Mutual Funds

What exactly defines the best mutual funds anyway? Funds are by far the most widely used investment vehicle in the world. There are now more mutual funds than there are stocks in the US market. With over 26 thousand funds that Morningstar keeps track of, how can someone know where to find the best ones?

You’ve come to the right place to find out!

You’ll have to read all the way to the end of this page to see my recommended list of “Best Mutual Funds for 2009″. But before we dive into that, let’s back up and do a little mutual fund 101.

What is a mutual fund?

A mutual fund is the most popular form of a pooled investment known today. They are designed for people who want to have their money professionally managed at a fairly reasonable cost. In addition to professional management, they give an investor convenience, diversification, record keeping, tax reporting, and safekeeping of securities.

How do mutual funds make money?

Mutual funds make money in several ways. The main way is from internal fees that are called expense ratios. Expense ratio sounds a lot better than FEES, right? But it’s the same thing. It’s a percentage of the funds assets that are taken out every day, and it’s how the mutual fund company stays in business. You never see these fees come out, but they definitely affect your annual returns. You want to try to make sure your expense ratios are around 1% or less per year. Some specialty funds are going to be higher, but for the most part you should try to buy funds that are under 1%. Funds are required by law to produce a document called a prospectus, which no one ever reads, that tells you important information about the fund. Fortunately, Morningstar reports most of this same information in a much easier to understand way. The best mutual funds will keep these internal costs to a minimum.

What about commissions?

This is an important one. Many mutual funds sold today by bank brokers and full-cost brokers like Merrill Lynch and Edward Jones have commissions, or loads. Loaded funds commissions can vary, but most are between 1% and 5.75%. That means for every $1000 you invest, $45 to $57.50 could be coming out for a commission to the broker, and the rest gets invested into your account. That’s not such a bad thing if the broker getting paid is actually helping you manage your account of mutual funds. Loaded funds can have either front-end or back-end commissions. Front-end means you pay it when you go into the fund with new money, these are called A share funds. Back-end means you pay it when you eventually sell the shares, these are called B share funds. With a B share, the back-end commission gradually declines the longer you hold it. It’s usually completely gone after 7 years. The problem is, B share funds have much higher internal expense ratios, sometimes 2.5% per year. This is how they make up for the commission that they paid the broker when you bought it. If you’re going to buy a loaded fund, you should NOT buy a B share. The other option is a C share. C share funds have no commission when you buy it, and a 1% back-end commission if you sell within the first year. The best mutual funds will have little or no commission on them.

What are 12b-1 Fees?

These are another kind of internal fee that you’ll never see come out, but you need to be aware of. Most loaded funds have 12b-1 fees, and a few no-load funds do too. These are basically an annual trailing commission that goes to the broker who sold you the fund. It’s supposed to be his or her incentive to continue to take care of your account. It’s generally .25% per year, so it’s not going to break you. But when you add that on to an up front commission of 5.75%, and an expense ratio of 1.50% or 2.5%, and it starts to become very difficult to keep up with the market. If you’re looking for the best mutual funds, try to avoid 12b-1 fees.

What are No-Load funds?

No load funds are funds that have no commission for the investor to pay at all. So every $1 that you invest goes right into the fund. Some famous no-load mutual fund companies are Fidelity Investments, Vanguard, and the Dimensional Funds. The only way a no-load mutual fund makes money is from the internal expense ratios. But that doesn’t mean that their expense ratios are higher. In fact, quite the opposite can be true. No-load funds are in our opinion are some of the best mutual funds available today.

	A Shares	B Shares	C Shares	No-Load
Front-End	5.75%	0%	0%	0%
Back-End	0%	7%	1%	0%
Expense Ratios	.75% – 1.5%	1.5% – 2.5%	.75% – 1.5%	.08% – 1.5%
12b-1 Fees	.25%	.25%	.25%	0%

Most full-cost brokers (ie. Merrill Lynch, Edward Jones, bank guys, etc.) won’t ever educate you about the way fund companies charge fees and make money. They will usually tell you that the best mutual funds are their own, which are generally loaded with fees and commissions. Knowing this can save you thousands of dollars and make a huge difference in the size of your account years from now.

What is an ACTIVELY managed fund?

This is a fund where the fund manager is actively buying and selling securities inside the fund in attempt to outperform the market. Many people think that actively managed funds are the best mutual funds. Keep in mind that each time a trade is placed, the fund has to pay a commission. These commissions are in addition to the funds expense ratio and are only reported in the annual report. Morningstar says that these trading commissions can run as high as 1% – 2% of the funds assets per year if the manager is a very active trader. You can get a feel for how much trading is going on by looking at the funds turnover rate, which is also reported by Morningstar. If a fund has a turnover ratio of 50%, that means the manager is selling and then buying again 50% of the funds assets each year. Many stock funds commonly have turnover ratios of over 100% per year.

Also, when a stock inside a fund is sold by the manager, any capital gains that are realized from that sale will be passed on to you as the shareholder. So even though you didn’t do anything, you could be paying taxes on your investment at the end of the year. Funds will estimate the amount of capital gains that they plan to pay out at the end of each year. It’s important to look at those estimates (usually published in November) and see if you should sell your shares before they pay it to you. This way you can avoid taking that gain and getting taxed on it. Yet, some of the best mutual funds are still actively managed.

So what’s a PASSIVELY managed fund?

A Passively managed fund, usually called an index fund, is a portfolio of stocks or bonds that replicate a major market index. The S&P 500 or the Lehman Brothers Aggregate Bond Index are two major indexes that most people have heard of. There are a lot of people who now agree that the best mutual funds are passively managed. Passively managed funds are very low cost funds to own because there are not a lot of analysts doing research on what stocks to buy and sell. These kinds of funds generally don’t do much trading of the stock or bonds they own, so this keeps the trading commissions and taxes low. Expense ratios of passively managed funds are usually in the 0.08% – 0.5% range, much lower than actively managed funds. These are an excellent choice for an investor who is satisfied to match the performance of the index.

So which mutual funds ARE the best mutual funds?

OK, so you’re just about ready to see my list. The best mutual funds to own tend to be index type funds. The truth is, most actively managed mutual funds UNDER-perform the major market indexes over time. There are a lot of reasons for this, and we’ve already mentioned most of them. Commissions, expense ratios, and taxes all add to the cost of owned actively managed funds. All these costs make it much harder for the manager to keep up with, not to mention out-perform the market index.

“…the best way to own common stocks is through index funds…
- Warren Buffett, Berkshire Hathaway Inc. 1996 Shareholder Letter

“A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money,” - Warren Buffett 2007

“Additionally, those index funds that are very low-cost (such as Vanguard’s) are investor-friendly by definition and are the best selection for most of those who wish to own equities.”
- see page 10 of Berkshire Hathaway Inc. 2003 Annual Report

“Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.” - page 5, 2004 Berkshire Hathaway Annual Report

“Most individual investors would be better off in an index mutual fund.” - Peter Lynch

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