Investing in Vanguard mutual funds doesn’t have to be difficult or confusing. Vanguard may not make it easy to plot the safest course for your 401k investments, but with a few pointers you can turn your retirement money into a healthy nest egg in no time.
Here are 11 secrets to mutual fund investing that Vanguard doesn’t want you to know.
Vanguard Secret #1: 500 Index is NOT the safest index fund
…nor is it the best-performing index fund, nor is it the best way to invest in large-cap stocks. In fact, during the tech bear market, investors lost more than $40 billion in this fund. 500 Index has more risk built into it than Vanguard wants you to know about.
Diversified? Risk-free? Below-average risk? Think again.
A whopping 20% of the fund’s assets are tied up in just 10 stocks, and nearly half (47%) of its assets are invested in just three sectors.
Vanguard Secret #2: This fund is like 500 Index, only better
Vanguard has a fund that’s remarkably close to the 500 Index, except it’s safer, performs better and it’s actively managed!
If you want to invest along with the S&P 500, fine. But you’ll be much better off when you do it with a fund that can weed out the dogs that live in index funds.
Instead of holding a toxic mix of 500 stocks — some good, some bad — this fund holds about 140 stocks, and 65% of its assets are /in some of the very best stocks from the 500 Index.
This fund dumps the index dogs. The remaining 35% are stocks picked by top-notch professional management.
Members of the Fund Family Shareholder Association (or FFSA, the organization I created in 1991 to help investors get richer, faster in their mutual funds) know all about this fund: Vanguard Growth and Income.
Vanguard Secret #3: Index funds are NOT the best answer.
Index funds, even the best ones, simply don’t compare favorably to Vanguard’s best actively managed funds.
Vanguard has a slew of index funds with growth objectives, the 500 Index among them.
And if you’re looking for capital appreciation and you’re indexing to get it, well you’re making a costly mistake, one that traps the average Vanguard investor time and time again.
Please don’t lose 40% of your profits this year. Don’t wait for Vanguard to tell you that indexing is last century’s way to profit safely. They will never reveal this fact to you.
Vanguard Secret #4: Vanguard’s high-power closed funds have clones
If you’ve ever researched Vanguard’s leading long-term performers, you’ve probably been frustrated to learn most of them are closed to new investors.
Does this mean you miss out on the profits? Not anymore.
Capital Opportunity is a great fund. But it’s closed. PRIMECAP is great, too, and it’s a lot like Capital Opportunity. But it’s closed, too. And Vanguard’s newest PRIMECAP fund, PRIMECAP Core is also closed. But there’s still a way you can access this superb management team. Vanguard won’t tell you, but I will.
Vanguard Secret #5: Sector fund investing is a bad bet for long-term investors
Buy a highflying sector fund at the wrong time, and you can see two-thirds of your money disappear.
Sector funds are tempting. But buying a sector fund is actually a form of market-timing, which individual investors never seem to master.
And what many investors also don’t realize is that sector investing is expensive (minimum investments hover around $100,000) and their performance over the long haul simply isn’t worth the price of admission — only half of the ten major stock market sectors that Vanguard follows have generated market-beating returns.
Without an expert guiding you, sector fund investing can be more akin to speculating, which is a nice word for gambling. If you want to be smart and limit your risks, make long-term investments that make real money for you safely and on a consistent basis.
Vanguard Secret #6: You can actually lose money in a “safe” fund designed to generate income
If you invest with Vanguard for income, you have no room for risk. Yet, many Vanguard income investors have their money in bond funds and Treasurys that are more than twice as risky as their benchmark, the Barclays Aggregate Bond Index.
OK, maybe you don’t expect returns as high as you might get in a growth fund, but you certainly do expect less risk. And you certainly don’t expect to lose money. But many Vanguard income investors do lose money. Take inflation into consideration, and even more are losing money in income funds.
Vanguard Secret #7: One Vanguard annuity has actually performed better than its underlying fund
Vanguard won’t steer you away from any of their variable annuities, but they should forbid you from buying some of them.
