by Richard Band | June 19, 2012 8:15 am
Have mutual funds become obsolete? Are they going the way of the 8-track and the VCR?
Some on Wall Street would unanimously agree. After all, take a look at the explosive growth of the ETF industry. Hey, who doesn’t love the ability to buy or sell ETFs anytime throughout the day (not just at the closing bell) and a low expense ratio that keeps more of your own money in your pocket?
Given the obvious advantages of ETFs, one may think that the “old-fashioned” mutual fund has become obsolete. But that’s hardly the case.
In fact, trillions of cash still resides in open-end mutual funds (the kind you buy straight from the fund company itself or through a sponsor). Now, some of that money can be quite lazy or ill-invested, but certainly not all of it. Yes, if you handle them wisely, mutual funds can be a very profitable part of your portfolio.
Here are 5 do’s and don’ts for the loyal mutual fund investor:
Steer your money to mangers with proven long-term track records. Now, I bet you’ve heard cynics say that it’s nearly impossible to identify truly superior portfolio managers. That’s simply not true. Here’s how you can pick a portfolio manger worth his or her weight in gold: Take a look back to see how their funds performed in the “lean” years, like say, investing in the global markets back in 2000 to 2002. If he or she was able to outdistance their peers during this troubled time for internationals (as well as the “fat” years) then you’ve got a pretty good indication of true talent.
You won’t make any more money in mutual funds by trying to time the market. In fact, some mutual funds actually penalize frequent traders by assessing a redemption fee on shares led less than a specified time frame (usually less than 90 or 180 days).
Few fund investors — even with the best technical tools — can consistently beat a simple buy-and-hold strategy. So, sell your mutual funds only when you believe that a major shift in the market is coming, when a fund’s performance has deteriorated to an unacceptable degree or when your life circumstances warrant it (for example, if you’re about to close on a house and need the cash for a down payment).
Front-end sales charges will put a serious dent in your long-term returns. Insist on buying no-load funds, preferably from fund families that charge lower ongoing fees than the industry median.
One thing that has irritated me over the years about mutual fund advertising is that they tout past performance, but never tell you how much risk they really took to achieve those rewards. Now, keep in mind that there’s no perfect measure of risk. I’ve found that an old maxim usually applies: “Live by the sword, die by the sword.” Therefore, funds that rack up extreme gains in bull markets also tend to lose their shirts (and yours) in bear markets.
Hence, you can, more often than not, form a reasonably accurate picture of a fund’s risk by looking at what statisticians call standard deviation — a common measure of volatility. Typically, I prefer funds that have generated higher returns than their peers over the past three to five years, with the same or a lower standard deviation (a.k.a. less risk). To find the standard deviation figures for most funds, visit Yahoo Finance and click the Risk link to the left of the fund quote.
Over and over, research has shown that the average fund investor captures only a fraction of the profits earned by the funds he or she invests in. How is this remotely possible?
Lured by seductive performance advertising, investors tend to buy heavily after a fund has enjoyed a long, powerful run. It’s called missing the boat. Then, when the fund stubs its toe, the same investors bail out — inevitably, close to the bottom. To break the cycle, investors must train themselves to ignore the hype and buy on the dips (and the deeper the dip, the better!)
Follow this simple golden rule (we all love those, don’t we?): Wait for a fund’s share price to drop 5% from its annual peak before you take the plunge, and you’ll outperform the vast majority of investors over the long haul.
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