In order to learn how to pick a profitable mutual fund, you have to understand what funds are and how they work.
There are different types of indices:
- Global Indices include companies that developed business in the whole world, for example, MSCI World and S&P Global 100.
- National Indices that reflect the state of the national economy of a country, for example, the S&P 500 for the U.S. or FTSE 100 for the U.K.
- There are also some indices that are focused on certain fields like real estate, biotech, technology, fuels and others.
The S&P 500 Index
The most popular index for the U.S. Stock Exchange is the S&P 500. It incorporates the largest 500 companies from the U.S. listed on NYSE or NASDAQ, for example, Amazon, Apple, Boeing, Alphabet, Nike, Bank of America, Disney.
The stock price of each of these companies influences the value of the index.
Starting from 1970 the average annual return of the S&P 500 is 12%, including dividends.
To meet the needs of those that want to invest, but don’t have the time and resources to do proper analyses, some smart guys invented mutual funds.
Investors don’t bother to study the market, to decide what stocks to buy, when to sell, and so on. So they decide to invest in a company that manages a mutual fund. This company hires professionals to trade with customers’ money and generate the best return rates for investors.
These companies make money from the commissions paid by the investors. One of the unpleasant parts of investing with such a company is that you pay commissions regardless of the performance of the mutual fund. In time, these commissions might reduce your capital if the fund doesn’t perform well.
Another downside is that in the long run, 92% of the mutual funds have lesser performances than the stock market average yield, for example, the S&P 500 index for NYSE.
Considering the fact that mutual funds hire professionals to analyze and trade, why only 8% of these companies have good returns?
There are several reasons:
- The pressure to report good results every year. The mutual funds that want to attract as many investors s they can to cash in commissions, want to report big profits every year and use strategies that are unsustainable in long term.
- The best stock pickers are hunted by the big funds, and when they leave a company, that mutual fund doesn’t have the same performance anymore.
- Asset elephantiasis.
I’m going to quote professor Benjamin Graham who has explained the term in his best-seller “The Intelligent Investor”:
“When a fund earns high returns, investors notice—often pouring in hundreds of millions of dollars in a matter of weeks. That leaves the fund manager with few choices—all of them bad. He can keep that money safe for a rainy day, but then the low returns on cash will crimp the fund’s results if stocks keep going up. He can put the new money into the stocks he already owns—which have probably gone up since he first bought them and will become dangerously overvalued if he pumps in millions of dollars more. Or he can buy new stocks he didn’t like well enough to own already—but he will have to research them from s ”
You need to stay away from these open mutual funds that want to attract more money and have an aggressive sales strategy.
To have a better understanding of this issue I’m going to give you a brief example:
One mutual fund raised $1 million from the investors and decides to put all that money into 10% of the shares of only one company, which is evaluated at $10 million. The value of the company doubles within one year and the fund made 100% profit.
But if the fund raises $1 billion and makes 100% profit out of a $1 million investment, overall the mutual fund’s profit is 0.1%
Even if they would have bought the entire company (which is impossible), the profit rate would have been only 1%.
The Index Fund
John C. Bogle, the founder of Vanguard Group, one of the greatest American investment companies, introduced the index fund in 1976 and offered the opportunity for the small investors to obtain the same yield as an index does, paying smaller commissions comparing to the mutual funds that are actively managed.
The managers of an index fund use the money raised from the investors to buy stocks for all of the 500 companies that are part of the index, achieving the same results.
Exchange-Traded Funds (ETF)
In 1993 appeared one of the easiest methods to invest, aiming for the yield of the S&P 500 Index or other indices.
The ETFs are financial products that you can buy just like stocks and that follow the exact performance of certain indices.
There are three ETF’s that follow the S&P 500 Index. The bigger and the best of them is SPY. Like the ones that manage the index funds, the managers of SPY use the investors’ money to buy shares from all the 500 companies of the S&P 500 Index.
What is the difference between an index fund and an ETF?
Both the index fund and the ETF follow the performance of a certain index, buying stocks from all the companies that the index consists of. So what is the difference between them?
In order to invest in an index fund, you have to sign a contract with a bank or with an investment company that manages that fund. The minimum amount that you have to invest is $10 000. You can’t withdraw your investment within a year unless you pay big penalties.
In order to invest in an ETF, you only have to open an account with a broker, which connects you to the market. It’s far more flexible and gives you a lot of options. You will be able to deposit as much money as you can afford, to buy and sell stocks, bonds, ETF’s and other financial products whenever you please.
What do you choose?
Considering the fact that both the economy and the stock market are on a bullish trend, with short-term pullbacks, you should expect the indices to reflect these trends.
If the historic average yield of a certain index matches your objectives, I recommend that you constantly invest in an ETF that follows the S&P 500 Index.
If you want bigger returns and decide to search for a performant mutual fund, you have some work to do.
The first criteria that people take into consideration when choosing a mutual fund are past years’ profits. And that’s why most people make the wrong decision because past results don’t guarantee future performance.
Here are some criteria that I recommend when choosing a mutual fund:
- Lower managing fees.
- The manager of the fund must be one of the major stockholders of the fund.
- The mutual fund should stand out from the crowd. Search for its portfolio and see if they own fairly the same companies as the big indices do and stay away from that mutual fund. Performant mutual funds dare to be different.
- It closes the door before it gets too big and blows up. Scarcity offers value.
- They don’t advertise. They are happy with fewer investors and they don’t spend money on advertising.
- In the end, verify past results, even if it doesn’t guarantee future performance. You want to invest with the winners, not with the losers.