Chapter 13
Stock Funds: Meeting Your Longer Term Needs
In This Chapter
Growing your money in the stock market
Investing in stocks through mutual funds
Getting some stock fund recommendations
Most stock market investors who don’t manage money for a living and who make money do so not because they’re pouring over daily market commentaries or are luckier or more clairvoyant than anyone else. They make money by simply being patient and using three simple investment methods:
Invest in a diversified portfolio of stocks.
Continue to save money and add to investments.
Don’t try to time the market.
A small number of extraordinary investors — Warren Buffett being a famous one who’s frequently in the news — generate exceptional returns. Buffett and these other elite investors do the above three things and have a talent for identifying and investing in undervalued businesses before most others see that value. The good news for you is that you can earn handsome long-term stock market returns without having Buffett’s talent. (And, you can some fun and make more money investing with the best fund managers who are able to post above-average, long-term returns.)
People who get soaked in the stock market are those who make easily avoidable mistakes. An investment mistake is a bad decision that you could’ve or should’ve avoided, either because better options were available, or because the odds were heavily stacked against you making money. Investment mistakes result from the following:
Not understanding risk and how to minimize it
Ignoring taxes and how investments fit into overall financial plans
Paying unnecessary and exorbitant commissions and fees
Surrendering to a sales pitch (or salesperson)
Trading in and out of the market
Give up the search for a secret code — there isn’t one. Focus on avoiding major gaffes.
The stock market isn’t the place to invest money that you need to tap in the near future (certainly not money you need to use within the next five years). If your stock holdings take a dive, you don’t want to be forced to sell when your investments have lost value. So come along for the ride — but only if you can stay for a while!
The Stock Market Grows Your Money
Stocks represent a share of ownership in a company and its profits (see Chapter 1). As companies (and economies in general) grow and expand, stocks enable investors to share in that growth and success. Over the last two centuries, investors holding diversified stock portfolios earned a rate of return averaging about 9 to 10 percent per year, which ended up being about 6 to 7 percent higher than the rate of inflation. Earning such returns may not seem like much (especially in a world with gurus and brokers claiming returns of 20 percent, 50 percent, or more per year). But don’t forget the power of compounding: At 9 to 10 percent per year, your invested dollars doubles about every seven to eight years. The purchasing power of your money growing 6 to 7 percent more per year than the rate of inflation doubles about every 10 to 12 years.
Contrast this return with bond and money market investments, which have historically returned just a percent or two per year over the rate of inflation. At these rates of return, the purchasing power of your invested money takes several decades or more to double.
Your investment’s return relative to the rate of inflation determines the growth in purchasing power of your portfolio. What’s called the real growth rate on your investments is the rate of return your investments earn per year minus the yearly rate of inflation. If the cost of living is increasing at 3 percent per year and your money is invested in a bank savings account paying you 3 percent per year, you’re treading water — your real rate of return is zero. (When you invest money outside of a tax-sheltered retirement account, you end up paying taxes on your returns, which could lead to a negative real “growth” in your money’s purchasing power!)
Be patient
The 9 to 10 percent annual historic return in stocks (quoted in the preceding section) isn’t guaranteed to be the same in the future. Consider some of the unexpected storms that hammered the stock market over the past 110 or so years (see Table 13-1).
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Table 13-1 Great Plunges (20 Percent or More) in the Dow Jones Industrial Average Index of Large-Company Stocks |
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Years |
Percent Decline* |
Years |
Percent Decline* |
|
1890–1896 |
47% |
1961–1962 |
27% |
|
1899–1900 |
32% |
1966 |
25% |
|
1901–1903 |
46% |
1968–1970 |
36% |
|
1906–1907 |
49% |
1973–1974 |
45% |
|
1909–1914 |
29% |
1976–1978 |
27% |
|
1916–1917 |
40% |
1981–1982 |
24% |
|
1919–1921 |
47% |
1987 |
36% |
|
1929–1932 |
89% |
1998 |
20% |
|
1937–1942 |
52% |
2000–2003 |
40% |
|
1946–1949 |
24% |
2007–2009 |
55% |
*The returns that stock market investors earned during these periods differ slightly from the above figures, which ignore dividends paid by stocks that mitigate some of the above declines. The returns also ignore changes in the cost of living, which normally increase over time and make these drops seem even worse. The Great Depression is the exception to that rule: The cost of living decreased then.
As you see in Table 13-1, the stock market can sometimes take a beating. But before you let the chart convince you to avoid the stock market, look at the time periods during which those great plunges occurred — notice how relatively short most of them are. During the last century, major stock market declines have lasted less than two years on average. Some of the 20-percent-plus declines lasted less than one year. The longest declines (1890–1896, 1909–1914, 1929–1932, 1937–1942, 1946–1949, and 2000–2003) lasted from three to six years.
