So you have settled on an asset allocation plan and have chosen your first mutual fund. For our purposes, we’ll assume you are going to invest in Vanguard’s S&P 500 Index Fund (VFINX), but the specific mutual fund doesn’t usually change how we’d go about buying it. Now you have two options: (1) buy shares of the fund directly from the mutual fund company (in our example, Vanguard); or (2) buy shares of the fund from an online broker like E*Trade or Zecco. So how do you decide?

Mutual Fund Company vs. Online Discount Broker

Opening an account: The process of opening an account and buying shares of the mutual fund are basically the same for both mutual fund companies and online brokers:

1. Sign up for a new account online: The online application process for a company like Vanguard or an online broker is very similar. For both you’ll obviously provide basic information such as your name, address and telephone number, and you will of course need to provide your social security number and set up a user name and password. With the online security used today, you also will have to create answers to several security questions (e.g., What was the name of the elementary school you attended?)
2. Link a checking or savings account: The most common way to transfer money to a mutual fund company or online broker is through direct transfers from a linked checking or savings account. To set this up, you’ll need your account number and routing transit number (RTN). The RTN is a nine digit number that appears at the bottom of checks next to the account number, and it identifies the financial institution the check is drawn from. Here’s what it looks like:

   

   Note: You can also transfer money the old fashioned way, by mailing a check. But using checks is slow and inconvenient. You can also set up automatic contributions through transfers from your checking account or direct deposits from your employer.

3. Buy shares of the mutual fund: It usually takes a couple of business days to get your checking account linked to your online broker or mutual fund company account and the funds transferred. Once that is complete, you can go to the mutual fund company or online broker’s website and execute the trade.

Cost: The cost of buying shares of a mutual fund is often the deciding factor in whether to buy directly from the mutual fund company or an online broker. Putting aside front end loads (and why would you ever buy a load fund?), there is generally no cost to buying shares of a mutual fund directly from the mutual fund company. In the case of Vanguard’s S&P 500 fund, there are no purchase or redemption fees. Vanguard does charge a $20 annual account maintenance fee, but will waive it if you sign up for account access on Vanguard.com and choose electronic delivery of statements, confirmations, fund reports, and prospectuses.

With online brokers, you will have to pay a fee for each trade you execute, although the fees are low. For example, Zecco, the home of $0 trades, currently charges $10 for each purchase of mutual fund shares. Zecco’s $0 trades for stocks does not apply to shares of mutual funds. E*Trade charges $19.99 per trade of mutual fund shares, although they do offer some mutual funds (not Vanguard) at no commission.

So why would you ever buy shares of a mutual fund through an online broker? Convenience.

Convenience: If you plan to invest in shares of mutual funds from several different mutual fund companies, using an online broker allows you to keep your investments in one place. And if you plan to invest in individual stocks or ETFs, the case for using an online broker is even stronger. Mutual fund companies like Vanguard over brokerage services where you can buy shares of non-Vanguard funds, individual stocks, or non-Vanguard ETFs, but the cost of these trades is generally more expensive than an online discount broker.

So what’s the bottom line?

If you plan to make monthly investments in the mutual fund, I would go directly through the mutual fund company. While the minimum purchase of Vanguard’s S&P 500 fund is $3,000, additional purchases can be as little as $100. Buying $100 worth of a mutual fund each month through an online broker is too costly.

On the other hand, if you are making a lump sum purchase and plan on investing in other stocks, ETFs or mutual funds offered by different companies, an online broker is probably the best choice.

Finally, you can do both. I have a Vanguard account through which I purchased several Vanguard funds. I also have a ShareBuilder account I use to purchases shares of Warren Buffett’s Berkshire Hathaway.

