Lazy Man and Money

Are Target Date Mutual Funds Right for You?

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An article from my friend, Jeff Rose caught my attention recently: Why I Hate Target Date Mutual Funds and You Should, Too. The title caught my attention – hate is a strong word that I haven’t seen Rose use too often.

For those who aren’t aware, target date mutual funds are typically designed to start out with more aggressive investments (stocks) and gradually get more conservative towards, well, the target date. The philosophy is that want to take the risks and reach for those high rewards at the beginning of your career, but as you get close to retirement, you want to preserve the nest egg. One of the biggest advantages is that you can “set it and forget it” (please don’t sue me Ron Popeil) – you can’t have to manage the portfolio, it manages itself.

The Good Financial Cents article, which I’ll get to in a minute, reminded me of my own story regarding target date mutual funds. A representative from USAA called my wife to make sure her investment objectives were being met. He suggested one of USAA’s target date mutual funds. I asked him why go with USAA when Vanguard and Fidelity’s have lower expense ratios. He didn’t have good answer for that other than USAA was charging a substantial fee (if memory serves) to get into those mutual funds. Long story short, we went some Vanguard ETFs based around index funds that had low commissions. This do-it-yourself wasn’t exactly what I was looking for, but it was the best use of money.

When I saw Jeff Rose’s article about hating target date mutual funds, I expected to read about how the funds have two sets of fees. There are the fees that the individual funds have, and the fees for managing/re-balancing the portfolio of mutual funds. He did get to that, but he uncovered something else. Some of the mutual funds included in these target date funds are, in his words, “just plum horrible.” (Side Note: Kudos to him for the use of plum as an adjective.)

Rose gives some examples of target date funds in some of his clients’ 401k plans and shows with back-testing that he could have made the client more than 3.5% with other choices in the 401k plan. Using the magic of compound interest Rose shows that in 20 years, that difference could be $295,000. Yep, that’s number is not a typo. We should all hate target date mutual funds right?

Maybe not so fast…

Here are a couple of thoughts that I had that may change your mind:

  • In 401k plans, there are limited investing options. Perhaps the target date mutual fund option in these clients had bad stocks, but I think it is a stretch to say that they are ALL bad. Outside of a 401k plan you may find a good target date mutual fund.
  • The 3.5% increase in returns in the examples are based on back testing a portfolio over the last ten years. Hindsight is 20/20. It’s easy to say that you should been in Legg Mason Value Trust when Bill Miller was beating the S&P 500 year after year… until it got decimated in 2008 (even in comparison to the market). Haven’t we read that past performance is not indicative of future results?

In the end, I realized that Rose’s views are different than mine. He’s into actively managing funds. I used to be that way, but I’ve settled into the low-expense index ratio camp. I haven’t been able to find that active advisor who is going to guarantee me that they’ll beat a broad index by 3.5% year after year, so stick with what I can control and that’s the fees.

Don’t Chase Mutual Fund Winners

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When it comes to investing, mutual funds are one the best known tools to help add diversity to a portfolio. Many people use a strategy of chasing after the top performing mutual funds and selling the underperforming ones. On the surface this makes sense. As a culture, we love winners, we don’t want losers. The winning mutual funds make the magazines. The losers… well not so much.

About that Past Performance…

When it comes to top performing funds, such as PIMCO Real Estate Real Return Strategy (PETAX) who showed one-year returns of around 25% percent or the Oceanstone Fund (OSFDX) which showed a three-year return of around 73%, the past performance is not a predictor of future gains. What you’ve heard that before? There’s a reason for that. Future gains are unpredictable and many of those top-performing funds are likely to have lower than average gains after a period of large growth.

Top performing funds only show a short-term historical track record. This short term growth does not always indicate continued growth in the future. Instead, it shows that the fund is currently at a higher price than previous years. Think of it this way, you are paying for a bunch of stocks that are priced much higher now than they were before. There’s a good chance that they are now overpriced and poised for a pull-back.