Also remember that these declines are from an absolute peak to an absolute bottom. While we all know folks who don’t seem to be possess good luck, no investor invests all their money at a precise peak of the stock market — and then would be hapless enough to sell at the exact bottom!
Table 13-1 tells less than half the story. True, the stock market can suffer major losses. But over the long haul, stocks make more money than they lose. That’s how they end up with that 9 to 10 percent average annual long-term return I’ve been telling you about. Stock market crashes may be dramatic, but consider the powerful advances in Table 13-2 that have happened after big market declines.
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Table 13-2 Great Surges in the Dow Jones Industrial Average after Major Market Declines |
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Years |
Percent Increase |
|
1896–1899 |
173% |
|
1914–1916 |
114% |
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1932–1937 |
372% |
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1942–1946 |
129% |
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1949–1956 |
222% |
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1962–1966 |
86% |
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1970–1973 |
67% |
|
1974–1976 |
76% |
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1987–1998 |
450% |
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2003–2007 |
98% |
|
2009-2010* |
71% |
*Increase may continue and add to the stated number
In each and every one of the cases, subsequent stock market increases more than made up for the previous declines. In other words, wait long enough, and time will bail you out! (Hence, why stocks are for long-term investors and long-term goals.) If you’re going to invest in stocks, you must have the time on your side to wait out a major market decline. If you don’t, you face the risk of selling your stocks for a loss. Don’t keep your emergency money in stocks. Only invest money that you don’t plan on using for at least five years — preferably ten or more.
Add regularly to your stock investments
Although the stock market may be able to double the purchasing power of your money on average every 10 to 12 years, the real key to creating wealth with stocks is investing in them regularly. Put $1,000 into stocks, and seven years later, you’ll probably have $2,000. But if you put $1,000 into stocks every year for seven years, you end up with nearly $9,500 — that’s nearly five times more. Remember the power of combining these two simple but powerful financial concepts: Regular savings and investing in growth-oriented investments lead to simply amazing long-term results.
Another advantage of buying in regular chunks (some call this dollar-cost averaging, a subject I cover in Chapter 10) is that it softens the blow of a major decline. Why? Because you can make some of your stock investments as the market is heading south; perhaps you may even buy at or near the bottom. After the market rebounds, you show a profit on some of those last purchases you made, which helps soothe the rest of your portfolio — as well as your bad feelings about the decline. If you used dollar-cost averaging during the worst decade for stock investors last century (1928–1938), you still averaged 7 percent per year in returns despite the Great Depression and a sagging stock market.
Using Mutual Funds to Invest in Stocks
The best stock funds offer you diversification and a low-cost way to hire a professional money manager. In Chapter 4, I discuss at length why purchasing individual stocks on your own doesn’t make good financial sense. (If you haven’t read Chapter 4 yet and you believe that buying individual stocks is the best route for you to take, please read it.)
Reducing risk and increasing returns
When you invest in stocks, you expose yourself to risk. But that doesn’t mean that you can’t work to minimize unnecessary risk. One of the most effective risk-reduction techniques is diversification — owning numerous stocks in many industries to minimize the damage of any one stock’s decline. Diversification is one reason why mutual funds are a proven way to own stocks.
Unless you have a lot of money to invest, you can only cost-effectively afford to buy a handful of individual stocks. If you end up with a lemon in your portfolio, it can devastate the returns of your better-performing stocks. Companies go bankrupt. Even those that survive a rough period can see their stock prices plummet by huge amounts — 80 percent or more — and sometimes in a matter of weeks or months.
Even during the 1990s bull market (a bull market is one in which stock prices are rising; its opposite is a bear market), certain individual stocks took it on the chin. A good example is Iomega, a darling of Internet message boards in the mid-1990s. After zooming to more than $135 per share in 1996, it plunged and languished below $5 per share (adjusting for splits). It was finally acquired by EMC for just under $4 per share
Of course, owning any stock in a company that goes bankrupt and stays that way means that you lose 100 percent of your investment. If this stock represents, say, 20 percent of your holdings, the rest of your stock selections must increase about 25 percent in value just to get your portfolio back to even.
Stock mutual funds reduce your risk by investing in many stocks, often 50 or more. If a fund holds 50 stocks and one drops to zero, you lose only 2 percent of the value of the fund if the stock was an average holding. If the fund holds 100 stocks, you lose 1 percent, and a 200-stock fund loses only 0.5 percent if one stock goes under. And don’t forget another advantage of stock mutual funds: A good fund manager is more likely to sidestep investment disasters than you are.
Another way that stock funds reduce risk (and thus their volatility) is by investing in different types of stocks across various industries. Some funds also invest in both U.S. and international stocks.
Different types of stocks don’t always move in tandem. So if smaller company stocks are being beaten up, large-company stocks may be faring better. If growth companies are sluggish, value companies may be in vogue. If U.S. stocks are in the tank, international ones may not be. (I discuss these different types of stock funds later in this chapter.)
