you are close to retirement, it looks more like this:
40 percent in the bond index
20 percent in the international index
40 percent in the total stock market index
Indexes Come in Many Varieties: An Advanced Lesson
You now know the layman’s language for the four basic indexes: the Standard & Poor’s 500 for large companies, the total stock market index for the full market of large and small companies, the total international index for foreign stocks, and the total bond market index.
Dozens of other indexes exist, so keep your eye on the four basic ones, to simplify your investing decisions. They will serve you well.
On the other hand, if you are an investor who likes to tinker with your investments, a growing array of index funds allows you to do it. New index funds let you fine-tune investments, slicing the market into tiny pieces like microcaps (extremely small companies), emerging markets (developing foreign country stocks), small value stocks, or real estate companies.
Let’s say you are interested in fine-tuning your portfolio more than I described with the very broad index funds, and you know that, over decades, small company stocks have provided greater returns than large companies. Let’s say you are willing to take on the short-term risk that small companies can crash hard. Let’s also say that you want some real estate exposure, besides your home, to diversify your investments. In that case, maybe you would reduce your holdings in the Standard & Poor’s 500 somewhat and increase your small company investments.
Here’s one mixture that shows you how you could tinker. Notice that, even when you believe in small caps outperforming, you don’t use all or nothing; you still keep a diversified portfolio intact.
30 percent in the Barclays Aggregate Total Bond Index (AGG)
20 percent in the Standard & Poor’s 500 (IVV)
10 percent in the Standard & Poor’s MidCap 400 (IJH)
10 percent in the Standard Poor’s SmallCap 600 for growth companies (IJR)
10 percent in the Russell 2000 Value for small value companies (IWN)
15 percent in MSCI EAFE for foreign stocks (EFA)
5 percent in the Dow Jones Diversified Real Estate Index (IYR)
You could do this through a fund company such as Vanguard or Fidelity, matching the names of indexes listed previously to the appropriate index fund. For midcaps, for example, you see that you would choose an index fund that mimics the Standard & Poor’s MidCap 400 Index. Knowing the exact name of the fund isn’t critical. Knowing the name of the index you want to mimic is the essential piece of information. Just ask for an index fund that mimics the index you want.
Exchange-Traded Funds
Another way to use indexes is go to a broker’s office or find a broker on the Internet, such as Scottrade (800-619-7283), TD Ameritrade (800-934-4443), or Charles Schwab (866-232-9890, or use a brokerage part of companies such as Vanguard and Fidelity. Through the brokers, you could buy another form of index funds, called exchange-traded funds, or ETFs, for short.
Don’t be concerned about the new vocabulary word I’ve thrown at you. Many ETFs are just like index funds, except that you buy them in a different way. You go to a broker and buy an ETF as you would a stock instead of just sending your money to a mutual fund company.
How do you decide between going to a firm such as Vanguard or Fidelity for traditional index funds and going to a broker for ETF index funds? Base it on whether you want to make contributions from every paycheck or several times a year. It’s often cheaper and more efficient to feed money month after month into a traditional index mutual fund at a company such as Vanguard, Fidelity, or T. Rowe Price than to buy ETFs routinely. You can set up an account so that your money automatically flows into a mutual fund from every paycheck—a smart move.
If instead you want to make only a single $4,000 contribution once a year into one fund in an IRA, the ETF can be a good, simple approach. Look at the portfolio I described on the previous page for the investor who likes to tinker. After each type of investment, I have put letters in parentheses. These letters are the ticker, or “symbol,” you use to identify an ETF when you buy it.
In other words, if you want to buy the Standard & Poor’s 500 exchange-traded fund instead of a typical index mutual fund, you would visit or call your broker or contact him or her on the Internet. You’d say, “I’d like to buy the IVV exchange-traded fund,” or maybe you’d prefer another one called Spiders (SPY). Many different ETFs mimic the same indexes.
You give your broker the money, and he or she buys shares of an ETF for you. With time, you would save money if you bought the ETF over the Internet through the broker’s Web site. The broker will tell you how to do it.
When buying ETFs, however, be sure to keep your costs down. If you go to a full-service broker such as Merrill Lynch or Smith Barney, you will probably face higher commissions, compared to those charged at so-called discount brokers such as Scottrade or Charles Schwab. Whether you pay $7 at a discount broker or $30 at a full-service broker, an ETF is the same; there is no reason to pay $30.