In addition the top performers are often high risk funds that are as likely to fall to the bottom of the charts within a year as they are to gain high profits. The high risk means that the funds are extremely unpredictable and it is possible to lose significant money as well.

Narrow Funds – Not Always Your Friend

Part of the high risk associated with top performing funds is the fact that the investment is extremely narrow. Instead of diversifying amongst different industries and countries, the fund puts the money into the same industry or country. For example, when gold does well, the funds that consist of gold will do well, when gold drops expect your investment to go with it. This lack of diversity means that if the industry as a whole increases, the fund is likely to have high gains and returns. Unfortunately, the same is true in the reverse.

The narrow choice of investments makes the fund riskier than many other fund options. Avoiding the high risk and opting for something more diverse is a key to increasing gains and cutting back on losses.

How to Improve Mutual Fund Gains

The key to investing and making more gains when working with mutual funds is avoiding the short term and seeking long term options. I’ve learned from experience that short term gains are not the best to chase because it is chancy and risky. In the end, chasing those short term returns results in higher losses that are difficult to make up later.

Instead, taking time to properly research the funds and find out how much diversity is included in the fund helps make a proper decision about which is best for long term gains.

I believe buying mutual funds based on the last year’s performance can be a mistake. Top performers are often risky funds that have limited diversity. Instead, well-researched funds that have a high level of diversity are better additions to the portfolio. Though the gains are often smaller in percentage, the risk of large losses is dramatically reduced.

How to Invest in Mutual Funds? (and other questions you asked)

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Last week, I wrote an article Understanding and Avoiding Mutual Fund Fees and a few commenters had some questions that I’d like to address here.

“Can you explain how one goes about investing in mutual funds?”

Thanks to Sun for this basic question. As he found out some brokerages charge a significant commission. In his case, Charles Schwab wanted $50 to buy a specific Vanguard fund that he was interested in. When I asked their customer support, it had gone up to $76! (In Schwab’s defense, they offer many mutual funds with no commission, but just not this particularly attractive Vanguard one.)

There are a couple of ways you can go with this – brokerage or fund family.

The online brokerage option has companies like Schwab, E-Trade, Ameritrade, or Zecco. You’ve probably heard of them (If you haven’t seen the E-Trade baby commercials, you need to give up the carrier pigeon communication and rejoin society.) I typically use online brokerages to buy ETFs, which are like mutual funds, but trade as stocks. This allows me to avoid the Schwab $76 mutual-fund commission since stock trades are usually under $10.

On the other hand you can go with a fund family. If you invest enough money with companies like Vanguard, Fidelity or, recent Lazy Man and Money advertiser, TIAA-Cref for example, you can buy the fund directly from them. I did this with Legg Mason to invest in their Value Trust fund managed by the legendary Bill Miller. I took advantage of his streak of consistently beating the S&P 500 in the late 90’s. (I think I hit something like the tail 6 years of it, before using the money to buy a car.)

More recently, I invested directly with Fidelity in my SEP-IRA a couple of years ago. Each year I add to that account and choose amongst Fidelity’s funds. I might be able to invest in other funds outside of Fidelity with that account, but I honestly have no desire as the Fidelity options suit me.

I’d like to read your thoughts about online brokers.

Todd came up with this question. In the early 2000, I was a little obsessed with day-trading Internet stocks. (I was lucky not to lose big money.) However, at the time, I had a number of brokerage accounts. I remember thinking how much smarter I was than anyone else for having Datek, which offered a great combination of speedy execution, low fees ($9.99 a trade were Ameritrade was around $15 I think), and some cool tools (I would see Datek Streamer in my dreams).

With the benefit of time, I’m a bit wiser. If you are going to be a day-trader, you should know enough about investing to pick out the best brokerage for you. You would be destined for failure at day-trading if you are going to my advice on brokerages. Did we get all the day-traders out of here? Good. You still around? Awesome.