You can diversify into various types of stocks by purchasing several stock funds, each of which focuses on different types of stocks. This diversification has two potential advantages. First, not all your money is riding in one stock fund and with one fund manager. Second, each of the different fund managers can focus on and track particular stock investing opportunities.
Making money: How funds do it
When you invest in stock funds, you can make money in three — count ’em, three — ways:
Dividends: Some stocks pay dividends. Many companies make profits and pay out some of these profits to shareholders in the form of dividends. Dividends are taxed at a far lower income tax rate than ordinary income. (Find the lowdown on fund investments and taxes in Chapter 18.) As a mutual fund investor, you can choose to receive your fund’s dividends as cash or reinvest them by purchasing more shares in the mutual fund.
Unless you need the income to live on (if, for example, you’re retired), reinvest your dividends into buying more shares in the fund. If you do this outside of a retirement account, keep a record of those reinvestments because those additional purchases should be factored into the tax calculations you make when you sell the shares.
Capital gains distributions: When a fund manager sells stocks for more than she paid for them, the resulting profits, known as capital gains, must be netted against losses and paid out to the fund’s shareholders. As with dividends, your capital gains distributions can be reinvested back into the fund. Gains from stock held for more than one year are known as long-term capital gains and are taxed at a much lower rate than your regular income (see Chapter 18).
Appreciation: The fund manager isn’t going to sell all the stocks that have gone up in value. Thus, the price per share of the fund should increase (unless the fund manager made poor picks or the market as a whole is doing poorly) to reflect the gains in unsold stocks. For you, these profits are on paper until you sell the fund and lock them in. Of course, if a fund’s stocks decline in value, the share price depreciates. Hold the fund for more than one year and you qualify for low long-term capital gains tax rates when you sell.
If you add together dividends, capital gains distributions, and appreciation, you arrive at the total return of a fund. Stocks (and the funds that invest in them) differ in the proportions that make up their total returns, particularly with respect to dividends.
Seeing your stock fund choices
Stock mutual funds, as their name implies, invest in stocks. These funds are often referred to as equity funds. Equity (not to be confused with equity in real estate) is another word for stocks.
Stock funds and the stocks that they invest in usually are classified into particular categories based on the types of stocks they focus on. Categorizing stock funds often is tidier in theory than in practice, though, because some funds invest in an eclectic mix of stocks. Funds and the stocks that they hold differ from one another in three major ways:
Size of the company: You can purchase stock in small, medium, and large companies. The size of a company is defined by the total market value (capitalization) of its outstanding stock. Small companies are generally defined as those that have total market capitalization of less than $2 billion. Medium-sized companies have market values between $2 billion and $10 billion. Large-capitalization companies have market values greater than $10 billion. These dollar amounts are somewhat arbitrary. (Note: The term capitalization is routinely shortened to cap, as in small-cap company or large-cap stock.)
Why should you care what size companies a fund holds? Because smaller companies behave differently than larger companies do. Historically, smaller companies pay lower dividends (yields) or none at all, but may appreciate more. Their share prices, although more volatile, tend to produce greater total returns. Larger companies’ stocks tend to pay greater dividends and on average are less volatile, but they produce slightly lower total returns than small-company stocks. Medium-sized companies, as you may suspect, fall between the two. Investing in companies of varying sizes can generally reduce a portfolio’s risk and volatility.
Growth or value: Stock fund managers and their funds are further categorized by whether investments are made in growth or value stocks.
• Growth stocks are public companies that are experiencing rapidly expanding revenues and profits and whose stocks are relatively costly in relation to the assets and profits of the company. These firms tend to reinvest most of their earnings in the company to fuel future expansion; thus, these stocks pay low dividends.
• Value stocks are public companies that are priced cheaply in relation to the company’s assets and profits. Such a company could possibly be a growth company, but that’s unlikely because growth company stocks tend to sell at a premium compared to what the company’s assets are worth.
Geography: Stocks and the companies that issue them are further categorized by the location of their main operations and headquarters. Is a company based in the United States or overseas? Funds that specialize in U.S. stocks are (surprise, surprise) called U.S. stock funds; those focusing internationally are typically called “international” or “overseas” funds.
By putting together two or three of these major classifications, you can start to appreciate all those silly and lengthy names that mutual fund companies give to their stock funds. You can have funds that focus on large-company value stocks or small-company growth stocks. These categories can be further subdivided into more fund types by adding in U.S., international, and worldwide funds. For example, you can have international stock funds focusing on small-company stocks or growth stocks.
The Best Stock Funds
Using the selection criteria outlined in Chapter 7, the following sections describe the best stock funds worthy of your consideration. The recommended funds differ from one another primarily in terms of the types of stocks they invest in. Keep in mind as you read through these funds that they also differ from each other in their tax friendliness (see Chapter 10). If you’re investing inside a retirement account, you don’t need to bother with this issue.
