Mutual fund secrets

Posted by Tad Johnson - Feb 2nd, 2008 at 19:02

Over the past decades, mutual funds have gained immense popularity. Most investors now own shares in one or more mutual funds, and virtually all 401(k) plans include mutual fund choices.

The allure of the mutual fund is clear: it allows the individual investor to purchase a share in many different companies and take advantage of the expertise of the investment banks who offer them.

As with all things in life, this is not a free lunch. Mutual fund managers are paid [well] and these payments come directly from you, the investor. Most funds simply take a percentage of assets right off the top each year. This is called the expense ratio, and is generally between 0.5 and 3%. This may seem insignificant, but it’s crucial that you understand and compare the expenses when choosing a fund. Over a long period of time (like the 30+ years until you retire) a difference of even 0.5% can make a huge difference.

Why are some funds more expensive than others? In theory, the best performing funds will charge (and justify) the highest expense ratios. Index funds–those that aim to match the performance of one of the large benchmark indices–generally charge a low rate. Specialty funds and those that actively try to beat the market will charge more.

For the young investor with decades to go before retirement, the goal should be finding funds that perform well with low expense ratios. Fidelity and Vanguard are both known for low-cost funds. Fidelity’s S&P 500 index fund (FSMKX) charges a mere 0.1%; Vanguard’s similar index fund (VFINX) is almost as low with a 0.15% expense ratio. Aim for 0.5% as a goal for all of your funds, and be wary if you’re paying more than 1%.

4 Comments »

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  1. Tad - Nice site, I’ve just recently become more interested in investing, so this is all quite interesting.

    Here’s my question for you - a fund like Fidelity’s S&P 500 Index requires a $10,000 minimum initial investment. This seems difficult due to the $5000/yr limit on my Roth IRA, and furthermore seems like a lot to dump in one place at a single time. Are there other similar options? What’s the best way to deal with these initial investment hurdles?

    Comment by Nick H-M — February 9, 2008 #

  2. Nick, good point. Fidelity recently increased their account minimums across the board–when I opened an account with them a few years ago, the minimum was only $2500.

    Check with Vanguard. Most of their funds carry a minimum of $3000 right now, and all have low fees.

    You can also use ETFs, which trade like stocks and carry no minimums. Be aware, however, that you will pay a trading fee to your broker when you buy and sell ETFs.

    Comment by tad — February 9, 2008 #

  3. You inspired me to write about this very subject.

    Comment by tad — February 10, 2008 #

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