Also be aware that firms including Vanguard, Fidelity, Scottrade, Charles Schwab, and TD Ameritrade offer a few basic indexes in ETF form without charging any commission for buying or selling them. That means they keep your expenses down, but it doesn’t mean they are completely free. As with mutual funds, you always pay some expenses, and you should always check the expense ratio on ETFs, Make sure you’re not overpaying for an index that might be almost identical, but cheaper, under a different company name.
If you are just starting out with ETFs and need some help, consider a discount broker with offices near you—maybe Charles Schwab, Fidelity, or Scottrade. They have offices around the country and brokers who will help you at a lower cost than full-service brokers.
To find ETFs that mimic the mutual funds you have, or to identify ETFs for any piece of your stock and bond mixture, try the screener at www.etfdb.com. You can also get ETF information at www.indexuniverse.com, www.xtf.com, and www.morningstar.com.
Some Exchange-Traded Fund (ETF) Ideas
Vanguard Total Stock Market (VTI), iShares Russell 3000 Index (IWV), iShares S & P 500 Index (IVV), Schwab U.S. Large Cap (SCHX), Vanguard Dividend Appreciation (VIG) Vanguard Value ETF (VTV), Vanguard Growth ETF (VUG), iShares S & P MidCap (IJH), iShares S & P SmallCap 600 Index (IJR), SPDR MSCI ACWI ex-US (CWI), iShares MSCI EAFE Index (EFA) Vanguard MSCI Emerging Markets (VWO), iShares Barclays Aggregate Bond (AGG), iShares Barclays TIPs Bond (TIP), and WisdomTree Emerging Market SmallCap Dividend (DGS).
Tinkering with ETFs: For Advance Investors
Morningstar, which analyzes mutual funds and ETFs, has created what it calls a hands-free portfolio. I show you this shortly. In other words, you can set it up and not feel compelled to change it based on market conditions. Yet despite the hands-free idea, Morningstar also suggests how you can tweak pieces in your mixture of stocks and bonds a little from time to time (maybe just 1 or 2 percent each month) if you want to be attentive to market changes. Through its ETFInvestor newsletter each month, you can watch the changes analysts suggest for people motivated to tinker.
Following I show you the Morningstar mixture so you can see how an individual could slice and dice the stock market and bond market with index ETFs into more finely tuned pieces than I described previously. Most of the slices you see are in the broad indexes I already suggested.
But by using smaller pieces of the index, you can fine-tune, if you want. For example, if you look at the bond mixture, you see specific investments in corporate bonds, mortgage bonds, and TIPs (which are U.S. government bonds that help protect you from inflation). The total bond market index I described previously for one-stop bond shopping also includes corporate bonds, government bonds, and mortgage-related bonds, but not TIP government bonds.
With the slicing and dicing you see here, Morningstar decided in early 2012 not to include the U.S. Treasury government bonds that are a significant part of the total bond market index. The reason: At that point in time, interest rates were so low that analysts worried about potential losses if interest rates started to climb. See the section “How to Lose Money in Bonds,” in Chapter 8, “Making Sense of Wacky Mutual Fund Names,” for the background on how rising rates can cause losses.
Morningstar decided to protect against that possibility by avoiding Treasury bonds, although it retained TIPs, or government bonds that are adjusted to pay more if inflation starts to build. TIPs also can suffer losses, but they can be nice protection if the economy goes through a cycle of rising inflation. Notice that Morningstar also has included in the portfolio a WIP ETF. That’s an index that invests in bonds from throughout the world that will be adjusted to help people get through inflationary periods.
Also notice that Morningstar puts a little money into gold through an ETF, another strategy that can protect people from inflation. By slicing and dicing your stock and bond indexes as you see Morningstar do, an investor can increase exposure slightly or decrease it slightly based on market opportunities or concerns on a moment’s notice. But do not be alarmed if this seems like too much work. If you don’t want to tinker, you can count on your total broad index funds over the many years you will be investing for retirement.
I offer this Morningstar portfolio—roughly 30 percent in bonds and 70 percent in stocks—merely so you can see how you can refine mixtures using ETFs if you are motivated or if control makes you feel better.