If you are just getting starting with investing, here are some additional articles worth reading:

35 Common Sense Rules for Investing (@ Moolanomy)

How to Become a Millionaire (@ Cash Money Life)

Resources to Learn About Stock Market Investing (@ Blueprint for Financial Prosperity)

Investment Management Tips to Help You Stay the Course with Your Portfolio (@ The Digerati Life)

Myth #1. S&P 500 Index Funds Invest in the 500 Largest Companies: The S&P 500 is comprised of large cap companies, but it is not just the largest 500 companies. Rather, the companies comprising the S&P 500 Index are selected by the S&P Index Committee comprised of Standard & Poor’s economists and index analysts. The goal is to create an index of leading companies in leading industries.

While the index includes many of the largest U.S. companies (e.g., Exxon and Microsoft), it does not include the 500 largest companies. One factor that can keep a company out of the index is insufficient liquidity (i.e., a company’s stock does not get bought and sold in sufficient quantity). A good example of this is Berkshire Hathaway, one of my favorite investments. With an A share costing more than $100,000, Berkshire’s lack of sufficient liquidity keeps it out of the index (I doubt Mr. Buffett loses any sleep over this fact).

Myth #2. S&P 500 Index Funds Own U.S. Companies Only: There is a bit of history here. In the early 1990’s, the S&P Index Committee announced that it would no longer add non-U.S. companies to the index. At that time there were a handful of foreign corporations, and the committee made clear that they would not remove existing foreign companies from the index just because they were foreign companies. By about 2000, the index was down to seven non-U.S. companies, and today all of the companies that form the S&P 500 index are considered U.S. companies by the committee.

However, many of the U.S. companies that comprise the index have substantial international operations. These companies conduct business and hold assets denominated in foreign currencies. Their foreign operations are subject to non-U.S. laws and can be negatively impacted by political unrest, particularly in emerging markets and frontier markets. The point is that an investment in an S&P 500 index fund creates some international exposure to your portfolio. This isn’t a bad thing, in my opinion, just worth noting.

Myth #3. S&P 500 Index Funds Own Equal Amounts of 500 Companies

Most S&P 500 index funds are what is called market capitalized weighted. What this means is that the fund does not invest the same amount in each of the 500 companies that comprise the index. Instead, it invests an amount in each company that is proportional to the market capitalization of that company. The market capitalization is simply the value of all shares owned by the public.

What this means is that a market capitalized weighted fund invests a lot more in Exxon (the largest company in the S&P 500 based on market capitalization), then it invests in the 500th largest company on the S&P 500.

There are funds that invest equal amounts in each of the 500 companies comprising the S&P 500. An example of such a fund is the Rydex S&P Equal Weight (RSP) exchange traded fund. The difference here is that more of the fund’s investments are put into relatively smaller companies.

So which is the better investment? There really is no “better”; each fund has a different investing objective. Most S&P 500 funds are market weighted. The more important point is simply to understand that there is a difference so that you can make an informed investing decision. I will say though that one key reason to invest in an index fund is to mimic the market, and an equal weighted index fund does not accomplish this goal.

Myth #4. S&P 500 Index Funds have Low Expense Ratios: While many S&P 500 index funds do have low expenses ratios, many do not. The DWS S&P 500 Index C (SXPCX) fund, for example, has an expense ratio of 1.4%. Why would you pay so much for an index fund, you ask? You wouldn’t, or at least you shouldn’t. The Vanguard S&P 500 index fund (VFINX) costs just 0.15% per year, and Fidelity’s Spartan U.S. Equity Index (FUSEX) fund, which I own, costs just 0.09%.

Some S&P 500 funds even come with front loads or deferred loads, which is really insane.

Myth #5. S&P 500 Index Funds are the Only Type of Index Mutual Fund: The S&P 500 index is so well known that I’ve talked to folks who think all index mutual funds track the S&P 500. The fact is there are many domestic and foreign indexes that are tracked by mutual funds and ETFs. One good website for researching such finds in Index Universe.

