low cost mutual funds Archives

August 3, 2018August 3, 2018

Ask An Ex-Banker: Mutual Fund Investing

Editor’s note: Paul recently purchased The Financial Rules For New College Graduates, then had some followup questions regarding mutual fund investments. Readers of the book…feel free to pepper me with your followups…

Dear Mike,

I’m on board 1000%¹ when it comes to 100% equity mutual funds, the questions in my mind now are: “Which one(s) and how many?”

1) I’m finding many front-end load (5.50%-5.75%) managed funds with anywhere from 0.89% Expense Ratio to 1.40% (with the 1.20% range being the most common). I’m assuming that the lower the expense the better, but am I overstating the importance of this number?

2) Without splitting hairs about what the top 10 holdings are, the turnover within the fund itself, the risk and return vs category, how long the managers have been there and what their philosophy is, what are some of the key things you’d look for before settling on a fund?

3) I’ve compared the 1 yr, 5 yr, 10 yr and Since inception returns of the funds. Many funds have returned 7-9% while some are well into the 10% and even 11% range. Would you put any stock (no pun intended) in those numbers when comparing and contrasting funds? Are these funds even worth looking into when an Index fund, through Vanguard for example, matches virtually every move the S&P 500 has made, returning the same 10.33% without the commission charge and SIGNIFICANTLY lower expense ratio (0.04%!!!)?

4) And, of course, is 1 fund enough, or would you explore the idea of having several?

Thank you for being willing to even read through this! Hopefully I haven’t strayed TOO far away from the simple approach I’ve attempted to internalize with your teachings.

–Paul F, Boston, MA

Dear Paul,

All great questions, I’ll take them one at a time

1. Front-end Load, Back-end Load – From my (consumer-driven, not industry-driven) perspective, these are all terrible, terrible fees and should be avoided. Never get a fund with them. Basically unconscionable. Can’t justify them at all. Only reason to pay these is if you are totally captive to an employer-sponsored plan and you have no choice of a no-load fund. If you are setting up your own investment plan, just eliminate them entirely.

On the other hand, from an industry (sales-driven) perspective, load funds are great. Makes the salesperson rich at the direct expense of the investor.

About the annual Expense Ratio…at this point 1% is kind of the industry marker. Less than 1% is a reasonable deal for an actively managed fund, over 1% is a little pricey for an actively managed fund. As I say in Ch.14 of my book, I don’t actually think paying for active management makes sense, but if you really want it then 1% is kind of the inflection point between cheap and expensive.

And finally, you are NOT overstating the importance of these numbers. They are – especially in the long run – the absolute key to not turning over between 20% and 50% of your lifetime investment gains to your investment managers. That’s not an exaggeration, its just math you can model out in a spreadsheet.

2. Fund factors to look for – For me (my big bias) the expense ratio is the #1 consideration. After that, of course you want to understand how active versus passive they are (my bias is for passive), how quick turnover is (my bias is for low turnover as it reduces costs and increases tax efficiency), how concentrated they are within the asset class (a case can be made for either diversification or concentration, depending on your overall goals and the rest of your investment plan), where it is in the risk spectrum (for a 20-something person I think you want to maximize risk in all long-term holdings. I still do and I’m in my mid-40s, and I will continue to maximize risk for my whole life, but that’s my bias for all my investments).

3. Time Horizon – For comparing returns, the 10 year and longest time horizons are the only relevant data points. I would ignore 1 to 5 year returns as essentially noise, since the right investment horizon is decades. If the manager is consistent in strategy, the long-term return will be what that particular market sector offers in the long run, which is all I’m looking for in an investment manager.

4. On Number of Funds – I’ll suggest a book for further reading by a guy I like: Lars Kroijer “Investing Demystified.” He doesn’t agree with me on my “risk maximization” point, but he and I agree on the efficient market hypothesis as a good starting point for most people. The reason I bring him up is he makes a case for owning a single “All World Markets” fund, which should be available from major discount brokers. After reading Kroijer you’d have a better sense of how many funds you’ll need. Whether just 1, or more.

As for me, I have just 3 funds in my 401K retirement account. All 3 are 100% equities:

1. US Small Cap,

2. Non-US Developed markets (Europe, Japan, NZ), and

3. an Emerging markets fund

I’m pretty happy with that and will probably never change it. Maybe I’ll re-balance once in a while if one starts to get too big relative to the others. But again, Kroijer’s book will probably explain well why that view makes sense to me.

I hope that helps!

Please see related posts

How To Invest

Book Review: Investing Demystified by Lars Kroijer

Everything in one place – The MINT interview

Post read (627) times.

Not sure about your math there, but OK ↩

October 20, 2014June 30, 2016

More On Actively Managed Equity Mutual Funds

Lately I’ve taken to saying boldly and loudly to anyone who asks my opinion (and some who don’t!) that every academic study ever done on actively managed (high cost) mutual funds vs. passively managed index (low cost) mutual funds shows that, in aggregate, the actively managed funds under-perform the passively managed funds by approximately the difference in fees charged by actively managed funds.

That’s the central and ongoing conclusion of not just the first edition of Burton Malkiel’s A Random Walk Down Wall Street, but every updated edition since the book first appeared in 1973. Although Malkiel’s view has won the academic battle, still the combined marketing heft of the actively managed mutual fund industry has not yet conceded the war.

