Mutual funds, which were invented roughly 80 years ago and have boomed in the past decade, are a triumph of financial democracy. They give small investors access to the sort of money managers who once worked exclusively for the wealthy. Funds also offer broad investment advice – much of it very good – on subjects such as allocating assets and minimizing taxes. And they do your financial bookkeeping each month. It’s hardly surprising, then, that today half of all U.S. households own mutual funds – up from one-tenth in 1982. Even more impressive: Thirty-six percent of families with incomes of $25,000 to $35,000 own funds, as well as 48 percent of families headed by someone aged 25 to 34.
In recent years, however, my enthusiasm for mutual funds has dimmed. Most of the time, funds don’t beat the benchmark indexes. A big reason is expenses. “Mutual fund managers unnecessarily increase your costs and decrease your net rate of return by more than three percent a year,” writes Ron Ross in a recent book, “The Unbeatable Market” (Optimum Press). But another reason is simply that markets are generally efficient and that the majority of investors – and experts – just can’t whip them.
Still, I haven’t given up on funds, and neither should you. Here are 10 principles to guide your fund investing.
1. Don’t chase performance. There’s a common pattern among funds. It’s called “mean reversion.” A fund that vastly outperforms the averages won’t keep it up over time, just as a baseball player who bats .460 in April won’t bat .460 through September. Many investors buy the hottest fund of the moment, but that’s nearly always a mistake. Ask anyone who purchased Firsthand Technology Innovators (TIFQX) at the end of 1999, after it had tripled in 12 months. The next year, it fell 38 percent. It does, of course, make sense to examine the long-term performance of a fund, especially if it has had the same manager. Some people can indeed beat the market, but the test is time. A good example is Bill Gross of Pimco. Harbor Bond Fund (HABDX), which Gross has run for more than 15 years, has returned an annual average of 8 percent over the past decade, easily eclipsing the long-term bond index.
2. Remember the No. 1 benefit of mutual funds: diversification. When you own just one or two or 10 stocks, you assume what economists call “idiosyncratic” risk – that is, risk that goes beyond the normal risk of investing in the market as a whole. And market risk is scary enough! To eliminate idiosyncratic risk, the latest research shows that investors need to own about 50 stocks, in a wide range of sectors. Hardly anyone who isn’t a professional can keep track of a 50-stock portfolio, not to mention the brokerage costs of buying 50 stocks, one at a time. But a typical mutual fund, with holdings of about 100 stocks, can give you diversification with ease.
3. Beware of expenses. Some funds charge investors upfront or back-end “loads,” or commissions, and all funds charge investors management fees, under the rubric “expense ratio.” The average expense ratio, according to Morningstar.com, is 1.5 percent for domestic stock funds and 1.1 percent for bond funds, but funds are all over the lot. Perhaps even a 2 percent fee sounds small – or, at least it did back when the market was generating returns of 20 percent annually. In fact, fees mount over time because your total assets mount as well. And fees kill profits. Assume a one-time investment of $10,000 and an annual return of 11 percent over 30 years. Assume also an expense ratio of 1.5 percent. Using the “mutual fund cost calculator” on the Web site of the Securities and Exchange Commission, I found that the $10,000 grew to $145,000, which sounded spectacular until the calculator told me that expenses and forgone earnings (that is, money I could have made if I had invested what I had paid in expenses) totaled $83,000. Imagine a fund advertising that fact: “Invest with us long-term. We’ll take one-third of your account as our fee.” By contrast, with a fund charging 0.8 percent (and getting the same returns), $10,000 grew to $179,000. In other words, an expense ratio seven-tenths of a percentage point lower produced returns that were 24 percent greater.
4. High expenses don’t mean high returns. There is little relationship between the performance of a fund and the expenses it charges. This downright weird fact is evidence that investors simply don’t pay enough attention to expenses. In other words, it’s your own fault. Just go to the Morningstar Web site and you can find the expenses charged by thousands of funds. Consider Dodge & Cox Stock (DODGX). It has no load and charges an expense ratio of a mere 0.62 percent, also expressed as 62 basis points. Yet it returned an annual average of 14 percent over the 10 years ended in 2002, beating the benchmark Standard & Poor’s 500-stock index by 4 percentage points and finishing ahead of 98 percent of the funds in its category, large-cap growth. Dodge & Cox is also consistent (it has whipped the average stock fund in its group in eight of the past 10 years), and its managers refuse to take wild risks. Compare D&C, which has been managed by a skilled San Francisco team since 1965, with a fund called Frontier Equity (FEFPX), which, according to Morningstar, charges a load of 8 percent plus lofty annual expenses. Frontier’s average annual return for the past five years: an incredible minus-33 percent.
5. Watch the cash. Many equity mutual funds will try to beat their peers by trying to time the market. When their managers think they see trouble ahead, they move out of stocks and into cash or bonds. This is an infuriating practice. If your fund does it, sell at once. Investors themselves should allocate their assets among stocks, bonds and cash – and the criterion is time horizon. If you don’t need the money for five years or more, it should go into stocks; between a year and five years, into bonds; less than a year, cash (including money-market funds, Treasury bills and certificates of deposit). These guidelines are flexible, but once you decide on your allocations, you don’t want managers changing them for you. When you buy a stock mutual fund, that’s the stock part of your portfolio – not the cash or bond part. The typical stock fund since the mid-1980s has kept an average of 8 percent of its assets in cash. That’s too much. Holding 4 percent or 5 percent cash is reasonable, in case shareholders bail out and want their money back, but more than that is an indication that the manager is trying to time the market – a dangerous and foolish practice.
