"Free Lunch" Funds

• Email
• Share
• Print

I've finally found the Holy Grail of investing: The free lunch. That means getting better returns and taking on less risk.

Until now, I honestly didn't believe it existed. But I found evidence of the free lunch in my old copy of Bogleon Mutual Funds. Author John Bogle is the highly regarded founder of The Vanguard Group, so if he says there's a free lunch, I'm willing to go along.

Your burrito is on the house
Here's how it works: Bogle claims that you can earn higher returns from certain mutual funds by taking on less risk -- if you keep your costs low.

Imagine an actively managed portfolio composed of 50% stock mutual funds and 50% bond mutual funds. Assuming a 10% annual return for stocks and 7% annual return for bonds, you can expect this portfolio to return 8.5%. However, because the portfolio is actively managed, it carries a cost of 2% (the industry average is actually around 2.2%, according to Bogle). After subtracting costs, your net return is 6.5%.

Now imagine a second portfolio containing 35% stock index funds and 65% bond index funds. The expected return is 8.1%, but notice the costs are much lower on the index funds -- only 0.2%. Because this portfolio is weighted to bonds, it carries less risk than the first portfolio. At the end of the day, your net returns are higher from the less-risky portfolio because of fewer expenses. That's a free lunch in my book.

	Actively Managed 50/50	Index Funds 35/65
Weighted portfolio return	8.5%	8.1%
Assumed cost	(2%)	(0.2%)
Net portfolio return	6.5%	7.9%

But what about .?
Let's make our assumptions more favorable for actively managed funds. We'll cut our costs in the first portfolio to 1% to reflect competitive, no-load funds such as Fidelity Growth Company (FUND: FDGRX) and Fremont Bond (FUND: FBDFX), and we'll assume that stocks return 12% rather than the 10%.

In this best-case scenario for actively managed funds, the lower-risk portfolio still manages to win by 10 basis points. Over 10 years, this small margin makes a $200 difference on a $10,000 investment. Never underestimate the importance of costs when it comes to mutual funds.

	Actively Managed 50/50	Index Funds 35/65
Weighted portfolio return	9.5%	8.8%
Assumed cost	(1%)	(0.2%)
Net portfolio return	8.5%	8.6%

In theory, fund managers should be able to use their skills to outperform the comparable index fund, thus making up for the higher costs. Bogle counters that most fund managers historically do not beat the indexes. In the case of load funds, only 20% beat the market after expenses.

Is dinner free also?
Unfortunately, this free lunch applies only to mutual funds. It does not apply to stocks. I cannot find better returns and take on less risk from individual stocks.

For example, I would expect a 20% return from investing in a small biotech company like Exelixis (Nasdaq: EXEL). Exelixis has most of its value hinging on cancer drugs that are still in the trial stage, which adds some uncertainty to this investment.

Now imagine if I could get a 20% return from stable, well-established companies with long histories like Procter & Gamble (NYSE: PG), PepsiCo (NYSE: PEP), or Johnson & Johnson (NYSE: JNJ). That would really be a free lunch! Of course, the market would never allow it. Procter & Gamble's price would increase until my expected return is far less than 20%, thus eliminating my free lunch.

However, because of mutual funds' cost structures, it is possible to get better returns with less risk.

Foolish bottom line
As John Bogle explains, the high cost of some mutual funds can really hurt your performance. But on the other hand, the astute investor can take advantage of low-cost funds or index funds to get better returns with less risk.

To find out more about low-cost mutual funds, give Motley Fool Champion Funds a free trial. Lead analyst Shannon Zimmerman will show you how to find the best-performing funds with very low expense ratios. As Shannon tells it, with mutual funds, you often get what you don't pay for. The Champion Funds portfolio is currently beating the market by a full 10 percentage points.

A free lunch and a free 30-day trial to Champion Funds ... what more could you ask for?

Fool research analyst Joey Khattab does not own shares in any of the companies mentioned. Exelixis is a Rule Breakers selection. Fremont Bond is a Champion Funds recommendation. The Fool has a disclosure policy.