Bonds: 30 percent of portfolio
10 percent in iShares iBoxx $ Investment Grade Corporate Bond (LQD)
6 percent in iShares Barclays MBS Bond, which invests in mortgages (MBB)
5 percent in iShares Barclays TIPs Bond (TIP)
4 percent in SPDR DB International Government Inflation Protected Bond (WIP)
5 percent in iShares Gold Trust, which invests in gold (IAU)
Stocks: 70 percent of portfolio
20 percent in Vanguard Mega Cap 300 ETF, which invests in giant companies (MGC)
10 percent in iShares Russell 1000 Value Stocks (IWD)
9 percent in Vanguard Mid Cap ETF (VO)
8 percent in Vanguard Small Cap ETF (VB)
12 percent in iShares MSCI EAFE (EFA)
6 percent in Vanguard Emerging Market Stock (VWO)
5 percent in iShares MSCI EAFE Small Cap Stock (SCZ)
Beginning Investors: Starting an IRA with Pocket Change
Unfortunately, some of the cheapest index funds that mutual fund companies sell directly aren’t available to people who don’t have much cash. Vanguard, for example, requires that you have $3,000 to deposit immediately up front. Don’t let that deter you.
T. Rowe Price is a fine firm and lets you get started in mutual funds or index funds with little money. For example, T. Rowe Price offers the T. Rowe Price Equity Index 500 (PREIX). The price of entry is only $50, as long as you commit to adding another $50 each month. That’s a great way to build up retirement money without feeling like you are depriving yourself. If you can provide $50 from every paycheck, or $100 a month, that would be even better.
Another way for people to invest small amounts month after month is to use the zero-commission ETFs that I described earlier. Just make sure that you know which ETFs don’t charge commissions and which ones do. You will have to pay commissions to buy most ETFs, and it would be expensive and foolish to pay a $7 or $8 commission every month to invest $50 per month in an ETF. A more reasonable approach would be to automatically put the $50 into a typical mutual fund that doesn’t charge a commission.
Warning: Not All Index Funds Are Good
Awhile ago, I was on a radio show and a man named Don called to ask whether I thought he had a good index fund. He told me the fund’s name, but like a lot of investors, Don was focused on the wrong thing. The name wasn’t important because his index fund was pretty much like any other. Remember, index funds offered by one company or another should be almost identical in content. That’s the idea—one Standard & Poor’s 500 index should be the same as another because both funds have only one job: to mimic that index. Consequently, the key factor to scrutinize in Don’s index fund—or any index fund—is fees. Always keep that in mind. The cheapest one will be the winner.
I looked up Don’s fund at www.morningstar.com, and I ached for all the people who had purchased it. Don had bought his index fund from a financial consultant who charged clients commissions. That was costing Don a bundle. The fund had a 1.25 percent load, which, you will recall, is the sales charge you pay a broker or financial planner to sell the fund to you. In addition, the fund was charging Don 1 percent in fees, which is noted as the “expense ratio.”
I ran the numbers through the SEC mutual fund cost calculator I mentioned in Chapter 12, “How to Pick Mutual Funds: Bargain Shop,” and here’s what I found: If Don invested $10,000 in his index fund for 10 years and averaged a 10 percent return, he would end up with about $23,100. If he instead chose a low-cost fund such as Vanguard’s, he would pay no load and only 0.18 percent in expenses. The result: He’d have about $25,400 after 10 years and would save himself more than $2,000 on expenses.
Everyone wants to earn $2,000 more over 10 years. That’s not the half of it. Look at what the power of compounding did to Don. If he kept averaging a 10 percent return and kept the money invested for 40 years, he’d accumulate only about $299,000 in his expensive index fund. The cheap fund would provide him a whopping $421,000 simply because expenses weren’t eating away his return.
Keep in mind that if you go to a broker or any financial adviser who works on commissions, you will likely have to pay excessive costs for index funds. That really doesn’t make sense because index funds are the easy funds; most people should be able to select them on their own without an adviser’s help. In other words, a broker cannot add value selecting a basic index fund such as the Standard & Poor’s 500 or Total Stock Market Index, so why pay him or her to do it?
Instead, if you want to find affordable index funds easily, simply think Vanguard, Fidelity, or T. Rowe Price.
Is Your Fund Good or Bad?
Although you can intentionally select index funds for IRAs, you might not get that choice in a 401(k). Your employer might not give you the opportunity. Also, whether you have an IRA or a 401(k), you might want to venture away from index funds for some funds—perhaps you want a stock-picking pro for small caps and international stocks.