You see, Vanguard’s annuity funds are tax-deferred clones of other funds. Buying one for your 401(k) is a costly mistake. Annuities are expensive when compared to the underlying funds they mimic, and there is absolutely no reason for you to have an annuity in an account that’s already tax-advantaged.
Since they are more expensive than their underlying funds, annuity returns are almost always subpar. I said, “Almost.” And it’s not like the underlying fund, Windsor II, is a dog. Through 2008, it rewarded investors with returns of 12.1% per year since the annuity’s inception. Still, the annuity fund did even better — 21.8% per year, despite higher expenses.
And yet, this is not the overall best Vanguard annuity fund. That title belongs to the tax-deferred equivalent of PRIMECAP. (Unlike PRIMECAP, this annuity fund is not closed to new investors.)
Vanguard Secret #8: 5 of Vanguard’s growth funds have the exact same top-10 holdings
MidCap Growth has a remarkably close correlation to SmallCap Growth, which is closely correlated to LargeCap Index.
No matter which type of fund fits your investment objectives the best, you’re looking for the safety of diversification. That’s why you turn to mutual funds, isn’t it?
Bet you didn’t realize that five of Vanguard’s growth funds have the exact same top-10 holdings. So, if you own two growth funds, chances are you’re overexposed on those stocks. Overlapping investments, which is the opposite of diversification, is a trap far too many Vanguard investors fall into.
Vanguard Secret #9: Don’t buy just prior to a fund’s distribution date
You could get hit hard with taxes on gains the fund achieved during the months before you jump in.
Can you imagine Vanguard telling you not to sink a large amount of money into any taxable fund late in the year?
Funds normally pay out capital gains at the end of the year. Why should you pay taxes on gains realized before you got on board?
So please, do not buy just prior to a fund’s distribution date. Wait until the beginning of the year, or at least until after distributions
are made. The money you’ll save on taxes adds up and goes directly to your bottom line.
Vanguard Secret #10: You can save on taxes and penalties by NOT automatically reinvesting distributions
When you receive dividends or distributions, you still owe taxes on those earnings, even if you reinvest them. But when you do reinvest, the price per share is usually different from the price of your original shares.
Make sure you keep track — otherwise you could wind up paying taxes twice on the same money: first when you receive the dividends and again when you sell the shares you bought with the reinvested dividends.
Here’s an example:
Say you bought 50 shares of ABC fund at $30 a share for a total of $1,500. Then you reinvested $350 worth of dividends at $35 a share (buying another 10 shares). You’d own 60 shares, but don’t forget that 10 shares have a cost basis of $35.
Many investors treat the entire 60 shares as having been bought with the original $1,500, giving a false cost basis of $25 ($1,500 ÷ 60) and opening themselves up to much higher capital gains when they sell.
In this case, the average per-share cost basis is $30.83 ($1,500 + $350 ÷ 60). So if you sold 10 shares at $35 a share, your capital gain would be $4.17 a share or $41.70, not $10 per share or $100. That saves you $8.72 in taxes based on a 15% capital gains tax rate.
Vanguard Secret #11: There’s no such thing as minimum additional investments
You’ve probably noticed that once you own a Vanguard fund, you’re supposed to only send in additional investments when you have $100 or more.
That’s a stumbling block for many investors. In fact, I’m constantly hearing from Vanguard investors who feel they can’t diversify their portfolios into three or four funds, even though they have enough money to open three or four accounts.
Why? Because they want to follow a systematic investment plan, such as dollar-cost averaging or value averaging, and according to Vanguard’s rules, will need $100 per fund each time they make an investment. For an investor using a monthly investment program on four funds, that can add up to at least $400 per month.
My advice: Forget the rules. You don’t have to wait until you have $100 to invest in your fund. Do it now! Vanguard will not return a check that you have endorsed over to one of their mutual funds, no matter how small the amount.
You have just $80 to split between four funds? Do it. Just write four $20 checks and send them in. Or sign one check over to Vanguard and enclose four InvestByMail slips splitting the amount as you wish.
How small an investment can you make? Would you believe checks as small as $0.28 can be deposited? I’m not advocating that you run up Vanguard’s expenses by sending them tons of tiny checks. However, it’s more important that you get your money to work for you, no matter how small the amount.
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