Here’s a secret about online brokers, they are more or less the same. The commissions change slightly, but it’s such a marginal difference for the casual investor that it isn’t worth worrying about. They all have a lot of tools, and I suppose some tools are better than others, but typically, I think people are best off in low-cost index funds – and there are plenty of free online tools to find those. Even if you don’t believe in looking for low-cost index funds, I’ve found just about every tool that I’ve wanted available for free online. (I’ll leave some margin of error for the chance that there are some tools that I didn’t know that I wanted available at some brokerages.)

What about everything else?

Hey, you have to ask questions if you want me to try to answer them. That’s what the comments space below if for. However, I suggest checking out Free From Broke’s ways to invest in mutual funds as a good gateway article to other topics that I didn’t discuss here – asset allocation comes to mind.

Understanding and Avoiding Mutual Fund Fees

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Every now and again, I wonder if I’m writing at either a level that is too personal. One one hand, I believe that some of the reason people ready Lazy Man and Money is because of the personal focus. On the other hand, even I have to admit that my life isn’t that exciting. It feels like I’m walking a fine line sometimes.

I’ve also been wondering if I’ve presumed too much financial knowledge of my readers. I was looking through some of my old posts and I realized that I have no “mutual fund” category. I couldn’t believe that in over 5 and half years of personal finance posts I haven’t written one post around mutual funds. It doesn’t feel like it can be true, but unless I miscategorized a bunch of posts (which is always possible), it is. It’s a little like teaching someone the fundamentals of quartberbacking in the NFL and excluding the screen pass.

I think the reason why I haven’t touched on mutual funds in the past is that I focus most of my investing in exchange traded funds (ETFs). In many ways, they are like mutual funds, but they are traded on stock exchanges, and in many cases, but not all, have lower fees. Also, they are relatively easy to understand. You typically pay a broker commission (usually under $10) to buy the ETF. The rest of the fees are built into the stock price and you can look up the expense ratio information for that. That’s information for another article. Today I’d like to talk about mutual fund fees…. particularly understanding and avoiding them. It’s time to cover some of the basics. Please bare with me, I’m not in the financial industry and I may gloss over minor details.

One of the differences with mutual funds is that the terminology is a little more difficult – at least for me. For example, you have load and no-load funds. A load in the mutual fund context is another word for fee. Typically, there are front-end loads, which means that you pay when you buy the fund. Sometimes they are just a percent or two, but when you are investing $10,000 (as in rolling over a 401K to an IRA) that translates to “just” a $100 or $200. It’s not so minor a detail now is it? Additionally some mutual funds charge back-end loads, or to make it more confusing, something that is often called a deferred sales load. These are fees that are charged will you sell the mutual fund. Sometimes if you hold the fund long enough, the fees are waived.

If that last paragraph was confusing, you can simply do what I do, look for mutual funds that are marked “No-load.” There are a lot of them available. Since basic index funds (an automated average of a large group of funds) typically outperform a majority of mutual funds, I really don’t believe in investing in any mutual funds that charge a load.

Just because you’ve avoided paying a load doesn’t mean that you’ve escaped paying fees. The mutual fund companies have to make money somehow, right? And we know most of the people Wall Street aren’t exactly poor. The other major form of mutual fund fees is called an expense ratio. Just like the ETF version, this is a percentage of money that is used to run the fund. This includes paying fund managers as well as advertising the fund, and probably a bunch of other small things in there that aren’t really important for you or I to understand. Just like the load, this is a percentage and in our mythical $10,000 investment the 1% or 2% comes out to $100 or $200… but it’s charged every year. It’s really important to keep this fee in check.

Expense ratios can vary widely. In my wife’s Thrift Savings Plan (like a 401k for the military folks) the expense ratio is 0.025% or $2.50 for a $10,000 investment. That’s as good as you can get. On the other of the spectrum, it took me about an hour of searching, but I think the highest expense ratio is the 9.72% one from Giordano Fund. That will cost you nearly a thousand dollars of your 10,000 investment – each year. This is an extreme case that you typically won’t find.

I’ll leave it up to you to do find the mutual funds that fit your goals. To push you in the right direction, I’ll offer you this stock screener from Yahoo.