Because stock funds are used for longer-term purposes, the subject of stock funds usually raises another important issue: How do you divvy up your loot into the different types of investments for purposes of diversification and to make your money grow? Chapter 10 also answers that question.
Mixing it up: Recommended hybrid funds
Hybrid funds invest in a mixture of different types of securities. Most commonly, they invest in both bonds and stocks. These funds are usually less risky and less volatile than funds that invest exclusively in stocks; in an economic downturn, bonds usually hold up better in value than stocks do.
Hybrid funds make it easier for investors who’re skittish about investing in stocks to hold stocks while they avoid the high volatility that normally comes with pure stock funds. You could place 60 percent of your investment moneys into a pure stock fund and the other 40 percent into a pure bond fund — but you can do just that by investing in one hybrid fund that has the same overall 60/40 mix. Because bonds and stocks often don’t fluctuate in unison, movements of one can offset those of the other. Hybrid funds are excellent choices for retirement account investing, particularly when an investor doesn’t have much money to start with.
Hybrid mutual funds come in two flavors:
Balanced funds: Balanced funds try to maintain a fairly constant percentage of investment in stocks and bonds. For example, a balanced fund’s objective may be to keep 60 percent of its investments in stocks and 40 percent in bonds. (Some balanced funds are exceptions to this rule and will, like asset allocation funds, adjust their mix over time.)
Asset allocation funds: These funds adjust the mix of different investments according to the portfolio manager’s economic expectations. Essentially, the fund manager keeps an eye on the big picture — watching both the stock and bond markets — and moves money between them in an attempt to get the best value. For example, if the manager thinks stocks are highly valued and bonds are not, he may move more money into bonds and out of stocks.
You should note, however, that most managers have been unable to beat the market averages by shifting money around instead of staying put in sensible investments. (See Chapter 10 for more on index funds.)
One of the brighter spots on the mutual fund landscape is the best mutual funds that invest in a variety of different funds offered by their parent companies. They’re known as funds of funds, and they’re the ultimate couch-potato way to invest! Later in this section, I discuss specific best funds of funds.
Because hybrid funds hold taxable bonds and, therefore, pay decent dividends, they aren’t appropriate for many investors who’re purchasing funds outside tax-sheltered retirement accounts. If you’re in a higher tax bracket (federal 28 percent and higher), bonds that you hold outside a retirement account should probably be tax-free. With the exception of the Vanguard Tax-Managed Balanced Fund (see the sidebar, “A tax-friendly hybrid”), you should avoid the hybrid funds if you’re in this situation. Buy separate tax-friendly stock funds (which I cover later this chapter) and tax-free bond funds (see Chapter 12).
The following sections describe some terrific hybrid funds. They’re loosely ordered from those that generally take less risk to those that take more. Higher risk hybrid funds tend to hold greater positions in stocks and/or make wider swings and changes in their investments and strategies over time.
Vanguard Wellesley Income
The Vanguard Wellesley Income is among the most conservative and income oriented of the hybrids. This fund typically has about 60 percent of its assets in high-quality bonds, with the remaining assets in high-yielding, large-company stocks. Since its inception in 1970, the majority of this fund’s returns have come from dividends. Like many of the other conservative Vanguard funds, this one is managed by Wellington Management and the duo of John Keogh and Michael Reckmeyer, who have more than five decades of investment experience between them.
This fund is ideal for people who’ve either retired or are on the verge of retiring — or anyone else who wants a high rate of current income but also wants/has some potential for growth from their investments. Its stocks are value oriented and among the more stable of stocks. Its high-quality bonds, which tend to be intermediate term, also don’t go through the gyrations that junk bonds do. Expense ratio is 0.31 percent (0.21 percent for the Admiral share class which requires a $100,000 minimum). Minimum initial investment is $3,000. The fund charges a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard’s Web site for electronic delivery of statements and fund reports. 800-662-7447.
Vanguard’s funds of funds
A fund of funds is simply a mutual fund that invests in other individual mutual funds. Although the concept isn’t new, it’s become increasingly attractive to investors who either are overwhelmed by the number of fund choices out there or who want to diversify. Vanguard offers some excellent funds of funds.
Begun in 1985 — and thus the oldest of the funds of funds — the Vanguard Star fund is diversified across 11 different Vanguard funds: 6 U.S. stocks, 2 foreign stocks, and 3 bonds. Its targeted asset allocation is about 65 percent in stocks and 35 percent in bonds. The Star fund’s diversification comes cheap: The expense ratio of the underlying funds is 0.32 percent. (There’s no additional charge for packaging them together.) The initial investment requirement is just $1,000.
