The 9 Steps to Financial Freedom (36 page)

You can buy mutual funds that invest in almost anything you want. Once you decide on your goals, you now have two other choices: Do you buy a managed mutual fund, or do you buy an index fund?

A
managed fund
is run by a manager who decides what he or she is going to buy and sell with all the money the investors have deposited into the fund. If you know what kinds of things you’d like to invest in, you find a like-minded manager and choose that fund, if its track record stands up to scrutiny. When you buy a managed fund, you’re actually investing in the manager who’s in charge of the fund. A good manager buys and sells wisely, so that the NAV or the value of your shares goes up and you make a profit. A mediocre manager could lose you money. Thus it’s important to keep track not only of how your fund is going, but also of the manager who’s responsible for your return.

Rule of thumb: Before you ever buy a managed mutual fund, look to see how long the manager has been in charge. Is the current manager the one responsible for a fund’s good track record, or has that person moved on, leaving someone new in charge? It’s the manager’s track record you want to know
about, in other words, not the fund’s, because the manager is the one who creates the fund’s success.

A number of websites monitor the funds—how they’re doing, who is moving on—but the one I like best is called
morningstar.com
.

When you don’t know which mutual fund to buy, and don’t want to learn all this stuff about managers, you have a great option: You can buy an index fund.

There are several indexes that track the values in the stock market. You hear about these every day when you listen to the news and constantly hear the newscasters quoting the Dow Jones Industrial Average. You know how they’ll say, for instance, “The Dow Jones is up twenty-three points today and closed at 11,000.” The Dow Jones average is an index based on thirty stocks. If these thirty stocks happen to go up, so does the Dow Jones average, and if they go down, same thing. I always found it fascinating that so much seems to rest on just thirty stocks, but it’s used widely.

To my mind, a far better index, and one that’s also widely referred to, is the Standard & Poor’s 500 index; also known as the S&P 500. This index tracks five hundred good-size stocks, which is a lot more than thirty. You will often hear this index quoted right alongside the Dow Jones, and when you do, pay attention. This is also a great index because so many people use it to measure the market—which means that many, many experts are keeping tabs on it every single day.

Another very popular index is the Nasdaq. This index currently tracks about 5,000 different stocks, mainly in the technology area. Since its inception in 1974, the Nasdaq index market
has been the industry innovator. It was introduced as the world’s first electronic stock market. With the boom and bust of the dotcom stocks, most of you by now have heard of the Nasdaq, and the truth is, as time goes on, you will hear more and more about it.

There are other indexes that track the American and overseas stock markets (as well as indexes that track the bond market, but we are focusing on stocks here); they aren’t quoted as much as the Dow Jones, Nasdaq, or S&P, but they’re also used to track how everything is doing overall. Among them:

The Wilshire 5000 equity index. This index tracks thousands of stocks of companies of all different sizes, large and small. It’s also outgrown its name—it really follows almost seven thousand stocks. Even though it’s not widely quoted, it’s one of the best.

The Russell 2000 index. This index tracks two thousand stocks that are traded on the OTC (over-the-counter) market.

The EAFE index. This one owns stocks of companies based in Europe, Australia, and the Far East.

Managed mutual funds constantly compare their performance to that of the various indexes. A fund will boast of “outperforming the S&P 500” over a certain period of time, meaning it increased in value by a greater percentage than did the S&P index. (Of course, many funds
underperform
the indexes, too.) So one easy and effective way to invest is to buy what’s called an
index fund
, which simply
mirrors
an index, by buying all the stocks in the index it is associated with. Its performance will, by definition, match that of the index exactly, whether that’s the S&P 500, the Dow Jones, or the EAFE less the expenses of the index fund. Many mutual fund companies
offer S&P index funds, as well as growth, international, and bond index funds, and it’s easy as can be to sign up with one of them.

You should also consider exchange traded funds (ETF). Just like an index mutual fund, an ETF tracks a benchmark index. But it trades just like a stock; in fact, you need to have a brokerage account to buy and sell shares of an ETF. The fact that an ETF trades during the day—unlike a mutual fund where the price is set just once a day after the market closes—can give you the ability to move in and out of an investment at the market price when you place your order. Some people consider that a nice advantage, though when you are investing for the long term, I don’t think that’s too important. You want to buy and hold anyway. But the real advantage of ETFs is that their annual expense charge is even lower than the typical index fund. There are some ETFs that charge just 0.10 percent a year. The largest ETF firm is Barclays, which runs the ishares ETFs; you can learn more at
www.ishares.com
.

