Saturday, March 26, 2005

Mutual Funds

It absolutely astounds me how few people have a clue about mutual funds. Most people rely on them for the bulk of their retirement income and yet are widely ignorant as to the basic facts of mutual funds. I have had this conversation countless times, with highly educated people no less:

Which funds do you own? Are you in index funds? What percent is in stocks? Are these no-load funds? What are the expense ratios on these funds?

Uh, em.... I am balanced. I have growth funds and value funds. I have long term stuff. I have blue chip stocks. As to the particulars, ... I really don't know.

I would estimate confidently that 90% of people, mis-invest, if I can coin a new word.

The absolute biggest mistake is owning mutual funds when you don't have to, say in a normal taxable account. In this case, one should generally own unit investment trusts or exchange traded funds. Of course your friendly broker will never recommend this because he will make zero money off of that transaction.

Yes the ETFs and UITs are mostly broader indices, but also include some industry specific indices. The reason I steer people towards the indices is simple - historical evidence. Ask any investor their time horizon and most will reply 20+ years. Research has shown that over one 25 year period, only 6 out of 10,000 or so (I think the number is higher) mutual funds outperformed the broader market. I don't know about you, but I lack the intellectual arrogance to think that I can pick the handful of funds that will outperform the market.

Why do mutual funds underperform? Excessive trading? Higher costs? Who knows and who cares. Just stick with the broader indices for the most part. At another date I will get more specific about portfolio allocation.

Question: In my retirement account, they only allow me to own mutual funds. What do I do here?

Just go with the broadest fund or two that they offer. A common mistake is to allocate to 5 or more funds, say a biotech fund, an energy fund, financials,..... Do not do this. All you are going to do is create a quasi index fund. The same goes with trying to diversify through value, growth, technology, and income funds. It is a poor substitute for just buying one broader fund by itself. Why doesn't this achieve diversification? - because these separate funds are all represented in the S&P 500. I remember a few years ago reading that Cisco was owned by 75% of mutual funds. It was considered a growth stock, an internet stock, a telecom stock, a large cap stock, etc. Imagine owning Cisco in all of your mutual funds as it dropped from 70 to 10. Many people did. (Of course they enjoyed the ride up until March of 2000.)

Lastly, if owning a bunch of mutual funds is financially equivalent to investing in the broader indices, what is the difference then?

The difference is the forementioned underperformance and FEES (or expense ratio). Consider the example below. In this hypothetical situation, a person puts away $10,000 per year into the market for 21 years.

Estimated average annual mkt return and resulting account value after 21 years.

7% -------------- $480,057

8% -------------- $544,568

9% -------------- $618,733

10% -------------- $704,027

11% -------------- $802,143

12% -------------- $915,026

Now back to the FEES. The Vanguard 500 index fund has a total expense ratio of .18% while many mutual funds have expense ratios of 1% and higher. Consider that the market annually yields around 10%, the historical average, it is easy to see that this investor will lose $85,000 (difference between 10% and 9% above) if they are paying 1% more in annual fees than the hypothetical Vanguard index investor.

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