Investment strategist and and nationally syndicated columnist Scott Burns of Asset Builder – points out in this post yet another important article debunking the usefulness of actively managed mutual funds, when compared to their admittedly doughty but nevertheless more profitable younger siblings, index mutual funds.

If you’re curious to dip your toe into these ideas, I recommend starting with Scott Burns’ post, then move on to the article itself.

Please see related posts:

Book Review of A Random Walk Down Wall Street, by Burton Malkiel

Book Review of Investing Demystified by Lars Kroijer

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May 8, 2014

Guest Post: The Simplest Investment Approach, Ever

Editor’s Note: Lars Kroijer is a former hedge fund manager, and the author of two books. He previously posted here on the advantage of conceding ‘edge’ in personal investing. I appreciate his debunking the value of high-cost financial services.

You probably can’t outperform the market – here is how you should invest once you accept that

As investors we are bombarded with stock tips about the next Apple or Google, read articles on how India or biotech investing are the next hot thing, or are told how some star investment manager’s outstanding performance is set to continue. The implicit message is that only the uninformed few fail to heed this advice and those that do end up poorer as a result. We wouldn’t want that to be us!

do_you_have_an_investing_edge — Do YOU have an edge investing? Doubtful.

What if we started with a very different premise? The premise that markets are actually quite efficient. Even if some people are able to outperform the markets, most people are not among them. In financial jargon, most people do not have edge over the financial markets; they can’t consistently outperform the market by picking different securities / sectors / geographies from the market as a whole, especially after costs. Nor are they able to pick which of the thousands of fund managers have the ability to do it for them. Accepting, embracing, and acting on this absence of edge should in my view be a key moment in most investor’s lives.

The absence of edge does not mean that you should avoid investing. Doing so would exclude you from potentially exciting long term returns in the equity markets, or benefitting from the security of highly rated government bonds. Also, what else were you going to do – leave your money under the mattress or in a bank at zero interest? Instead we should assume that the current market prices of securities capture all available information and analysis, and that the price reflects that security’s future risk/return profile. In equities we should then pick the broadest possible selection of stocks because just like we don’t know which one stock will outperform, we don’t know which sector or geography will outperform.

And what is broader than an index that track equities from all over the world in the proportion of value that market forces have already put on them? With a world equity index tracker we maximize diversification and minimize exposure to any one geography, sector, or currency. And since we simply track an index (like the MSCI All Country World, etc.) it is very cheap to put together for a product provider like Vanguard, iShares, etc., and thus cheap to us. If an all equity exposure is too risky, you can combine this world equity portfolio with government bonds in the proportions that suit your risk profile. The lower the risk desired, the more bonds you want.

global_etf_investing — How much of the world equity market to invest in? All of it

So my key takeaways to most investors can be summarized as follows:

You almost certainly do not have edge in the financial markets. That’s ok. Most people don’t, but you should plan and act accordingly.
There is an easy and cheaply constructed portfolio which is close to optimal. It combines the highest rated government bonds in your currency with the most diversified possible world equity portfolio. Get close to that in the right proportions, which depend mainly on your risk tolerance, stick to it and in my view you are doing better than 95% of all investors. That’s it – two securities: one being an index tracker of world equities and the other a security that represent government bonds of maturity and currency that match your need. Both equity and bond exposure perhaps via an ETF. Simple perhaps, but you capture an incredible diversification of exposures via the equities and the portfolio is at your risk appetite when you incorporate the bonds in a proportion that suit your risk. You can add other government and diversified corporate bonds if you have appetite for a bit more complexity in your portfolio, but the portfolio is very powerful even without those.
Your specific circumstances do matter a great deal. Think hard about your risk appetite and optimizing your tax situation. But also pay attention to your non-investment assets and liabilities – many people already have a disproportionate exposure to their domestic economy through their house and some sector via their jobs. Don’t add to this concentration risk with your investment portfolio.
Be a huge stickler for costs, don’t trade a lot, and keep your investments for the very long run. The portfolio above should only be implemented via extremely cheap index tracking products that charge 0.25% per year or less.

Follow these steps and I think you will have a personal portfolio strategy that lets you sleep well at night, knowing that you have created a powerful and diversified portfolio cheaply, tailored to your risk appetite. To emphasize the point of costs, suppose you are a frugal saver who diligently put aside 10% of $50,000 annual income from the age of 25 to 67 that you invest in world equities. Further assume markets return 5% real per year in line with historical returns (ignoring taxes). Considering a typically 2% annual cost difference between an index tracking product and an actively managed fund (potentially in addition to the cost of an advisor), as you get ready to retire at age 67 the difference in the savings pot is staggering. You are left better off by perhaps $250,000 in today’s money simply by investing with an index fund as opposed to an active manager.

porsche_savings_from_low_cost_mutual_funds — Can index funds save you enough to afford this?

If you think you have great edge in the market and think you could easily make up this 2% annual cost difference then by all means pick an active manager or your own stocks. If not, then the sooner you shift out of the expensive investment products or active stock picking and into cheap index tracking products the better off you will be. To put things in perspective consider that these additional and unnecessary fees for just one saver over their investing lives could buy 6 Porsches. And paradoxically this is money paid to the finance industry from a saver who could typically not afford to drive a Porsche.

Lars Kroijer is the author of Investing Demystified – How to Invest Without Speculation and Sleepless Nights from Financial Times Publishing. He founded and ran Holte Capital, a London based hedge fund in 2002. You can follow him on Twitter @larskroijer.