Friday, January 31, 2014

Mutual funds vs. index funds

I wrote this in 2007. 

Many people don’t want to spend the time, or don’t have the interest, to follow a variety of individual stocks in their portfolio. So what are some choices? Both stock based mutual funds along with stock based index funds have been very popular options for people who fit that profile. I’d like to cast some light on each of those types and point out some key tidbits that every investor should be aware of. Also, I hope that by the time you are finished reading this, most of you will come to the conclusion that index funds make a lot of sense for the savvy investor.       

Mutual Funds

I’m not a big fan of them but I still think everybody should be at least aware of them. They are actively managed funds that contain money from a variety of investors, spread out over many companies, just like index funds. Sometimes people feel more comfortable with the fact that a mutual fund offers professional management.  Of course, nothing is free and this professional management carries with it an expense ratio which is higher than what you would typically find with an index fund. The average typically hovers around 1.5% or so, and, over time, this can really take a big bite out of your earnings. You’ll have to decide if this is this is the price you want to pay for active management.

Index Funds

Index funds operate in much the same way as mutual funds in the sense that there are many companies that are owned within a single fund. In contrast to mutual funds, however, index funds simply mirror a particular index. The nice thing about index funds is that they have historically outperformed mutual funds, all without the added management fees. Again, inactive management can translate into more money in your pocket! 

I chose to go with a total stock market index fund, which allowed me to allocate my investments amongst the entire U.S. stock market (3,500 stocks). It has an average yearly return of 10.77% (as of 8/31/’07) since its inception in ’92. (In the long term, the S & P (Standard and Poor’s) 500 index has appreciated at approximately 10 percent). People sometimes ask me if I get stressed out when it does down and the answer is not really. In fact, I usually think I should buy more in to it. If you can weather the downs the chances are that you will be up in the end. Another nice thing I like about this index is because I can usually just turn on the TV and instantly see how’s it’s performing. Why? Because it’s a mirror of the market as a whole and commentators on TV talk about the market in general terms all the time. I’ll touch upon this below when I get into the r-squared. 

Analyzing the Risk

You’ve probably heard the terms large (blue chip), medium, and small cap. Each term corresponds to the size of the company (for instance large-cap funds contain huge companies). Large cap companies are generally thought to be a more stable investment than small cap, with the medium cap in between. If you’re a conservative investor, or are closer to retirement, large-cap funds are generally the best bet as they are more stable. On the flip side many younger investors like to pursue riskier (smaller cap) investments because the potential for payoff is greater, along with the available timeline for recovery. It all depends on your personal objectives and circumstances.

There are three primary stock styles to be aware of: value, blend, and growth. Growth stocks, simply put, are anticipated to have a strong growth rate. Of course, the flipside of growth stocks is that they are more shaky, and could therefore more likely to plunge in value. Value stocks are generally thought to be ‘bargains.’ They are bought when their price is at a low point, hoping that their price goes up. Blend stocks are simply a blend of growth and value stocks. Check the historical rates of return for the particular fund you are interested in. They are often reflected in 1, 3, 5, and 10-year intervals, in addition to performance since inception.

When you are looking at particular fund’s risk there are two terms that you may run across, specifically, the “r-squared,” and the “beta.” The r-squared is a range from 0-1, which corresponds to how closely it matches the market as a whole or a particular market index (1 being a perfect match). The beta compares changes in a fund’s share price to changes in the overall market/index. For example, if the market that is being used in comparison increased by 8% (so it then has a beta of 1.00), and the beta of the fund that you are checking out is 1.10, your fund is 10% more volatile than that particular market. A beta higher than 1.00 has the potential for greater payoff but at the same time is riskier. Because the beta is tied to market variations, when a fund’s r-squared is low, the beta figure becomes less important. As you could have probably guessed, both the r-squared and beta of a broad-based index fund will be 1 or close to it. 

Money Saving Tips

You may run across some funds which have a purchase fee or a redemption fee. I think these terms are pretty self-explanatory. There are many funds out there that do not charge these fees so it is a good idea to avoid them!

Try to look for a fund which does not have a 12b-1 fee. This nondescript name (taken from the Investment Company Act of 1940) is supposed to cover the advertising costs of the fund.  It is taken right out of the fund’s assets. This fee often hovers around .25-.75%, depending upon whether or not it is a load-based fund. (Note any fund with a 12b-1 fee over .25% is a load fund.) 

As a rule of thumb avoid investing in an index fund with an expense ratio (these are operating costs taken from your fund) of more than .21%. If you are paying more than that you are cheating yourself (shop around). Again, mutual funds have higher expense ratios and usually don’t beat the market.  

Go electronic. Since it costs investment management companies a lot of money to print out documents, they have created incentives to encourage their customers to select “e-delivery” or “e-service.” By receiving fund reports, confirmations, statements, and so forth through e-mail in formats such as pdf’s, you can often reduce fees. I saved a yearly charge of $20 because when I started my balance was under $10k, and balances below $10k were subject to that fee, unless the investor chose e-delivery. Regardless of what you decide, it is pretty easy to change your preferences online or by calling your investment management company’s customer service number. 

There may be some other fees that are particular to IRA’s, ect., and they typically vary from investment company to investment company. Make sure you analyze the fee schedule closely so there are no surprises. If you have any questions, companies typically have a customer service number on their Web site and you can talk with a representative who can fill you in. 

Choosing an Investment Company

There are so many different companies out there--it’s difficult for many investors to know where to begin. It’s a good idea to go with a well-established company with a sound reputation. Here’s some that are worth taking a look at: Vanguard, Fidelity Investments, Scottrade, Ameriprise, Merrill Lynch, T. Rowe Price, Charles Schwab, and the list goes on. 

To me, customer service is a very important. I want to be able to call in and have a knowledgeable person answer the phone quickly. Find out what’s important to you and do a little research. I’ve found that many trade financial magazines and journals seemed to be tied up in conflicts on interests (advertising contracts, ect.). Because of this, I tend to read blogs and ask friends and acquaintances what their experiences have been like with particular companies before making any decisions regarding who I’ll end up choosing.

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