Some research suggests that skilled stock pickers can be worthwhile in the small-cap and international arenas, although other research refutes the finding.
The argument for stick pickers in international and small-cap funds is this: It’s silly to use a stock picker for large-cap U.S. stocks because information about the largest companies in the marketplace abounds and many stock pickers are examining that information. Small caps and international stocks, on the other hand, are more difficult to examine because information isn’t as plentiful. So a great sleuth might earn his keep.
Still, it’s up to you to make sure that spending money on a stock picker is worthwhile. And if you have a mutual fund that’s acting like a loser, you will want to know whether you should keep it or dump it and buy another.
To compare funds, you must analyze performance of funds in two ways. First, you must compare only similar funds. Second, you must compare each fund to an appropriate index. For example, if you have a small-cap fund and think it’s rotten, compare it only to another small-cap fund, not a large-cap fund, an international fund, a midcap fund, or a bond fund.
Remember, cycles will affect each category differently. So if your small-cap fund is down 5 percent, but the average small-cap fund is down 10 percent, your fund is actually outstanding. If your small-cap fund is down 5 percent, and your large-cap fund is up 10 percent, it doesn’t mean your small-cap fund is bad. It probably means that the cycle at that moment is friendly to large caps and not small caps.
Advanced Comparison Lesson
If you are debating between two funds in the same category, that is a valid comparison. Say that you have two large-cap growth funds in your 401(k). How do you know which to pick?
Your employer might offer you a Web site with what’s called Morningstar information on it. Morningstar is a company known for its research on mutual funds. That research, available at www.morningstar.com, will make your decisions easier.
To find out whether your fund is a good one, follow this process at the Morningstar site. Type in the name of your fund in the Quote box, and when you come to a report on your fund, look for the word Performance. Then notice whether your fund did better (+) or worse (–) than others like it. The performance information will also tell you whether your fund did better or worse than the index—in other words, whether you would have done better with an index fund.
The easiest thing to do, however, is to focus on % Rank in Category. This shows you how your fund compared to other funds like it. If your fund ranks close to 1, it is outstanding. If it ranks close to 50, it’s average, and that’s fine. If it’s below 50 percent, that’s not a good sign. It means that the fund you are considering did worse than half the other funds like it.
Keep in mind, however, that one year is insignificant. You want a fund that consistently is in the top half of funds like it, or one that performs as well as, if not better than, an index fund—but not just for one year. You want to base your decision on several years because one year might have been a fluke during a cycle.
Notice performance for five years and 10 years. Then check to make sure that the same fund manager who was there five years ago is still running the fund. If the fund has been outstanding, but the fund manager recently left, all the performance figures from the past are probably irrelevant (unless a comanager who was working alongside the old manager simply takes over where the old manager left off).
But if the fund has a new manager who hasn’t worked with your fund in the past, that person is starting fresh. You really don’t know what that new manager will do with your money. He or she might or might not handle your fund like the previous manager did. If this concept seems difficult to understand, think of the teachers you’ve had over the years. Fifth-grade math is fifth-grade math, but if a new teacher comes into the course midyear, the new teacher might offer a class that differs greatly from the class taught by the teacher you first had.
Then focus on one more piece of information about the fund. You should be able to guess. It’s the expense ratio, the one number that tells you more about how you are likely to do with that fund in the future than any other measurement. If your expense ratio is below 1 percent, your fund has consistently been in the top half of its peers, your fund is performing better than an appropriate index, and the manager is still there, you probably have found a keeper.
Remember, what doesn’t matter is whether your fund made a lot of money or lost a lot of money. What matters is how it compares to the index. If you have a large-cap fund that’s up 13 percent, but the Standard & Poor’s 500 is up 15 percent, your 13 percent is stinky. You’ve been wasting your money on high expenses to do worse than an index. That’s foolish—maybe not in just one year, but if it happens year after year, it certainly is.
On the other hand, if the Standard & Poor’s is down 5 percent for the year and your fund is down only 1 percent, your fund manager earned his keep. You have an outstanding fund if it keeps outpacing the Standard & Poor’s 500 year after year.
The indexes are the key to measuring and evaluating your mutual funds. Savvy investors, such as pension funds, use indexes to tell them whether they have been employing a worthwhile investment manager. The mutual fund industry uses them to determine whether to give a fund manager a juicy bonus.