Realizing that in the case of asset allocation, one size doesn’t fit all, Vanguard introduced the LifeStrategy series of funds in 1994. Although each of the four LifeStrategy funds draws from numerous Vanguard stock and bond funds, they differentiate themselves by their target asset allocations. The LifeStrategy Income fund, the most conservative of the bunch, has 70 to 80 percent in bonds and 20 to 30 percent in stocks, whereas the LifeStrategy Growth portfolio, at the other end of the risk spectrum, invests 80 to 90 percent in stocks and 10 to 20 percent in bonds. The asset allocations of the LifeStrategy Conservative Growth and the LifeStrategy Moderate Growth funds fall somewhere in between. (If you want a fund that gradually scales back its risk as you get closer to retirement, take a look at Vanguard’s Target Retirement fund series.)
By relying more heavily on index funds than the Star fund does, the LifeStrategy funds come through with an even lower average expense ratio of 0.22 percent. Minimum initial investment is $3,000, and these funds charge a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard’s Web site for electronic delivery of statements and fund reports. 800-662-7447.
The Dodge & Cox Balanced fund is one of the oldest and best-balanced funds, having started in 1931. Like Dodge & Cox itself, this fund is conservatively run, investing primarily in medium- and large-company U.S. value stocks and high-quality, intermediate-term bonds. Typically, it invests about 60 to as much as 70 percent in stocks and the rest in bonds.
This fund has always been managed by using a team approach, so if you like to be able to rattle off the name of a star fund manager who’s investing your money, this fund isn’t for you (although you can impress others by saying that the minimum account size that Dodge & Cox normally accepts is several million dollars). This fund has a low 0.53 percent expense ratio.
Vanguard Wellington
The Vanguard Wellington is the oldest hybrid fund: It dates back to the summer of 1929 (which means that it even survived the Great Depression!). This fund typically invests about 60 to 65 percent in larger company value-oriented stocks, with the remainder in high-quality, intermediate- to longer-term bonds. In recent years, approximately 10 to 15 percent of this fund’s stocks were overseas.
This fund is co-managed by Wellington Management’s Edward Bousa and John Keogh, who together have more than 55 years of investment management experience. The fund’s expense ratio is 0.35 percent (0.23 for Admiral shares that require a $100,000 minimum). Minimum initial investment is $10,000. The fund charges a $20, annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard’s Web site for electronic delivery of statements and fund reports. 800-662-7447.
Fidelity Puritan
One of the company’s oldest funds (it began in 1947), the Fidelity Puritan fund is co-managed by Ramin Arani and George Fischer, who have a combined four decades with Fidelity in investment research and management. Puritan typically has about 60 percent in stocks that tend to be large company and value oriented. In recent years, the fund has been investing about 10 percent of its stock allocation overseas.
Most of the bonds are intermediate term, and a modest portion of them are junk bonds. The expense ratio is 0.67 percent. Minimum initial investment is $2,500. The fund charges a $12 annual low-balance fee for nonretirement account balances below $2,000. 800-544-8888.
Fidelity’s Freedom funds of funds
Fidelity offers 12 Freedom funds of funds: Freedom Income, Freedom 2000, Freedom 2005, Freedom 2010, Freedom 2015, Freedom 2020, Freedom 2025, Freedom 2030, Freedom 2035, Freedom 2040, Freedom 2045, and Freedom 2050. The Freedom Income fund is the most conservative, targeting 40 percent of its assets to fixed income funds, 40 percent to money market funds, and 20 percent to equity funds. At the other end of the scale is the Freedom 2050 fund, the most aggressive, with about 90 percent of its assets in equity funds and 10 percent in fixed-income funds. The asset allocations of the other funds fall between these extremes. (The higher the number in the fund title, which is theoretically the customer’s approximate retirement date, the greater its percentage of stock funds.)
All the Freedom Funds draw from a fixed pool of Fidelity funds, such as Capital & Income, Strategic Real Return, Investment Grade Bond, Blue Chip Growth, Disciplined Equity, Equity-Income, Growth Company, Large Cap Value, Diversified International, and Fidelity Overseas.
The combined operating expenses of the underlying funds within the Freedom Funds typically ranges from 0.7 to 0.8 percent. The Fidelity Freedom funds charge a $12 annual low-balance fee for nonretirement account balances below $2,000. 800-544-8888.
T. Rowe Price offerings
T. Rowe Price Balanced invests mainly in large-company stocks within the United States and has about one-quarter of its stocks overseas and 10 to 15 percent of its bonds in junk. The expense ratio is 0.69 percent. T. Rowe Price Personal Strategy Balanced is another fine hybrid fund, which typically holds 60 percent stocks of companies of varying sizes and has 20 to 25 percent of its stocks overseas. The expense ratio is 0.86 percent. Minimum initial investment for both of these funds is $2,500 ($1,000 for retirement accounts).
