It's that time of the year again. April 15 is right around the corner, which means procrastinators everywhere (myself included) are scrambling to remember where they put the file folder with all the W-2s, 1099s, and other pertinent tax information needed for the dreaded 1040 tax form. It's a safe bet that many of those same people, when they reach line 25 of the form, will put down their pencil, scratch their heads, and try to remember how much they contributed to their IRAs this year -- if anything at all.
When it comes to IRAs, last-minute filers tend to be last-minute investors. Fortunately, Uncle Sam makes no such distinction, and will grant your contribution tax-favored status whether your check is dated tomorrow or January 2004. However, Fool retirement guru Robert Brokamp makes a compelling argument for why that check might just be better off in a tax-free Roth IRA. In either case, though, eligible workers are permitted to stash up to $3,000 ($3,500 for the over-50 crowd) in their accounts for the 2004 tax year.
So now the question remains: Where do you put that new money to work? Shannon Zimmerman recently pointed out a few tips to help mutual fund investors uncover IRA-friendly funds. What about the other side of the picture, though? Are there certain breeds of mutual funds that deserve a spot in your IRA account about as much as Jessica Simpson belongs on Jeopardy's Tournament of Champions? If you answered "What Is 'Yes,' Alex," then award yourself $100 and keep on reading.
Expensive funds
This first category is a somewhat obvious yet still dangerous group to avoid. Funds with excessively high expense ratios are problematic enough for regular taxable investors, but they have even more potential to inflict serious damage inside IRAs. Though a select few funds can and do overcome the handicap of high management fees, the vast majority find it nearly impossible to make up that extra ground over a long-term basis -- which IRA accounts by definition are designed for.
A $10,000 investment in a fund that imposes a 1.5% expense ratio (about the market average) will grow to about $74,000 in 25 years, assuming a 10% annual return. Not too shabby. However, an identical investment in a fund charging just 1.0% will be worth $84,000 -- and that extra $10,000 would cover plenty of pina coladas during your first post-retirement trip to a tropical resort. Even better, a portfolio with a mere 0.74% in annual expenses -- what the average selection in the Motley Fool Champion Funds Aggressive model portfolio will ding you -- will grow to almost $90,000.
Closet index trackers
While the active-vs.-passive debate is unlikely to be resolved soon, I think there is one thing that both sides can safely agree on. There is absolutely no reason to pay for active management that deliberately delivers passive performance. That is exactly the scenario faced by investors who hand their money to closet index trackers. Actively managed funds can often be worth the added expense, but not when managers fail to make a concerted effort to materially outperform their benchmarks.
One of the easiest ways to spot these imposters (they're essentially little more than overpriced index funds in disguise) is by the R-squared score, which measures how closely correlated a fund's returns are with those of an underlying index. For example, Fidelity Magellan (FUND:FMAGX) recently showed an R-squared score of 99 relative to the S&P 500.
There is absolutely nothing wrong with earning index-like returns per se. But why pay extra for it? Instead, get those returns directly through low-priced options like the Vanguard Total Stock Market (FUND:VTSMX), Vanguard 500 (FUND:VFINX), or the popular Spiders (AMEX:SPY), an exchange-traded fund that tracks the S&P.
Today's "hot" fund
Don't be tempted by funds that recently appeared in mainstream financial publications with titles like "25 Sizzling Summer Funds" or "Brazil's Best Biotech Funds." Curiously, many people who would be skeptical about jumping into a stock that skyrocketed 85% over the past six months wouldn't think twice about buying a mutual fund that has done the same. And for the most part, that's all today's "hot" funds are -- yesterday's winners.
More often than not, though, the list of tomorrow's winners comprises yesterday's losers. In fact, many studies have confirmed that pouring money into the prior year's best-performing asset classes is nothing more than a recipe for mediocrity. If anything, overweighting the worst performers is a savvier strategy. Better still, forget about timing the market altogether and stick to an appropriately constructed asset allocation model. When it comes to your retirement assets, don't bet against a reversion to the mean.
It's all relative
On a similar note, be wary of funds whose recent strength is largely just a function of their asset class suddenly coming into favor. For example, the Fidelity Advisor Natural Resources (FUND:FANAX) chalked up a 24% gain last year on the strength of stocks such as Valero (NYSE:VLO) and ExxonMobil (NYSE:XOM). The return looks fairly solid on an absolute basis. However, it was not the product of astute management (in fact, the fund underwent a midyear managerial change) but rather the end result of being in the right place at the right time.
Driven by broad macroeconomic factors, a supply-demand imbalance sent the price of oil soaring, which, together with strength in other commodities, carried the natural resources sector to the top of the charts in 2004. Fidelity Advisor Natural Resources Fund was a recipient of this tailwind, but its total return trailed the 31% sector average by a wide margin -- placing it near the category's bottom quartile. It can be misleading to judge a fund's returns without placing them in the proper context -- be sure they also stack up well against the appropriate benchmark, as well as other sector peers.
And if the fund does compare favorably -- perhaps a little too favorably -- check to see if its outperformance was the result of the manager going against the grain by making concentrated sector bets, using derivatives excessively, or employing some other high-risk strategy.
Time's almost up
Time is running out on the 2004 tax calendar, and many fund complexes will be actively campaigning for your business. Some will even lower their required minimums to get you in the front door. Don't fall prey to this technique, though, and don't assume that funds with excessively high turnover ratios or poor tax efficiency are acceptable inside tax-sheltered accounts just because capital gains distributions are no longer a concern. Often, funds that are unsuitable for taxable accounts should probably be crossed off your IRA wish list as well -- regardless of the relaxed entry requirements.
Whether it's the end of one year or the beginning of the next, don't unwittingly give a few questionable fund picks the chance to sink your IRA.
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Fool contributor Nathan Slaughter plans on mailing his taxes, and his IRA contribution, on April 14 -- no sense waiting until the last minute. He owns none of the companies mentioned. The Fool has a disclosure policy.
