Every investor dreams of earning amazing returns. Yet if you're planning to pay premium rates to a professional for the privilege of managing your money, you're creating an obstacle to good performance that you'll find extremely difficult to overcome.
The sad facts
Mutual funds are a wonderful tool for investors. Even if you don't have that much money to invest, a mutual fund can give you a diversified portfolio of stocks that can weather even the worst market storms and provide you with long-term growth.
Unfortunately, though, actively managed mutual funds don't have as good a track record as you might expect. Just last week, the Fool's Rule Your Retirement enlisted the help of fund and ETF expert Rick Ferri to look at the returns of actively managed mutual funds, and the results were pretty depressing.
Specifically, only 28% of domestic large-cap stock funds outperformed the S&P 500 index over the five-year period ending Dec. 31, 2008. Even worse, though, the figures for mid-cap and small-cap stock funds were even lower, with just 21% and 15% of those funds respectively beating their index benchmarks. Foreign stocks suffered from the same phenomenon, with just 16% doing better than a world stock index. Worst of all, just 7% of bond funds beat the Barclays bond benchmark.
Three solutions
Selecting an actively managed mutual fund without extensive thought and research is likely a losing move. Instead, you should consider these alternatives.
1. Go with the index fund.
With the emergence of hundreds of ETFs, investors can now find passive investments in nearly every corner of the market. Whether you want a broad-market fund that owns stocks in lots of different sectors and countries or a highly focused fund that drills down on a very specialized investment theme, you can probably find an index fund or ETF that meets your needs.
Index funds have a couple of benefits: they tend to be relatively inexpensive, and they also are tax-efficient. The trade-off, though, is that you give up any real chance of outperforming your benchmark. For many, however, not having to worry about trailing the benchmark by more than a token amount is more than worth it.
2. Think cheap.
If you're still convinced that active funds are the way to go, then the first thing to do is to make sure you don't overpay your manager. Ferri's research showed that on average, growth and income stock funds that fell into the cheapest third by fees had an annual return that was more than a full percentage point higher than the costliest third of funds. Corporate bond funds saw similar outperformance by funds with lower fees.
Funds with relatively low expenses often make the best investments over the long haul. Take a look at these low-cost actively managed funds that have managed to post good returns during a period in which a typical S&P index fund actually lost money:
|
Fund
|
Expense Ratio
|
10-Year Avg. Annual Return
|
Holdings Include
|
|
Vanguard Dividend Growth (VDIGX)
|
0.36%
|
2.5%
|
UPS (NYSE: UPS ) , Cardinal Health (NYSE: CAH )
|
|
Yacktman (YACKX)
|
0.95%
|
12.3%
|
Coca-Cola (NYSE: KO ) , Procter & Gamble (NYSE: PG )
|
|
Fidelity Contrafund (FCNTX)
|
0.94%
|
3.7%
|
Google (Nasdaq: GOOG ) , Apple (Nasdaq: AAPL ) , Wells Fargo (NYSE: WFC )
|
Source: Morningstar.
Low fees don't guarantee success. But without low fees, it's a lot harder to get yourself to the top of the fund rankings.
3. Pick stocks yourself.
Arguably, the best way to keep fees to a minimum is to take control of your own portfolio. You'll have to pay transaction costs and other fees associated with having your own discount brokerage account. But you get to control those costs.
More importantly, as you learn the skills that will help you pick winning stocks, you'll realize that there's much more profit potential from making your own investing decisions than you can get from relying on others to make those decisions for you. The cost savings is just an added fringe benefit.
Be smart
So before you invest your money in just any actively managed mutual fund, stop to consider what you're up against. The odds are good that if you think about it, you'll realize that other alternatives are more likely to give you the results you want.
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