T. Rowe Price also has a series of target-date retirement funds, with names such as T. Rowe Price Retirement 2040, that are funds of funds. On the conservative end of the spectrum, it has T. Rowe Price Retirement Income and T. Rowe Price Retirement 2005, with expense ratios around 0.6 percent. At the most aggressive end of the spectrum, it has T. Rowe Price Retirement 2055, with an expense ratio of 0.79 percent. These funds gradually reduce their stock exposure and risk as you near the retirement date in the fund’s name. 800-638-5660.
Letting computers do the heavy lifting: Recommended index funds
Index funds are passively managed — that means an index fund’s money is invested, using computer modeling, to simply track the performance of a particular market index, such as the Standard & Poor’s 500. When you buy into an index fund, you give up the possibility of outperforming the market, but you also guarantee that you won’t much underperform the market either.
Beating the market is extremely difficult; most actively managed funds are unable to do it. The best index funds, however, have an advantage — the lowest operating expenses in the business. In Chapter 10, I further discuss the virtues of index funds and the role they should play in your portfolio.
Exchange-traded funds (ETFs) are index funds that are the newer kids on the block. ETFs trade on a stock exchange, and the best of them have low expense ratios like Vanguard’s index funds. In fact, many of the best ETFs come from Vanguard. Where relevant, I have included recommended stock ETFs in this chapter. For more information about ETFs, including their pros and cons, please see Chapter 5.
Vanguard’s index funds are generally the best stock index funds available. John C. Bogle, Vanguard’s founder and former CEO, was the first person to take the idea of indexing to the mutual fund investing public; he’s been a tireless crusader for index funds ever since. Today, Vanguard continues to be the index fund leader with the lowest operating expenses (which directly translates into higher index fund returns) and the biggest index fund selection around.
The flagship of Vanguard’s index fleet, the Vanguard Index 500 fund invests to replicate the performance of the popular stock market index — the Standard & Poor’s 500 index — which tracks the stocks of 500 large companies in the United States. These 500 stocks typically account for about three-quarters of the total value of stocks outstanding in the U.S. market. I don’t enthusiastically recommend this fund because you miss out on medium- and smaller-sized companies. Also, because it’s weighted by the market value of the stocks in its index, you end up over-investing in sectors of the market (for example, technology stocks in the late 1990s and financial services stocks in the mid-2000s) that are bloated and due for a more substantial correction. The expense ratio on this fund is a razor-thin 0.18 percent, and if you invest $100,000 in the fund, you can use the Admiral share class with its ultra-low 0.09 percent expense ratio.
A more diversified and tax-friendlier fund than Vanguard’s Index 500 is the Vanguard Total Stock Market Index, which replicates the performance of the MSCI US Broad Market Index, comprising 99.5 percent or more of the total market capitalization of all of the U.S. common stocks regularly traded on the New York and American Stock Exchanges, and the NASDAQ over-the-counter market. This index comprises the entire U.S. market of large-, medium-, and small-company stocks. This fund, which holds more than 3,400 stocks, also has a wafer-thin expense ratio of 0.18 percent and also offers Admiral shares with a 0.09 percent expense ratio.
Value-oriented indexes generally are a little less volatile, produce more dividend income, and offer slightly higher long-term total returns. Among U.S. index funds and exchange-traded funds I like is iShares Russell 1000 Value ETF, which invests in large cap U.S. stocks. For smaller cap stocks, check out iShares Russell 2000 Value ETF, Vanguard Small Cap Value Index fund, and Vanguard Small Cap Value ETF.
Vanguard Total International Stock Index seeks to replicate a combination of two international indexes: the Morgan Stanley Capital International Index (which is comprised of established economies) and the Select Emerging Markets Index. This fund is actually a fund of funds, as it includes Vanguard’s index funds for Europe, the Pacific, and Emerging Markets. At 0.34 percent, this fund’s expense ratio is a bargain for an international fund.
Vanguard FTSE All-World ex-US ETF is also a solid core international fund worth considering.
For nonretirement accounts, the minimum initial purchase for Vanguard index funds is $3,000. Vanguard’s index funds charge a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard’s Web site for electronic delivery of statements and fund reports. 800-662-7447.
Keeping it local: Recommended U.S.-focused stock funds
This section focuses on the better actively managed funds that invest primarily in the U.S. stock market. I say primarily because some “U.S.” funds venture into overseas investments. The only way to know for sure where a fund is currently invested (or where the fund may invest in the future) is to ask. You can start by calling the toll-free number of the mutual fund company that you’re interested in. You can also read the fund’s annual report (which I explain how to do in Chapter 8). A prospectus, unfortunately, won’t give you anything beyond the general parameters that guide the range of investments: It won’t tell you what the fund is currently investing in or has invested in.
