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Course 211
What to Look For in a Fund

Introduction

Let's be honest: Very few investors are as geeky as Morningstar mutual fund analysts. Most people don't have time to fly around the country attending investment conferences and they don't waste their time swapping fund industry gossip. Furthermore, most investors have better things to do than to monitor dozens of funds. Finally, people starting out in investing probably don't have the money to buy more than one fund anyway.

So here's our advice for those searching for their first—and perhaps only—mutual fund.

Index Funds

Index funds are about as simple as it gets. You might remember from "Lesson 209: Why Knowing Your Fund Manager Matters" that index-fund managers aren't picking stocks in the traditional sense. Instead, they are buying the same stocks in the same proportion as they appear in a particular index. In other words, they don't buy a stock because they like a company's prospects or sell because a firm's outlook has become less than rosy. They simply own the index. They are passive investors.

Index funds have plenty of benefits. Most important, they tend to be low in cost. For example, Schwab 500 Index's SWPPX expense ratio is just 0.09% versus 0.84% for the typical large-blend fund. Because the index-fund managers aren't actively managing their funds—instead of making buy and sell decisions, they're simply doing what the index does—management fees tend to be low.

Index funds are also advantageous because they are fairly predictable. First, they tend to return what the index does, minus their expenses. Second, they always own what the index owns, which means they tend to be style specific. For example, if a fund indexes the S&P 500, that means it owns large-blend stocks; it'll own those types of stocks today, tomorrow, and the next day. You know what to expect from an index fund. Funds that aren't indexed, also called actively managed funds, might not own the same types of stocks day in and day out. It all depends on the manager's style. He or she may like large companies one day and then see value in smaller firms the next.

Finally, index-fund investors don't have to worry about manager turnover: If the manager leaves, the next manager is likely to do just as well, as long as the mutual fund shop's resources haven't changed. Nor is asset size an issue. Index funds can handle plenty of assets, because they generally don't use fast-trading strategies.

If you only plan to own one index fund for awhile, make sure it favors large companies. Some funds, including Vanguard Total Stock Market Index VTSMX, hold stocks of all sizes, though larger companies are most heavily represented. Such funds would be excellent choices for one-fund owners.

Funds of Funds

Funds of funds are mutual funds that invest in other mutual funds. That may sound redundant, but it's true.

Just as a regular mutual fund offers the skills of a professional manager who assembles a portfolio of stocks or other securities, the manager of a fund of funds will select a portfolio of funds, managed by other managers.

If you have only a small amount to invest each month, a fund of funds allows you access to more funds than you might be able to afford on your own. It also allows investors to avoid the recordkeeping and paperwork that comes with owning an assortment of funds.

So what's the catch? Expenses, mostly. The fund of funds structure creates a double layer of costs. First, there are the expenses associated with running the fund of funds itself—management fees, administrative costs, etc. Second, there are the costs associated with the underlying funds—the same sorts of management fees, administrative costs, and so on. A fund of funds may report an expense ratio of just 1%, but keep in mind that you're still paying the expense ratios on each and every fund that the fund of funds owns.

Some fine funds of funds eliminate the double-fee problem. Families such as T. Rowe Price and Vanguard offer funds of funds that invest only in their own funds. The families then waive the cost of the funds of funds—their reported expense ratios are 0%—and you only pay the costs of the underlying funds. Obviously, these funds are a much cheaper option.

Quiz 211
There is only one correct answer to each question.

1 An index-fund manager:
a. Buys stocks that he likes.
b. Buys what an index does.
c. Sells stocks when he doesn't like them.
2 Which is not an advantage of indexing?
a. Low costs.
b. Predictability.
c. Great stock-picking.
3 Funds of funds directly buy:
a. Stocks.
b. Bonds.
c. Other mutual funds.
4 The main drawback to most funds of funds is:
a. Hidden costs.
b. Extra paperwork.
c. High up-front investment minimums.
5 Target-date funds:
a. Are all index funds.
b. Will shift their asset allocation over time.
c. Are all actively managed.
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