Myth #6. All S&P 500 Index Funds Have the Same Returns: This is a really important point to take note of. The returns of S&P 500 index funds can vary dramatically. This is due in part to variance in expense ratios noted above. In addition, some index funds spend more money buying and selling stock than others. Based on Morningstar’s fund screener, S&P 500 index funds’ returns for this year have ranged from a low of about -14% to about -12%. And if you think 2 percentage points is not much, you should read how even 0.5% can ruin your retirement.

Myth $7: An S&P 500 Index Fund is Enough for a Well Diversified Investment Portfolio: An S&P 500 index fund is diversified within the context of U.S. equities. But there are many important asset classes that are not represented in this index. For example, the S&P 500 does not include bonds or other fixed income securities. It does not include small cap companies, foreign companies, REITs, or commodities. As noted above with respect to foreign companies, the S&P 500 index does have some exposure to these asset classes, but not enough to create a well diversified portfolio. So while an S&P 500 index fund can be an important part of a diversified portfolio, investments in other asset classes is important.

An S&P 500 index fund is, in my opinion, a great way to start investing. If I were just starting off today, it would be one of my first investments. Over the long run, the S&P 500 beats most actively managed mutual funds. But it is important to make sure you are investing in a low cost, well managed fund, because not all index funds are created equal.

Much like the convenience of target date funds for retirement investing, VTWSX provides instant diversification with the investment in a single mutual fund.

Vanguard’s Total World Stock Index Fund (VTWSX) Details

The FTSE All-World Index includes approximately 2,900 stocks of companies located in 47 countries, including both developed and emerging markets. As of March 31, 2008, the largest markets covered in the Index were the United States (41%), the United Kingdom (9%), Japan (9%), France (5%), and Germany (4%). Thus, the fund holds approximately 59% of its portfolio in companies outside the United States.

The Fund typically holds 2,800–2,900 stocks in its target Index (covering nearly 99% of the Index’s total market capitalization) and what is called a representative sample of the remaining stocks. This means that the fund, using computer programs, picks a sample of stocks to mimic the index, which does expose the fund to index sampling risk. According to Vanguard, however, the fund “holds a broadly diversified collection of securities that, in the aggregate, approximates the full Index in terms of key characteristics. These key characteristics include industry weightings, country weightings, and market capitalization, as well as certain financial measures, such as price/earnings ratio and dividend yield.”

VTWSX’s Fees and Minimums

The initial minimum investment is $3,000, except for educational savings accounts, which has a $2,000 minimum. Additional investments of $100 or more can be added to the fund. The fund’s estimated expense ratio is 0.45%, which is relatively low given that much of the fund is invested in foreign and emerging markets. The fund also charges a 0.25% purchase fee and a 2% redemption fee for shares held less than two months. It’s important to understand, however, that the purchase and redemption fees are paid into the fund, not to Vanguard.

Vanguard also offers its World Stock Index fund in ETF shares that trade under the ticker, VT. These ETF shares charge an expense ratio of just 0.25%, but as with all ETFs, there is a brokerage fee for the purchase of these shares.

Building a Simple Portfolio with VTWSX

If constructing an asset allocation plan is not how you like spending your time, you can create a well diversified portfolio with the VTWSX fund. In fact, a simple investment strategy could consist of VTWSX for the equity portion of a portfolio, and Vangaurd’s Total Bond Market index fund (VBMFX) for the bond portion. Once you decide what percentage of your investments you want in equities and bonds, buying these two funds to achieve those percentages would result in an inexpensive, well diversified investment portfolio.

Be sure to check out all of the money making resources here at The Dough Roller.

As this is my first video post, I’d appreciate hearing what you think, how quickly the video loads, and if you had any trouble viewing the video.

In years past, this meant changing your asset allocation mix with greater focus on bond investments over stock investments. Recently, both Fidelity and Vanguard introduced retirement investment options that do the work for you through a single mutual fund. In this article we’ll first look at what investments during retirement should accomplish, and then we’ll review Fidelity’s Income Replacement funds and Vanguard’s Managed Payout funds.