Of all the different types of funds offered, U.S. stock funds are the largest category. To see the forest amidst the trees, remember the classifications I cover earlier in the chapter. Stock funds differ mainly in terms of the size of the companies they focus on and whether those companies are considered “growth” or “value” companies.
I highly recommend another of the fine but few funds offered by Dodge & Cox, the Dodge & Cox Stock fund, which focuses on large- and medium-company value stocks, including about 10 to 20 percent in foreign shares.
Unlike most U.S. stock funds today, this fund does little trading, often less than 15 percent of its portfolio annually. Like the Dodge & Cox Balanced Fund, this fund is managed by a team and doesn’t try to time the markets. Its annual expense ratio is a low 0.52 percent.
Fairholme Fund
You may think that a fund that was started in late 1999, right before the peak of a long bull market and just before U.S. stocks in general suffered their worst decade was destined for trouble. But, you’d be wrong in the case of the Fairholme Fund. Fund managers Bruce Berkowitz and Charles Fernandez scour the world stock markets for undervalued stocks, primarily in medium- and larger size companies. This firm started out in the private money management business — Fairholme Capital Management — in 1997, which required a $1 million initial investment. The Fairholme fund’s expense ratio is 1 percent. Initial minimum investment is $2,500; $1,000 for retirement accounts. 866-202-2263.
Fidelity Low-Priced Stock
The Fidelity Low-Priced Stock fund specializes in investing in small- and medium-company value stocks. As of this writing, about one-third of its stocks are overseas. As you may guess from its name, it buys stocks that have low share prices. Lower priced stocks tend to coincide with smaller companies, but not always: The price per share of a stock may bear little resemblance to the size of the issuing company because companies can “split” their stock and issue more shares, which cuts the price per share. This fund has been managed since its inception in 1989 by Joel Tillinghast, an amazing run given the turnover of managers at many funds, especially at Fidelity. Annual operating expenses are 1 percent. The minimum initial investment requirement is $2,500 for all accounts. 800-544-8888.
Sequoia
A conservatively managed fund with a long history (dating back to 1970) of success, Sequoia got a boost from Warren Buffett who closed an investment fund in 1969 and recommended that investors invest with the newly formed Sequoia, which was managed by Bill Ruane.
The fund generally focuses on larger company stocks. This fund is co-managed by Robert Goldfarb and David Poppe. Its expense ratio is 1 percent. Minimum initial investment is $5,000, $2,500 for retirement accounts. 800-686-6884.
Vanguard Primecap
Vanguard Primecap is one of the few growth-oriented stock funds that doesn’t trade its portfolios heavily, trading typically less than 20 percent of its fund per year. It invests in companies of all sizes and even invests a small portion overseas. This fund has been managed since its inception by Howard Schow and Theo Kolokotrones of Primecap Management, a Southern California investment management company. Joel Fried was added as a co-manager in 1993; several additional co-managers were added in recent years. The expense ratio for this reasonably tax-friendly fund is a competitive 0.49 percent. (Note: This fund is currently closed to new investors.) Although this fund is closed, you can, however, still tap in to the investment expertise of Primecap Management through the Primecap Odyssey Growth fund ($2,000 minimum, 0.73 percent expense ratio). 800-662-7447 for Vanguard; 800-729-2307 for Odyssey.
Vanguard Selected Value
James Barrow and Mike Giambrone, who have nearly six decades of investment management experience between them, are principals in the money management firm of Barrow, Hanley, Mewhinney, & Strauss, which have managed most of this fund since 1999. A portion of this fund has also managed by Donald Smith & Company since 2005. Vanguard Selected Value focuses on mid-size value stocks and invests a small portion overseas. The fund’s expense ratio is a low 0.45 percent. Unfortunately, Vanguard raised the minimum investment amount on this excellent fund to $25,000, so those with smaller balances to invest will need to look elsewhere. 800-662-7447.
Vanguard Strategic Equity
Using models honed by Gus Sauter and Joel Dickson of Vanguard’s Quantitative Equity Group, this fund has invested in small- and medium-sized U.S. companies since 1995. This fund, too, has a higher minimum: $10,000. Expenses are a low 0.30 percent. 800-662-7447.
Being worldly: Recommended international funds
As I discuss in Part I, for diversification and growth potential, funds that invest overseas should be part of an investor’s stock fund holdings. Normally, you can tell you’re looking at a fund that focuses its investments overseas if its name contains words such as international, global, worldwide, or world.
Generally, you should avoid foreign funds that invest in just one country. As with investing in a sector fund that specializes in a particular industry, this lack of diversification defeats the whole purpose of investing in funds. Funds that focus on specific regions, such as Southeast Asia, are better but are generally problematic because of poor diversification and higher expenses than other, more-diversified international funds.
