Getting Started Series Part 7- What to Look for in a Mutual Fund


This is a series intended to answer the question “I’m covering my bills, now what?” It’s for people who have a steady source of income and have a vague notion that they should be doing something more with their money, but don’t really know how to begin. This will go through what to do with that money post-bills, from setting up an emergency fund, to debt management, retirement, and investment. Although most of this information is applicable to civilians, we’ll also be providing resources and information specifically geared toward military servicemembers and their families.

Through this series we’ve explored how best to put your money to work once you’re covering your monthly bills. We talked about why having an emergency fund is so essential and we discussed debt management. After those two elements are tackled, you’ll want to start a retirement account. In the last few posts we’ve been looking at the ins and outs of investing; information you can use when choosing where to allocate your retirement accounts or for investing in a non-retirement account once you’ve maximized your tax-advantaged accounts.

Today we will discuss the process of shopping for mutual funds, including index funds. When looking for the information below, you may have to reference the fund’s prospectus. It’s a document that discloses information about the fund. So if you find yourself searching in vain for the expense ratio or the minimum investment and you can’t find it anywhere, click the prospectus button and you will find it there for sure. Also, remember that ctrl+F is your searching friend. The prospectus can be over a hundred pages long, so I recommend pushing ctrl+F and then searching whatever information in particular you are looking for.

Without much further ado, here is our guide about….

What to look for in a mutual or index fund

  1. The fund type. First of all- is it a mutual fund or an index fund? If it’s an index fund, it might say index directly in the name, or it might quote an index such as the S&P 500 or the DJIA. For example, we currently heavily invest in the Vanguard Total Stock Market Index Fund Admiral’s Shares (VTSAX). We can tell that it’s an index fund because it says it in its name. The description also reads “…Vanguard Total Stock Market Index Fund is designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks.” This tells us that it is an index fund that measures the domestic market and that description of small-, mid-, and large-cap tells us that it doesn’t cover just gigantic well-known companies, but also some up starters who are doing less business. (You can read more about the different caps here)

That previous example was pretty straight forward, so let’s look at a fund that is steeped in more mystery. Another investment I used to own was the New Perspective Fund from American Funds (ANWPX). What is this? Not quite so easy to decipher from the title. The description tells us “Global flexibility. Seeks to take advantage of changing global trade patterns by investing in multinational companies based in the United States and overseas that have strong growth prospects.” This lets us know that this is going to be at least in part an international fund, or at least domestic companies doing international business. I can double-check this by the provided pie chart that tells me that it is 47.6% U.S. equities (stocks), 45.5% non-U.S. equities, and 6.8% cash and equivalents. So now we know that this is a stock heavy fund, about half domestic and half international. Moving further along, they have a break-down of the different cap levels. This fund invests in 93.1% large-cap stocks and 6.8% medium-cap stocks. This tells me that this probably won’t be a very volatile fund, since large-caps tend to be more steady than small-caps. Furthermore, it appears to be just a mutual fund rather than an index fund as there are no key words telling us it’s an index. There’s also a chart on the page comparing the All Country World Index to this fund. So if it’s being compared to an index, it’s probably not following the index, otherwise they would match perfectly. As you can see, deciphering the type of fund takes some detective work. But don’t be intimidated! Persevere, google the words you don’t know, or hop on the phone and ask the customer service representatives. They want your patronage (and money) and will be happy to answer your questions about their funds.