Here’s a simple process for comparing your funds. For any fund that you own or are considering buying, simply see whether its returns measure up to the appropriate index:
For an international stock fund, use the MSCI EAFE or MSCI ACWI Ex U.S.
For a large-cap fund, use the Standard & Poor’s 500.
For a large-cap growth fund, use the Russell 1000 Growth.
For a large-cap value fund, use the Russell 1000 Value.
For a small-cap fund, use the Standard & Poor’s SmallCap 600.
For a small-cap growth fund, use the Russell 2000 Growth.
For a small-cap value fund, use the Russell 2000 Value.
For midcap funds, use the Standard & Poor’s MidCap 400.
For bonds, use the Barclays Aggregate Bond Index.
If your fund performed better than the index for at least three years—and hopefully five or more—you have an outstanding fund if the manager is still there. If it performed much worse, ask yourself why you spent more on fees to get less. Consider dropping your fund and buying an index fund instead.
You can find the indexes and their performance on the Internet. If you simply type in the index names I provided previously, you will find an ETF that mimics that index. If you compare your mutual fund’s performance to the ETF that’s appropriate, you will be comparing your fund to an index. You will see whether your fund is a laggard or is worth the fees you pay to own it.
How to Analyze a Fund
Let’s walk through an example. Say you have been putting money into the Fidelity Contrafund in your 401(k) for years. You want to know whether it’s a good fund or a bad fund.
You go to www.morningstar.com, type in “Fidelity Contrafund,” and click on FCNTX (the ticker investors use to get information on that fund). After you click on FCNTX, you come to a report on the Contrafund. Immediately, you see close to the top of the page that the fund category is large growth fund. So you know that the matching words you need to focus on are large growth fund. In other words, this fund invests in large company stocks, and it would not be meaningful to compare that fund to any other fund except another large-cap growth fund.
You can also see at the upper right that when Morningstar compared the fund to similar large-cap funds, it was a strong performer. See the four stars? That’s Morningstar’s second-highest rating—four stars on a scale of 1 to 5.
That’s a good sign. But you aren’t done. Beneath the stars, you see a 0.81 percent expense ratio. That falls within the 1 percent threshold that’s acceptable for fees. So expenses are okay if the fund performs well.
Now, you need to examine the fund’s performance, or how investors do when they put money into the fund. Under the fund’s name, you see “Performance” and a graph that shows how the fund has grown $10,000 over the past few years. Under that, you see performance numbers for several periods. “YTD” is for the current year and is not very meaningful about long-term quality. Look at five-year and 10-year performance instead. In June 2012, you would have seen that, for five years, the fund had given investors an average annual return of 2.1 percent; for 10 years, it was 7.7 percent. But you think, “Is that good or bad?”
The answer comes in the information you see just below those numbers. The Contrafund’s return is compared to an index here—the Standard & Poor’s 500 (large-cap stock) index—and the results are good.
You see that, in the Contrafund, you earned 8.3 percent a year, on average, for the last 10 years, whereas the index would have paid you just 5.3 percent during the same time period. That’s extremely important. It means the investors are ending up with more money in the Contrafund than they would in an index fund, and that’s unusual, especially for five years or more. If instead Morningstar had shown that the fund’s return was worse than the index, or below 5.3 percent, that would have been a bad sign. It would have suggested that an index fund would be a better deal. Instead, you will see in the information under the performance heading that this fund has been so strong for 10 years that it ranks at number six, almost the top ranking. That’s significant.
You need to run one more check before deciding whether the fund is for you. Check on the manager by clicking “Management” in the blue bar at the top. You see that the strong manager is still at the fund and has been there since 1986. Looks like the fund is a keeper!
You can do more research by clicking on all the choices in that blue bar where I had you click on Management. But you have the basics. You found that the fund has continually beat its index, the expenses aren’t out of line, and the savvy manager is still there. Doing this analysis took about five minutes.
If analyzing funds still seems like too much work, you can avoid the headache by simply using low-cost index funds—those with an expense ratio of 0.35 percent or less. On the other hand, I have one more shortcut for you, the simplest of anything the mutual fund industry offers.
Now that you understand how to analyze fees and evaluate asset allocation models, you have the background necessary to use this shortcut wisely. It’s a couch potato’s delight. And you will find it in the next chapter.