Retirement Income Investing Objectives

Investments during retirement must meet several objectives. First, the investments must generate income to fund expenses during retirement. This is one of the reasons retirees shift investments from growth stocks to dividend paying stocks and bonds. Second, retirement investing requires greater consistency in investment returns. Losing 25% in your portfolio when your 35, while disconcerting, is not financially fatal. Losing 25% of your retirement portfolio when your 70 can have a sever impact on your golden years. Finally, investing during retirement still requires some growth in the portfolio. Given average life expectancies, at age 65 most still have an investing horizon of 20 years or more.

Addressing all of these factors in an investment portfolio is a challenge. So let’s see how Fidelity and Vanguard each address these retirement investment objectives.

Fidelity’s Income Replacement Retirement Investments

Fidelity’s Income Replacement funds invest in a mix of Fidelity equity, fixed income and short-term mutual funds. Each fund is designed to pay out a certain percentage of your balance each year. Depending on how long you want your money to last, you can select a fund that will have paid out 100% of your balance by 2016 through 2042. The longer the period of time you select, the less you’ll receive each month. Over time, the investment mix of each fund will automatically shift to become more conservative as you near the Fund’s horizon date.

Fidelity has an easy to use tool to help you determine which fund is best for you. As reflected in the screen shot below, there are two ways to use Fidelity’s calculator. First, you can enter how much you have to invest and how long you want to invest it, and the calculator will estimate how much money you’ll receive each year. Second, you can enter how much you want to receive each year, and Fidelity will calculate how much you need to invest to generate that annual income.

Using the calculator, I entered $5,000 per year in income for 20 years, and here are the results:

It’s important to understand that Fidelity’s Income Replacement funds are not annuities. There is no guaranteed annual income from these retirement investments. If the market performs better than anticipated, these funds will pay more than expected. If the market under performs expectations, the annual payout will be less.

The minimum investment for the Income Replacement funds is $25,000. The annual expense ratio ranges from 0.54% to 0.67%.

Vanguard’s Managed Payout Retirement Funds

Vangaurd’s Managed Payout Retirement funds take a much different and simpler approach. Vanguard offers three retirement income funds. The Managed Payout Growth Focus fund (VPGFX) maximizes the growth of capital by minimizing annual payouts. Vanguard’s Managed Payout Growth and Distribution fund (VPGDX) balances capital appreciation and income distribution. And the Managed Payout Distribution Focus fund (VPDFX) has a higher payout per dollar invested, and therefore, little or no capital appreciation.

Vanguard’s retirement income calculator will estimate how much monthly income will produce for each of these funds based on the amount invested. As the monthly income distributed goes down, growth of the invested capital increases.

The Vanguard funds require a $25,000 minimum investment, and expenses range from 0.57% to 0.58%.

Although I prefer the simplicity of the Vanguard funds, both Vanguard and Fidility’s retirement income funds offer a simple approach to retirement investing. There are alternatives, of course, which are covered in the mutual fund investing section here at The Dough Roller.

Image credit: ansik

Certainly if we could invest with hindsight, all we would care about is performance. Of course, if we could invest in hindsight, we’d all be long in Berkshire Hathaway (BRK) whose price has risen 7,000-fold (yes, 7,000-fold) since Mr. Buffett took over in 1965. Because we don’t know what the future holds, however, a fund’s expense ratio is a critical factor to consider when selecting a fund. I’ll explain why I believe the expense ratio is so important, and then I’ll throw some data at you to back up my view.