In addition to the risks normally inherent in stock fund investing, international securities and funds are also influenced by changes in the value of foreign currencies relative to the U.S. dollar. If the dollar declines in value, the value of foreign stock funds goes up. Some foreign stock funds hedge against currency changes. Although hedging helps to reduce volatility a bit, it costs money to do, so I wouldn’t worry about it if I were you. Remember, you’re investing in stock funds for the long haul. And in the long haul, your international stock funds’ performance will largely be driven by the returns generated on foreign stock exchanges, not currency price changes.
The following sections offer my picks for diversified international funds that may meet your needs. Compared to U.S. funds, fewer established international funds exist, and they tend to have higher annual expense ratios. So I’ve listed fewer options for you. (Don’t forget the Vanguard Total International Stock Index fund and the Vanguard Tax-Managed International fund, which I discuss earlier in this chapter.)
Vanguard International Growth
The Vanguard International Growth fund invests primarily in large companies with growth potential, mainly in established countries. It also invests a modest 15 to 20 percent in emerging markets.
International Growth is primarily managed by London-headquartered Schroder Capital Management, which has research offices around the world focused on specific countries and has managed this fund since its inception in 1981. In 2003, James Anderson of Baillie Gifford was added to manage a portion of this large fund. This fund has an expense ratio of 0.53 percent and has been reasonably tax friendly. Initial minimum investment is $3,000 (Admiral shares of this fund have a $100,000 minimum and levy 0.34 percent in annual expenses). The fund charges a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard’s Web site for electronic delivery of statements and fund reports. 800-662-7447.
Dodge & Cox International
This excellent private money management firm also offers a handful of excellent mutual funds and manages the Dodge & Cox International fund, a foreign stock offering, which focuses on larger company, value-oriented stocks. The fund is managed by a team of investment managers, most of whom have been with the firm for 20+ years. Expenses are a low 0.64 percent. Minimum initial investment is $1,000 for retirement accounts; $2,500 for other accounts. 800-621-3979.
Masters’ Select International Equity
Like a fund of funds, Masters’ Select International Equity has some of the best fund managers each managing a portion of fund. Some of these top fund managers manage funds that are closed to new investors. Although each manager has a somewhat different investment orientation, collectively this fund invests in foreign companies of all sizes, including those in emerging markets.
Masters’ Select International’s expenses are 1.07 percent. (Unfortunately this fund is closed to new investors.) If you sell shares in this fund within six months of purchase, you must pay a 2 percent redemption fee. Minimum initial investment is $10,000 ($1,000 for retirement accounts). 800-960-0188.
Expanding your horizon: Recommended global stock funds
A select number of stock funds invest globally (overseas as well as in the United States) and do so well and cost-effectively; I detail those funds in this section.
Oakmark Global
The Oakmark Global fund invests in an eclectic mix of companies worldwide. Oakmark is one of a very short list of fund firms that has successfully managed a global stock mutual fund. While the fund commenced operations in 1999, fund manager Clyde McGregor has been with the Oakmark Funds parent company (Harris Associates) since 1981 and co-manager Robert Taylor has been with Harris since 1994. Together, McGregor and Taylor have five decades of experience in money management. While expenses are a little high at 1.23 percent. Minimum initial investment for all account types is $1,000. 800-625-6275.
T. Rowe Price Spectrum Growth
T. Rowe Price offers a number of good stock funds, both U.S. and international, and the Spectrum Growth fund of funds offers a simplified way to invest in them. The U.S. stock funds in this fund cover the entire range of company sizes. Spectrum Growth also invests about 25 percent of its assets overseas.
This fund of funds is managed by regular meetings of a committee made up of fund managers within the company. Slight changes in allocations among the different funds are made based on expectations of how particular types of stocks (for example, growth versus value, larger versus smaller company) will fare in the future. The expense ratio of the funds in this fund come to about 0.82 percent, and the company doesn’t charge an additional fee for the fund’s packaging. Minimum initial investment is $2,500 ($1,000 for retirement accounts). 800-638-5660.
Tweedy Browne Global Value
Tweedy Browne Global Value invests in value stocks of companies of all sizes worldwide, primarily in established countries. Although it can invest in the United States, its U.S. holdings are generally 10 to 15 percent of the fund. The parent company has an excellent reputation, managing money privately since the 1920s; this fund itself has been in existence since 1993 and has done well. Operating expenses, consistently lowering as the fund grows in size, are still a bit on the high side at 1.4 percent. Initial minimum investment is $2,500 ($500 for retirement accounts). 800-432-4789.
Vanguard Global Equity
This excellent fund is co-managed by three leading private money management firms: Marathon Asset Management, Acadian Asset Management, and AllianceBernstein. U.S. stocks currently comprise about 40 percent of the fund. The expense ratio of 0.47 is low for a global fund. Minimum initial investment is $3,000. The fund charges a $20 annual low-balance fee for account balances below $10,000 unless you register your account on Vanguard’s Web site for electronic delivery of statements and fund reports. 800-662-7447.