As an investment advisor and freelance writer specializing in mutual funds, I occasionally allow myself to fall into the somewhat annoying but incredibly useful trap of this scenario analysis:
The question is often followed by other questions or arguments common in the investment world: Which stocks perform the best over time — small caps or large caps, foreign stocks or domestic stocks? Should we use actively-managed mutual funds or passively-managed funds?
Of course “best” is a subjective term and the ideal investment for any individual will depend upon their unique investment objective, tolerance for risk, and their personal and financial circumstances.
With that disclaimer out of the way, let’s get down to the business of defining the one best mutual fund to hold for the long term.
Finding the Best Mutual Fund Types
- Risk/Return: For my “island-bound fund” I want to choose one of the top performing mutual funds in recent history. Also, for a long-term objective, I won’t mind taking the market risk necessary to achieve higher returns. Therefore, I’ll eliminate bond funds and balanced funds and go with a stock mutual fund.
- Time Horizon: I will use 15-year annualized returns because that takes us back to 2000, where a massive tech boom was busting and the Great Recession of 2008 is also included in that time frame. Also I don’t want excessive market risk or a reasonable doubt the performance can’t be continued in the future, so my final choice won’t be too concentrated in any one particular sector.
- Active vs. Passive: I will eliminate actively-managed funds because the risk of losing a star manager plus the added weight of higher expense ratios for the active management makes me feel more comfortable with passively-managed index funds.
- Foreign vs.Domestic: This was a close call but easy decision. The MSCI ACWI Index has a 15-year annualized return of 3.8% and the S&P 500 averages 4% during the period. I’m leaning toward U.S. stocks for the next 10 or 15 years so foreign stock funds are out.
- Small-, Mid- or Large-Cap: For the 15-year annualized returns, small caps, as measured by the Morningstar Small Blend category, weigh in at 8.5%;, mid caps, as measured by the Morningstar Mid Blend category, are at 8.1%; and large-caps, as measured by the S&P 500, average 4%. I’ll eliminate large-cap stocks funds.
Selecting the Best Long-Term Mutual Fund
To recap, we’ve narrowed down to a small- or mid-cap domestic stock index fund. The average small-cap blend stock fund edged out the average mid-cap blend stock fund for 15-year annualized returns. But this doesn’t mean we select a small-cap index fund. In different words, the best category average does not mean the best individual fund.
I have a bias toward Vanguard funds but for good reasons: They are masters of indexing and their expense ratios are consistently among the lowest in the mutual fund universe. So we have the two finalists:
- Vanguard Small Cap Index (MUTF:NAESX): The 15-year annualized return is 7.6%, which is 3.6 ahead of the S&P 500. There are dozens of actively-managed small-cap stock funds that beat this return for 15 years, but NAESX beats at least 80% of small-cap blend category peers for the 3-, 5- and 10-year returns.
- Vanguard Mid Cap Index (MUTF:VIMSX): The 15-year annualized return is 9%, which handily beats our small cap index choice and more than doubles the S&P 500’s 4% return for the time frame. VIMSX also beats more than 70% of mid-cap blend stock funds for the period.
My final selection for the one mutual fund I’d hold for the long term is Vanguard Mid Cap Index. I love the low expense ratio of 0.23% and I believe mid-cap stocks hit that sweet spot of aggressive growth with less volatility than small-caps. The minimum investment is $3,000.
Although this is a hypothetical scenario, mid-cap index funds like VIMSX can be used wisely as a core holding in a diversified portfolio of mutual funds.
As of this writing, Kent Thune did not personally hold a position in any of the aforementioned securities, although he recommends VIMSX and the Admiral share class, VIMAX, for his advisory clients. His No. 1 holding is his privately held investment advisory firm. Under no circumstances does this information represent a recommendation to buy or sell securities.
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