Expenses are one of the few variables investors can control

With investing, like life, there are some things we can control and some things we cannot control. For example, we can control whether we invest in actively managed mutual funds or index funds. We can control our asset allocation and pick funds that invest in the type of stocks that match our asset allocation plan. And we can control how much in expenses we are willing to pay for a mutual fund. We cannot control, however, performance. Given two funds with similar investing styles, why would we pick the more expensive fund? What would lead us to believe that the more expensive fund will outperform the less expensive fund? We are most likely going to rely on the past performance of the fund, because we have nothing else to base our prediction of future performance. And that would be a major mistake. A given fund my perform very well for a period of time, even a relatively long period of time. But if we rely on history, we should conclude that expensive funds cannot continually beat their competition by a wide enough margin to justify the high expense ratio.

Mutual fund performance over the past 20 years supports the low expense approach to investing

The top performing funds change from year to year. In fact, many of the top ten funds in one year, end up in the bottom quartile the next. These funds often cost the most, too. I decided to compare the top 10 performing mutual funds over the past 1, 10 and 20 years, and look at the expense ratios for those funds. Before looking at the data, my assumption was that the 1 year top performers would have, on average, a higher expense ratio than the 10-year top performers, who in turn would have a higher average expense ratio than the 20-year top performers. Why?

Think of the expense ratio as an anchor and mutual funds as swimmers. The bigger the expense ratio, the heavier the anchor. Some funds may be able to tread water for awhile, but eventually the heavier anchor of expenses will slow them down if not drown them. As it turns out, the data support this conclusion.

Data for the top performing funds over the past one and ten years was taken from Morningstar. Data on the top performing funds for the past 20 years was taken from an article by Richard Widows published on TheStreet.com in October 2007. The data show that expense ratios of the top performing funds decrease as the period of time increases. The average expense ratio for the 1-year top performing funds was 1.54, the 10-year top funds 1.34, and the 20-year best funds 1.00. Here are the details:

This data shows that over the long run, funds with lower expense ratios perform best. We do have to be careful, however, not to misinterpret the data. For example, some of the 20-year top performers have high expense ratios. And some of these funds have lowered their expenses as the funds have grown in size. But the fact remains that without knowing what the future holds, choosing low cost funds is a sound decision for long-term investors.

If you disagree, let’s hear about it.

Image credit: MobilFunk7

The primary reason a fund closes to new investors is so the fund manager can continue to invest in the style he or she has chosen. For example, the manager may wish to keep relatively small positions in each stock owned, which becomes harder to do as more cash rolls in. Or the manager may believe that he or she doesn’t have a good place to invest more cash. Warren Buffett has this problem given the billions of dollars Berkshire has in its vault. He’s said he’ll return cash to investors in the form of a dividend if his return on capital diminishes past a certain point. We’ll see.

So does closing a fund help or hurt it’s performance? In a study by Morningstar, it found that most funds underperformed after closing, although it attributed this to the up and down cycle of a hot mutual fund. The study did find, however, that taxes for existing investors went up after a fund closed. Why? Because there was no longer an influx of new investors to share the tax burden. In fact, Vanguard has said that the tax consequences of closing a fund usually outweigh any advantages.

So which funds are reopening? Here they are, and keep in mind that one fund is only opening to those who already invest in the fund family, although the fund may open to all investors.

Third Avenue International Value

• Ticker: TAVIX
• Style: Foreign small/mid value
• Morningstar Rating: 3 stars
• Expense Ratio: 1.45
• Reopening: December 20, 2007

FPA Crescent

• Ticker: FPACX
• Style: mid-cap value with large foreign exposure and holding lots of cash
• Morningstar Rating: 5 stars
• Expense Ratio: 1.25
• Initial Investment: $1,500 ($100 if opening an IRA)

Longleaf Partners

• Ticker: LLPFX
• Style: Large blend
• Morningstar Rating: 4 stars
• Expense Ratio: 0.90
• Reopening: Partial reopening to investors in other Longleaf funds, but may fully reopen to new investors.

Be sure to check back for more investing tips from The Dough Roller.