When it comes to mutual fund investing, it is true that there are some genius managers out there—who can outperform the S&P index in a given year or for a few years. But it is rare for a managed fund to beat its benchmark index on a consistent basis. And many younger funds simply lack the track record to know how they will do over the long term. Remember, when you are investing for growth, you hope to leave your money right where it is for at least ten years. Only time will tell which would have been a better way to go, but if I were a betting woman, I would just stick with index funds and ETFs if I did not want to be actively involved with watching everything about the fund I was in.

Index funds and ETFs have lower fees than actively managed funds and typically generate no, or low, annual tax bills. All this in the end adds to your overall return.

Expense Ratio

Every mutual fund and ETF charges annual expenses, known as the expense ratio. The average is about 1 percent a year for actively managed stock funds. And I’ve seen them higher than 2 percent. Whatever the expense ratio, it will definitely affect your net rate of return. Let’s say that one spectacular year the manager of your mutual fund makes a return of 20 percent. Do you get that 20 percent? No. Before you get your money, the fund subtracts the expense ratio. If the expense ratio is 1.5 percent, your real return will be 18.5 percent.

Some of my favorite index funds and ETFs, on the other hand, have total expense ratios of less than 0.20 percent and do very well, thank you. Why in the world would you want to pay someone to manage your money for you if that manager couldn’t consistently outperform the index that it’s comparing its performance to? You wouldn’t.

Capital Gains Tax

The other advantage of an index fund over a typical managed fund—and this can be major—is that mutual funds are set up so that if there’s a capital gain when they sell a stock, that gain is passed through to the investors. At the end of the year the fund will pay you (or reinvest in the fund, your choice) all the realized capital gains they’ve acquired that year. Whenever a mutual fund has a capital gain distribution, it also reduces the NAV by the price of the capital gain. Let’s say that you’ve invested in a mutual fund with a NAV of $10, which itself has a capital gain distribution of $1. If you have chosen not to reinvest capital gains, you’ll get $1 for every share you own, and
you’ll have to pay tax on it. If you have decided to reinvest the capital gains, then the fund will buy you as many shares as that capital gain allows, but you’ll still have to pay tax on this amount. In addition, in both cases the NAV of the mutual fund has now been reduced to $9 a share. That said, funds you own in a 401(k) or IRA do not owe tax each year; your investments grow tax-defined, or in the case of a Roth IRA or Roth 401(k) tax-free if you follow certain rules.

Maybe this doesn’t sound so bad, but depending on how much money you have in the fund, you may be unpleasantly surprised to see what this capital gain distribution does for you if it happens to come in a year when you’re in a high tax bracket to begin with. It’s definitely a drawback in a managed mutual fund that you have no say or way to plan in its decision whether or not to take a large gain in a given year. All that fund cares about is making the greatest return for you, which is fair enough. They don’t care whether it’s a convenient year for you to pay taxes on a capital gain.

Happily, this isn’t as big a problem with an index fund. Since index funds buy the whole index, they do not in general distribute capital gains. Why? Because they don’t sell with such planned regularity. They buy and sell when only one of the stocks of the index is removed and a new stock takes its place. Since a fund that matches the S&P 500 index is meant to track the stocks in the index, it has to make these appropriate changes as necessary. But these trades occur with nowhere near the frequency they do with a managed fund. So if the idea of paying taxes on unexpected capital gains worries you, this should be taken into consideration before you decide on a managed fund or an index fund. Exchange traded funds are even more tax efficient; you owe tax only when you sell, and assuming you have a profit.

Remember, it’s not how much you make that counts. It’s how much you get to keep.

The difference is about 4.5 percent, give or take, out of your pocket.

In addition to the expense ratios that all funds charge, if an adviser suggests you purchase a fund and you do so through him or her, you may also pay the adviser a commission. The average commission costs about 5 percent. The commission is known as a
load
. Think of it as a burden on your money.

A
no-load fund
, on the other hand, is a mutual fund you buy directly, and therefore there’s no commission attached to it. In my opinion, no-load mutual funds are the only way to go. Many advisers charge clients a flat fee and use no-load funds. If you work with an adviser, this is the way to go. Think about it. If you were to invest $10,000 in a no-load mutual fund and decided, two seconds later, that you wanted to withdraw your money, you’d get all $10,000 back, assuming the market didn’t move. Loaded funds, on the other hand, would cost you.

The Price of a Load

There are two kinds of loads, a front-end load and a backend load fund. Back-end load funds also have a high expense ratio because there is a special fee known as the 12b-1 fee, buried in the expense charge. Sound confusing? It’s meant to be. The people making this money, your adviser or broker, would rather you didn’t know how much you were paying.