401(k)/403(b)

Index Fund Understanding

401(k)/403(b)
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The line you're in at the toll booth is always the slowest. Somebody else always wins the lottery. The dog has, again, eaten that sandwich you took your eye off for a second. Yup. Life is unfair sometimes. (But what are you doing playing the lottery in the first place? Sure, we sympathize with you about that problem with the toll booths, and I think we've all been there with the dog, but, c'mon, the lottery?)

Sorry. Back to the issue we were discussing, which was.

What should you do when your 401(k) plan doesn't include an equity index fund? That isn't fair after all, is it?

Well, no, it isn't fair, but there is a way out. You need to find a Foolish fund, which, as things turn out, is the fund that is most like an S&P 500 index fund. Essentially, you are looking for a fund with the following features:

  • Low management fees (below 0.75%)
  • No sales charges (also known as loads or commissions)
  • No 12b-1 fees
  • Turnover no higher than 40% a year
  • Established track record
  • Consistency of return

Studies show that virtually all of the difference in return between managed funds and index funds is attributable to the higher costs imposed by actively managed funds. A low expense ratio is simply the most important reason a fund does well. If you can't choose an index fund, make sure that you pick a fund that does not impose significant costs -- and all the costs matter.

Management fees are annual fees charged by all funds, and you want to maker sure that management fees are as low as possible. Index funds typically charge about two-tenths of one percent of the assets, and actively managed funds currently average about 1.6% per year. The average fee, by the way, has actually been climbing in recent years.

Any fund that has management fees above 1% per year can be expected to underperform the total returns offered by an index fund.

You also want to make sure that you aren't paying any sales charges. Sales charges come in various stripes, also known as loads or commissions. There might be a charge for buying into the fund (a front-end load), or selling the fund (back-end load, deferred sales charge, or redemption fee). Avoid all of these. Some funds have back-end loads that are reduced the longer you hold the fund. Best to avoid all of these. If you have to buy an actively managed fund, buy the fund with no sales charges at all. Funds that normally have sales charges sometimes waive them or have reduced sales charges for large 401(k) accounts.

12b-1 fees are really remarkable. These are yearly charges that the fund takes out of your money so that it can market itself. Enough said. You don't want to be paying those at all. Any fund with a 12b-1 fee above 0.25% can probably be excluded.

Turnover measures how long a fund is holding onto the stocks it buys. The longer a company holds onto a stock, and the less trading it does between different stocks, the lower the turnover will be. Since a fund incurs costs every time it buys and sells stocks (just like you do), the lower the turnover, the lower the transaction costs incurred by the fund. Ideally, Fools like to see funds that practice the "buy and hold" method of investing -- those funds are the most index-like. Funds that have a turnover of 100% are essentially buying a completely new set of companies every year. Turnover should ideally be substantially lower than the mutual fund average of about 80%. Index funds have turnover as low as 5%.

A mutual fund that has an established track record is less important than you would think. Studies show that measuring performance over two decades or longer, 99% of funds that outperform the market in one decade revert to the mean in the next decade. Past performance really isn't an indication of future results. However, a fund that dramatically underperforms the market is more likely to keep doing so. How about a fund that's existed for less than five years? You don't know what that fund is going to do. And if a new fund manager has recently switched into the fund you're considering, that's pretty much a brand-new fund. Let her experiment on other guinea pigs for five years before you give her any of your money.

Make sure to check out the consistency of the fund's returns. You're looking for funds that not only have shown good returns on the whole, but ones that do so on a consistent basis, rather than having great runs followed by lousy ones. Most funds that claim to have outperformed the market over a 10-year period really had most or all of their truly good performance when they were young and small. Once the fund had attracted a couple billion extra dollars, the fund, usually, started performing more in line with the market.

Phew! All that to go through instead of just buying an index fund? Wouldn't it be better to just get an index fund into your plan? It just might be.

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