Friday, April 22, 2011

How to get better returns on your mutual fund

One of the surprising truths about investing is that the average person can often beat the performance of financial experts. This isn't because the experts are incompetent, it is because the financial industry is set up to provide benefits both to themselves and to their customers. One of the places where you can easily see this is in mutual funds.

Mutual funds are one of the most popular ways to invest in the stock market, and one of the easiest. If you have a 401(k) type plan, you typically can choose from a number of mutual funds. Once you decide on which funds to use, you can leave the rest up to the financial professionals who manage those funds. You would think that if the financial industry spends lots of money hiring seasoned experts to manage these funds, that the results would be a lot better that what you can do on your own. The sad fact is that this is not at all true.

The easiest way to compare mutual funds is to compare their performance to a reasonable benchmark. If you use the S&P 500 index as a reasonable benchmark for mutual funds that focus on stocks of large companies, than most mutual funds don't measure up.

According to the Motley Fool, over the long term an S&P 500 index fund such as the one run by Vanguard index fund has outperformed over 90% of all domestic equity (stock based) mutual funds over the past five years.

For some data to back up this claim, I looked at a Smart Money article that compared the Vanguard S&P 500 index fund (VFINX) to other funds in the same category, and over the last 10 years, it ranked 11 on a scale of 1 to 100 (data for period ending 4/21/2011). The return over the last decade wasn't huge, about 2.7%, but it was still better than about nine out of ten in that same category.

Why index funds do better
All mutual funds have overhead and administrative costs, but those costs are minimized for an index fund. Instead of spending money on staff to make trading decisions, an index fund only has to mimic the performance of that index. The difference shows up in the expense ratios, which you can get for any fund that you may want to use.

Over time, even a small difference in expenses can make a huge difference in returns. For example, in the Motley Fool article, the average mutual fund in the same category as the Vanguard S&P 500 index fund charged about 1.3% per year in expenses, compared with about 0.19% for Vanguard, about a 1% difference per year. If you invested $100,000 and got an average of a 5% return per year, over ten years, that it would grow to $159,966 in the Vanguard index fund after expenses, but the average mutual fund's expenses would have cut that down to $143,800. In other words, investing in the Vanguard index fund would have put over $16,000 extra dollars in the investor's pocket after 10 years.

More mutual fund disadvantages
The story is actually worse than this example. The Smart Money article showed that most alternatives to the index fund did not perform as well, so if you chose a competing fund in the same category, not only would you have higher expenses, but likely a lower performance. In the previous example, if the average fund returned a half percent less than the index fund, after 10 years the investor would receive $137,024, a difference of almost $23,000.

What this means for you
If you know that all mutual funds are not equal when it comes to their performance and their expenses, then there are a few things you should do before you invest in mutual funds:

- Compare the fund's performance to the S&P 500

- See if the performance over the last few years beats the S&P 500

- Find out what kind of expenses the fund has

If the performance beats the S&P 500 even after you consider the expense ratio, then maybe that fund is worth considering. Otherwise, your easiest mutual fund course would be to stick with an S&P index fund until you find something better.

Better options than mutual funds
While mutual funds may be a great option for someone who doesn't want to take the time to learn how to invest, there are many better options available, but only if you are willing to take the time to educate yourself.

Future articles will discuss how investing is a skill that can be learned and that the average investor can learn to invest on their own and get better returns than even the best mutual fund. If you want to make sure that you get notified when new articles come out, please join the mailing list , follow me on Twitter, or connect with me on Facebook.

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