Two of the biggest arguments against mutual funds are high costs and poor performance. When your mutual fund starts under performing and increasing costs, instead of finding another mutual fund money sink, build your own.
When a mutual fund is started, it’s built around a goal. Something that easily explains to investors how all that money will be invested. There’s a hitch, though. With an active manager you just never know how much they veer off course from that goal. And when they fail, it only costs you more. Which is just one of many limitations.
Costs limit your investment performance. There is no way to cut costs entirely. So we have to focus on keeping it to a minimum. This keeps more money invested and growing over the years.
Then there is the performance issues. Your money has a goal (at least it should have a goal). So you search through all the possible funds to, hopefully, find a few that sync up with your goal and don’t eat away too much of your profits.
It all works out for a while until the cost and performance of those mutual funds don’t live up to expectations. So you look for another fund to put your money in and the cycle starts all over, compounding the costs.
Of course, there is another, cheaper option. You can take your goal and mold your investments to it. Instead of searching for several actively managed funds that come close to matching your goal, you do it yourself and build your own mutual fund.
The Do-It-Yourself Solution
One of the issues I have with mutual funds is good stocks are lumped in with bad stocks. The same can be said with bonds and their bond fund equivalents.
A typical fund will own hundreds if not thousands of different stocks. I believe in diversification, but at some point it can be too much. More isn’t always better and we need to cut out the excess fat. If I can invest in the best stocks of the bunch, I can avoid for the most part, all the excess bad stocks holding the fund down.
This, of course, will require time and a bit of extra knowledge. But it’s certainly possible to do and puts complete control in your hands. Cutting out the middle man altogether, will save you money in the long run.
All you’ll need is some good research tools and a discount broker. A place to start is to take a cue from the fund managers and look where they’re invested. You can find great stocks in mutual funds, then do the research and see if any fit your goals.
Now, if you don’t have the time to put into building your own fund from scratch there is an alternative in ETFs.
The Easy Solution
The easier and more hands off solution is with ETFs. Since you’re just replacing your current mutual funds this is easy. ETF categories mimic mutual fund categories. That large cap growth fund or bond fund can easily be found in ETF form. The same goes for index funds.
The only difference with using an ETF, you lose the active management and the fees that come with them. Which is the point. The ETF isn’t trading in and out of different stocks or bonds. The investments stay static, for the most part, so you know exactly what is owned. This makes it easier to find ETFs that fit your goal perfectly.
Costs are still a concern, though. Just keep an eye on the expense ratio. The lower the better. An expense ratio less than 0.5% is a good place to start. Don’t be surprised to find ratios less than 0.1%. When you find yourself having to choose between two similar ETFs, you can’t go wrong with the lower cost option.
Since ETFs are traded just like stocks, it comes with a commission fee every time you buy and sell. Stick with the lower cost brokers. Even a couple of dollars more per transaction can add up and eat into your profits. There are brokers that offer commission-free ETFs, which is a great place to start.
The Bottom Line
When you find those mutual funds aren’t living up to expectations, it might be time for a change. There is no point in paying more money for average performance. The simple fix is to move toward low-cost ETFs. But if you have the time and persistence you can build your own mutual fund from scratch.
Remember, every dollar spent has to be made back first, before you can make a profit. Costs are key. Just lowering your investment costs will improve performance. Which may be all that is needed to turn an average investment into a great one.