  1. Fees and expense ratios. Are there any fees associated with this fund? For mutual funds, the fees are usually wrapped up in the expense ratio and presented as a percentage. This percentage is what the brokerage company keeps as payment for investing your money. We will be showing in Part 8 why these expense ratios are crucial. The lowest expense ratio I’ve ever seen is the 0.029% that’s charged to all TSP (LINK) accounts. The second lowest I’ve seen is 0.05% charged by VTSAX as mentioned above. But they can also get really high- up to 8%. If you’re investing through your employer with your retirement account you will likely have higher expense ratios (TSP is the exception of course). However, because of the tax advantage, I still think these accounts are worthwhile and I would still try to choose a fund with a relatively low expense ratio.
  2. Minimum investment. This shouldn’t be a problem with your employer provided retirement account. However, with your IRA and with your non-retirement individual investments you’ll have to pay attention to this. Many funds have a minimum amount that you have to invest. They vary from company to company and fund to fund. I typically see the minimum amount somewhere between $1,000 – $3,000. I’ve seen some bond funds start as low as $100. On the other hand, the VTSAX that we invest in has a fairly high minimum amount of $10,000. If you don’t meet the minimum for the fund that you want to invest in, either invest in something similar at a higher expense ratio and transfer it later when the money grows and you have the minimum, or see if there’s a monthly deposit plan that will allow you to contribute less principal.
  3. Returns. This tells you how much you can expect the fund to return you. I will admit that I don’t pay much attention to this. Instead, I look at the graph. Nearly every investing website has a graph comparing that fund to an index. Does the fund underperform, match, or outperform the index? If it underperforms I don’t bother, I’ll just invest in the index instead.
  4. When talking about risk with mutual and index funds, you’re also talking about volatility, or the likeliness of the fund going up and down. Typically the overview of the fund will tell you the risk-level, with a label of something like “moderate” or “low”. However, if you have a general sense of what’s risky and what’s not, you can determine for yourself the riskiness of the fund. For example, bonds and government securities are typically low risk funds, while stocks are higher risk. If you look at a fund and see that it’s 96% stock holdings, that’ll be a riskier fund than one that is 25% stocks and 75% bonds. Within stock funds, small-cap and international stocks are riskier than large-cap and domestic stocks. Once you know these guidelines, you can make a pretty good guess about the risk of the fund.

Where can you buy mutual or index funds?

If you are contributing to your employer provided retirement account, you go through the company that your employer has contracted. But once you retire or leave that job you can roll it over to a company of your choosing, which you should do immediately because you are likely paying a high expense ratio.

I will be listing companies today for those shopping for an IRA or non-retirement individual investment account. I do think it is useful for beginners to have an idea about what financial institutions they should look into. However, I am by no means endorsed by any of these companies, nor am I am a professional, and I urge you to do your own research.

My personal top choice is Vanguard. They have many index funds (they invented them after all) and low expense ratios. Additionally, it has a unique ownership structure where its customers are owners, which probably helps them keep those expense ratios low. They’re a reputable company that’s been around many decades and I’ve always had good customer service with them. As you peruse the personal finance blogosphere you’ll see many other bloggers drinking the Vanguard Kool-Aid.

I’ve also previously invested with USAA. We bank and have our insurance with USAA and we’ve always been very pleased with their customer service and their insurance rates. However, they’re expense ratios were higher than we expected and we ended up transferring our investments to Vanguard.

Another firm I’ve invested with is American Funds. Again, great customer service, no real issues, just expense ratios that were higher than Vanguard’s which is why we ended up changing companies. My new 403b through work is with Fidelity and so far I’ve been happy with them as well. Good customer service, quick set-up, and the expense ratio for my S&P 500 index fund is only 0.07% so I was very pleased with that.

Many many more companies exist. Other investment firms that I’ve heard of but not used personally include Charles Schwab and Edward Jones. If you are still unsure with what company to use, I would ask around with family and friends and go with a reputable name that you’ve heard of.

Thoughts on diversification

Have you heard the phrase, “Don’t put all your eggs in one basket?” The same goes true with investing. What if you had all your money tied up in Blockbuster or Mervyns or another long gone company? Mutual funds in their nature do provide some diversification intrinsically, since they are pooling investors’ money to buy a variety of stocks and/or bonds rather than just one.

However, this idea of diversification is not limited to just which stocks or bonds you buy, but also in diversifying your risk. Like I stated above, a mutual fund is intrinsically diversified, so let’s imagine that you’re invested in an index fund of the S&P 500. Although the market always grows in the long term, there will be some ups and down in the short term. If you are young and decades from retirement or from withdrawing that money you can let it ride out and it won’t be a problem. If you’re young you’re probably also in the wealth accumulation stage, where you are trying to grow your money, which means you’ll most likely want to invest heavily in stocks. On the other hand, once you are older and at or past retirement, you’ll be in the wealth maintenance stage. At that point your goal is to keep your money and save it from deflation. At that stage, bonds will be a better choice. But it’s not an all or nothing situation. You should have a mix of stocks and bonds to diversify your risk. But alas I believe that’s another discussion for another day.


Stay tuned next week for Part 8 on why expense ratios matter!



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