With the recent volatility in the stock market, many investors may have finally decided to stop chasing the Nasdaq cyber-rockets and return to the more sedate world of mutual funds.
The key question: “How to choose?”
Investors have to pick from a mind-boggling number of funds — about 7,000 at last count and still growing, according to the Investment Company Institute.
In fact, there are now more mutual funds than individual stocks traded on the Nasdaq Stock Market — 4,840.
“People do get overwhelmed,” said Christine Benz, senior mutual fund analyst at Morningstar, the mutual-fund rating service. “And there are new funds coming out all the time.”
But by following a few simple suggestions, the task of choosing the appropriate fund doesn’t have to be so daunting, Benz said.
And she and other financial experts say it’s important to keep in mind one overriding principle: Do not select a fund based only on past performance.
“Some people try to pick funds based on which funds were the biggest gainers last quarter,” she said. “That is a terrible way to pick a fund, because they are probably taking on a lot of risk to have the potential for the big gain.”
Those who doubt the wisdom of that need only look at some of the Internet-related mutual funds: those that posted the best gains last year only to become the biggest losers this year.
Chasing the hottest sector is fool’s play, says Richard Sapio, chief executive officer of Mutuals.com Inc., a Dallas-based firm that helps investors select the best funds.
“Statistics prove that mutual funds rarely, if ever, sustain their performance after they have appeared on a best-performing list,” Sapio said.
The better starting point for investors is to first determine their objectives, or more specifically, whether they need an income stream fairly soon or whether they can let their money grow for three years or longer.
Investors nearing retirement may soon need their savings to generate income to live on. In that case, a diversified bond fund might be the most appropriate vehicle.
And that would reduce the number of fund choices from about 7,000 overall to one of the 2,000 bond funds.
However, those with longer investing horizons would probably want to put 80 percent to 90 percent of their savings in stock funds and the remainder in bond funds.
“If you are 40 years old and have two decades of working years remaining, you can be more aggressive with your asset allocation,” said James Whiddon, a Dallas financial planner.
“If you can sleep at night, I would recommend more than 85 percent in stock funds, because with the long-term return of stocks, they will be fine.”
It’s at this point, though, that many investors become confused because there are still some 4,200 stock funds from which to choose. And they come in every imaginable type and size.
There are the so-called large-cap funds, small-cap funds, growth funds, value funds, sector funds, overseas funds and precious metal funds.
There are even socially responsible funds for those who want to steer clear of companies that pollute, poison or peddle pornography.
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Lipper Inc., a well-known mutual fund research company, currently tracks about 50 fund categories.
The mutual fund industry continues to churn out and market new funds every year, but small investors probably should avoid most of them. Prudent investors would be best served by having one solid mutual fund “core holding” and then filling in around it with three or four other funds.
Most financial experts agree that an excellent core holding is a fund that is a blend of large growth company stocks and large value company stocks.
Growth stocks are investments in fast-growing companies, often technology companies, that are expected to increase earnings by at least 15 percent a year.
Value stocks reflect slower-growing, so-called cheaper stocks, such as in the industrial or consumer products sectors.
There are about 500 “blended funds” that provide a combination of these two categories, and most of the large to medium-size mutual fund companies offer them.
But selecting one fund from 500 is still tough.
The number of choices can be whittled even further by looking at three more factors: the experience of the fund manager, the size of the fund and the fees it charges.
Sapio said he advises clients to screen out all funds where the manager has been there less than three years. Doing that, an investor would end up with just a handful of funds, making the choice that much easier.
Benz of Morningstar said lack of management experience is another reason to avoid the so-called sector funds, which focus on just one industry segment, such as telecommunications, utilities or real estate.
Often, fund companies use the sector funds as a training ground for younger managers. As they gain experience they are moved to the larger, more diversified funds, she said.
Fund size is also important, Sapio said. He thinks it’s wise for clients to choose funds with at least $100 million in assets but not more than $10 billion.
“Huge funds can’t move fast enough, while small fund managers might not be able to manage large amounts of new money,” he said. “We’ve just found that the really large funds and the small funds don’t perform as well.”
And finally, investors should always consider the fees that the funds charge, because they vary widely.
The annual fee of the average large-cap growth fund is 1.45 percent, while the annual fee for some of the popular index funds — which invest in all the stocks of a particular index, such as the Standard & Poor’s 500 — is 0.2 percent, according to Morningstar.
“I try to get my clients into funds where the annual expense ratio is no more than about 0.5 percent,” said Whiddon, the financial planner.
The amount of assets allocated to the core mutual fund will obviously vary according to an investor’s age and tolerance for risk.
But in general, Whiddon said those in their 40s should allocate about 45 percent of their stock portfolio to the core fund.
To fill out the remaining percentage, he suggested about 25 percent in a mutual fund that invests in small and large international companies and 15 percent in a fund that specializes in small U.S. companies.
At first glance, investing 25 percent in the international arena may seem a bit much, but Whiddon said that in recent years the overseas markets have become increasingly important.
“In 1970, the U.S. economy accounted for about 66 percent of the world’s economy,” he said. “Today, it makes up about 40 percent. That tells you that even though we’ve had a tremendous period of growth in the United States, the international markets are growing at an even faster rate.”
With a balanced, diversified portfolio, investors are much more likely to at least match the returns of the overall stock market.
But sadly, many investors don’t structure their portfolios properly, and they jump in and out of funds trying to time the market, Sapio said.
That has been costly.
From 1984 through 1997, the S&P recorded annualized returns of 17.2 percent, while the average equity investor had returns of 6.7 percent, according to a study by Dalbar Inc.
“This is an absolute crime that this is going on,” Sapio said. “And it makes my blood boil.”