The Problem with ETFs

Through small, monthly investments when I was younger, I’ve built up a substantial investment in a number of index funds, Vanguard’s Emerging Marekt Index Fund (VEIEX) being one of them. Now that my investments in the fund have grown and I’m not making small, monthly contributions, I would love to sell the fund and buy the equivalent ETF (VWO). The annual expenses are 12 basis points lower, and ETFs generally are more tax efficient than funds (although VEIEX is a very tax efficient fund). By tax efficient, I mean that ETFs generally do not generate yearly capital gains that are taxable, thus, you only pay capital gains tax if and when you sell any of your investment. The problem I have is that selling my investment in VEIEX would trigger substantial capital gains tax. In recent years the fund has sky rocketed, returning 57% (2003), 26% (2004), 32% (2005), 29% (2006) and 23% so far this year. So in the past four and a half years, my investment has more than quadrupled. So selling now would result in substantial taxes.

Converting a mutual fund to an ETF

It turns out that with this particular Vanguard fund, I can convert (not sell) my Emerging Market Index shares into Emerging Market ETF shares without triggering capital gains tax. The reason for this, according to Vanguard, is that the ETF shares are just one of several share classes within the Emerging Market fund. And converting from one share class to another is not considered a sale for capital gains tax purposes, again according to Vanguard. The following is from Vanguard’s website:

Shareholders of Vanguard stock index funds that offer Vanguard ETFs may convert their conventional shares to Vanguard ETFs of the same fund. This conversion is generally tax-free, although some brokerage firms may be unable to convert fractional shares, which could result in a modest taxable gain. (Bond ETFs do not allow the conversion of bond index fund shares to bond ETF shares of the same fund.)

Vanguard will charge $50 for each conversion. (This fee is waived for Flagship clients.) Your brokerage provider may charge an additional fee for this service. For more information, contact your brokerage firm, or call 866-499-8473.

Once you convert to Vanguard ETFs, you cannot convert back to conventional shares. Also, conventional shares held through a 401(k) account cannot be converted to Vanguard ETFs.

Note that once you convert to the ETF, you cannot convert back to the index fund (why would you want to?). Also, you cannot convert index funds held in a 401(k) account. You do have to determine whether the conversion is worth the $50 fee. In my case, I’ll recover that cost in less than a year, so there is no question that converting to the ETF is a smart move. One final comment. When I first read the above information about converting to ETFs, I called Vanguard to confirm my understanding. The first representative I spoke to told me that the conversion would trigger capital gains tax. It turns out, though, that the person I spoke to did not work in Vanguard’s brokerage division, which handles ETFs. When I inquired further, she transferred me to the brokerage division who confirmed that conversions do not trigger capital gains tax. Remember, though, that the conversion has to be within the same fund (e.g., Emerging Market index to Emerging Market ETF).

I hope this mutual fund investing tip has been helpful, and be sure to stop back soon for more wealth building ideas from The Dough Roller.

Of course, some will say that the mutual fund that costs more will return more. My response is simple–How do you know? Cheaper is not always better, to be sure. But in mutual funds, spending less can be the best investment you’ll ever make.

My first reaction was that those with $20 million or more made their money from running their own business, but that would explain only some of the results. Frankly, I think something must be missing here. I’ve searched for the survey, but can’t find it. If you can, let us know. But the survey as described on The Wealth Report does highlight at least two important concepts.

First, mutual funds are for the poor (and the rich, too). My first investment outside my 401(k) was $100 in a mutual fund. I automatically invested $100 each month. That’s one of the great things about mutual funds–you don’t have to be rich to invest in them. Second, as investments grow, particularly in taxable accounts, many investors do tend to look for opportunities outside of mutual funds. Some look to real estate, others, according to the survey, look to hedge funds and start-ups. I’m not convinced that these other investment opportunities necessarily result in better returns, although they do add another level of diversification, which is one reason I started investing (slowly) in residential real estate. Regardless, all of these investment vehicles can, if used appropriately, help build lasting wealth.

So, if you’re worth at least $20 million, what do you invest in?