6. When in doubt, buy an index fund. If you are a novice investor or you can’t be bothered with trying to pick among thousands of candidates, then simply buy an index fund – for instance, a fund that owns all 500 stocks in the S&P, which represents about 85 percent of the total capitalization of the U.S. stock market. The largest such fund is Vanguard Index 500 (VFINX), which charges expenses of only 18 basis points. Other index funds focus on more specific targets – small-cap or mid-cap stocks, European or Asian companies, or bonds. For instance, Barclay’s Global Investors Bond Index (WFBIX) mimics an intermediate-term bond benchmark and charges only 23 basis points. Over the past five years, it has returned an annual average of 7.3 percent.
7. Use funds for sector investments. If you like a particular sector – especially one that is hard to analyze, such as real estate stocks – then invest through funds rather than by trying to pick stocks or bonds. I am a fan of biotechnology, but in this highly volatile sector, where diversification is a must, I can’t possibly pick enough good companies on my own. I need expert help – or at least the broad ownership offered by a conventional fund, or, in this case, an exchange-traded fund (ETF) called Biotech HOLDRs (BBH). Think of an ETF as a portfolio that trades on a stock market as though it were a single company. ETFs, closed-end funds or traditional open-end funds are also the best vehicles for emerging-market stocks, a favorite of mine at the moment. Among the best are Sanford C. Bernstein Emerging Markets Value (SNEMX), with a five-star rating (tops) from Morningstar; Dreyfus Premier Emerging Markets (DPBMX), which is recommended by Sheldon Jacobs, editor of the No-Load Fund Investor newsletter; and Matthews Asian Growth and Income (MACSX), which I have lauded in the past.
8. Bond funds never mature. Over the past year, investors have plowed $125 billion in new money into bond funds, and, unfortunately, many of them don’t understand what they are buying. When you purchase a new 10-year Treasury bond paying interest of, say, 4 percent or a 20-year AAA-rated California municipal bond paying interest (tax-free) of 5 percent, then you know precisely what you are getting – a stream of regular income ($40 per $1,000 invested for the T-bond and $50 for the muni) with your original investment returned at maturity. But buy a fund that concentrates in Treasurys or California munis, and you are at the mercy of the manager, who typically doesn’t wait for bonds to mature but buys and sells them according to guesses about where interest rates are headed. A $10,000 investment could become $8,000 in 10 years. That can’t happen if you own an individual Treasury bond. I have never owned a bond fund and probably never will. For the bond part of my portfolio, I want as much certainty as I can get. Still, you don’t have to be so dogmatic. Great managers like Gross of Pimco produce impressive returns, and funds do provide diversification, which is especially important with corporate bonds and munis.
9. Shun frenetic managers. The average turnover for a large-cap growth fund is about 100 percent. In other words, the typical manager keeps the typical stock for only one year. That’s absurd. The only good reason to buy a stock is that you want to be a partner in a great business, and few great businesses become mediocre in a year. In his book, Ron Ross points to a study by Edwin J. Elton and other scholars, which found that “high turnover was robustly associated with poor performance.” One reason is that high turnover means high transaction costs – which are assessed in addition to the expense ratio I cited earlier. Transaction costs include brokerage fees, the “spread” between the bid and asked price of a stock that’s bought or sold, and the market impact of sales or purchases of large blocks of stock (for example, when a fund sells a big block of shares, it naturally drives down the price it gets for them). Ross estimates that these transaction costs total “at least 2 percent.” Ouch. So search for funds with low turnover – another figure reported by the best mutual-fund site, Morningstar.com. Dodge & Cox has annual turnover of about 20 percent; Dreyfus Appreciation (DGAGX), another excellent fund, usually has turnover in the single digits. Turnover at Fidelity Blue Chip Growth (FBGRX) was 33 percent last year and, at Babson Value (BVALX), 25 percent.
10. Buy and hold. The best advice for stocks is also best for funds. Take your time, find funds with good track records and able managers, and hang onto them. Don’t sell a fund simply because it has disappointed you for a year or two. Sell, instead, because a manager has abandoned a longtime discipline for the latest trend. Oakmark I (OAKMX), a low-turnover fund with a superb long-term record and expenses of 1.2 percent, got clobbered in 1998 and 1999, trailing the average fund in its category by a total of more than 50 percentage points. But Oakmark did not ditch its value-oriented approach, and over the next three years it returned a total of 14 percent while the S&P fell more than 40 percent. Also, watch management changes carefully, but give the new folks a chance. And sell if performance deteriorates over three years or more. How to protect yourself against owning a clunker? Never own one fund, unless it’s an S&P index fund. Own two or three “core” funds plus several targeted funds. Diversification works with funds the way it works with stocks and bonds.
