Earlier this week I had a colleague who told me he had a Fidelity account and he was investing into ‘some’ mutual fund. “That’s great!” I said, because I love talking about investments and love seeing people invest. He then rambled off the name of the mutual fund and asked “is this a good investment?”. Its a question I get all the the time. Its a great question because it is the first step to understanding your portfolio (or investment). Unfortunately though there’s no “yes” or “no” answer. What makes a good investment for me, might not be a good investment for you. When I get that question I usually go over 5 things, and explain them all with whomever asked me, and then finish off with “thats a sound investment” or “you might want to get out of that”. I don’t like saying something is a good or bad investment because none of us have a crystal ball, that can tell us what will happen next. We can only make an investment that falls in line with our outlook and mentality as an investor.
1. You understand it. My friend above was invested in a target date fund, but he had know clue what a target date fund was. Not understanding the investment, and why the value of your investment increases (or should increase) is a recipe of disaster. Unfortunately many people invest with no understanding of the market, which results in failed attempts at timing and substantially less returns.
2. You can stick with it (risk tolerance). That target date fund which is currently around 90% equities is likely to have some nasty drawdowns. Many young investors pile into a target date fund with no idea of the risk of such high equities. If you can’t stand seeing the value of your portfolio fluctuate greatly, as much as 80% in 1929 and then 50% in 2008, you might want to go into something a bit more conservative, like a Vanguard Lifestrategy Moderate Growth fund which only has a 60% allocation to equities or even a Betterment portfolio with 60% allocation to equities.
Likewise if you want to capture a market premium through a smart beta factor, like small cap value, you need to be prepared for not only high volatility and drawdowns, but a long term deviation from the market. Will you be able to stick to small cap value when all your friends are in a simple market beta portfolio making bank, and you’re losing sleep wondering if the small cap premium exists or has been arbitraged away? The odds are against you.
3. Its Diversified. We all know the old saying, “don’t hold all your eggs in one basket”. Holding a single stock like GE because someone told you it’s “like a mutual fund” is a poor idea. Make sure that what you’re invested in is diversified. For most investors that means holding thousands of companies through a through a Target Date Fund, or etf portfolio.
Granted there are times when concentration in a portfolio could be good, but if you’re a math whiz like that, this post isn’t for you.
4. Its low In Fee’s. Fee’s in the financial industry are borderline criminal. Some firms charge a custodian fee of 1-2% and then put you in high fee mutual funds charging another 1-2%. The 1-2% here and there seems like such a measely amount to someone inexperienced with investments and compounding returns, but overtime those fee’s eat away at a portfolio. There’s no reason for this as those high fee’s as statistically you don’t get you any better returns. You can get a fully diverse portfolio from Betterment for a whopping .37% and that portfolio will outperform nearly all of the alternatives.
Ready to hear something awful: According to Meb Faber, there is over 300 billion in asset allocation mutual funds that still charge over one and a half percent a year. In otherwords pockets are being line with 4.5 billion dollars for doing absolutely nothing at all. These investors could switch to Betterment or Vanguard, and instantly gain at least 1.13% return!
That said their can be a time to pay a little more fee’s, IF you really understand what the funds objective is, and management is highly invested in the fund themselves. For example I’m an investor in the First Eagle Global Fund (SGENX), which charges 1.16%. The fund is extremely defensive and correlates high with a quality factor. I believe that in the very long term companies that meet that factor criteria will outperform, and I am fine with under-performance in the short term while market capitalization based funds are rocketing skyward.
5. Its Tax Efficient. In a world where no returns are guaranteed, you and can’t control the future, you can control your taxes which have a direct effect on your total return (just like fee’s). Many investors simply pay no attention to the tax consequences of their portfolio. Every investor should understand the impact of their portfolio come tax time and invest in the appropriate manner. That means opening a traditional IRA, Roth IRA, 401K or other tax advantaged account.
If all these things are checked off, you’ve got a sound investment. Only time will tell, whether or not its good. Perhaps in one of my next posts, I’ll analyze a portfolio a little more complex than holding one target date fund.