Burton Malkiel is a Princeton University economist and author of the best-selling book, A Random Walk Down Wall Street.
Whether you are looking to invest in a new fund or evaluate the funds you already own, the 50-50 rule can help you pick long term winners. The 50-50 Rule has just two components, a fund’s expense ratio and its turnover ratio.
Invest in Mutual Funds with an Expense Ratio Under 0.50%
The expense ratio is how much a mutual fund charges investors to manage the fund. An expense ratio of 1%, for example, will cost you 1% each year of the amount you have invested in the fund. An investment of $10,000 will cost $100 for a fund that has a 1% expense ratio. That might not seem like a lot, but at $100,000 invested, the cost goes to $1,000 per year, and at $500,000 the cost goes up to $5,000. Many retirement funds rise to seven figures (hopefully) as you near retirement, so the expense ratio becomes even more important.
Malkiel believes that most investors should stick with funds that charge less than 0.50%. According to his research, funds with expense ratios under 0.5% generally perform better than their higher cost competitors. He does note that with some funds, like those investing in emerging markets or other highly specialized assets, a higher expense ratio may be acceptable. But on the whole, he recommends keeping the costs below 0.50%.
As it turns out, this is the same rule I’ve followed for years. While some of my funds charge more than 0.50%, my goals is to pay less than 0.50% on a weighted average for all of my mutual fund investments. Currently, my weigted average cost is 0.19%.
If you’d like to check the weighted average cost of your mutual funds, Morningstar’s Portfolio Manager is just the tool you need (and it’s free). Check out this article on how to use Morningstar’s Portfolio Manager for all the details.
Invest in Mutual Funds with a Turnover Ratio Under 50%
The second part of the 50-50 rule is really important, but one that many people overlook. A mutual fund’s turnover ratio is the portion of its portfolio that it will trade in a given year. For example, a turnover ratio of 100% means that the fund trades the equivalent of 100% of its portfolio every 12 months. A 100% turnover ratio would not mean that the fund bought or sold every security it owns. Rather, a $100 million fund with a 100% turnover ratio means that it buys and sells securities valued at $100 million each year. And that means that a fund can have a turnover ratio of more than 100%.
There are several factors that contribute to a fund’s turnover ratio. First, a fund’s management may buy and sell large blocks of securities as part of their investment strategy. Second, if outflows of a fund greatly exceed inflows, a fund may have to sell securities to pay investors as they exit the fund. A fund may also trade securities for tax purposes, matching losses with gains to help minimize the tax hit to its investors.
Malkiel recommends that investors stick with funds with a turnover ratio of 50% or less. The reason he gives is that it costs mutual funds a lot of money to buy and sell securities. And these costs are NOT included in the expense ratio. The reason is that a fund does not know what the cost of trading will be for a given year until the year is over. But the higher the turnover ratio, the higher the costs. Consistent with seeking funds with low expense ratios, funds with low turnover ratios will further keep costs down.
Mutual fund companies must disclose the cost of trading in a document called the Statement of Additional Information. Check out this article on the costs of mutual funds, which includes information on the Statement of Additional Information.
A high turnover ratio can also mean other potential problems with a fund. If your investment is in a taxable account, for example, a high turnover ratio my mean you pay more capital gains tax each year. That’s not always the case, as some fund managers can sell stocks at a loss to offset any gains they have accumulated. But a high turnover ratio is at least cause for concern and further investigation.
Morningstar’s Portfolio Manager makes it a snap to see the expense ratio, turnover ratio, and just about every other imaginable data point for your mutual funds. Using Malkiel’s 50-50 rule, I checked out my portfolio to see how my funds stacked up. Here is a snapshot:
You can see that the weighted average expense ratio is 0.47%. The turnover ratio, however, is a tad over 50%. This is due entirely to the PIMCO bond fund, and is to be expected for a short to intermediate term bond fund. Apart from this fund, the turnover ratio is well below 50%.
Update: My portfolio has change significantly since this article was published. You can check out my current portfolio here.
So whether you are looking to invest in a new fund or evaluate the mutual funds you already own, you can use the 50-50 Rule to see how the funds measure up.
For more tips on getting the most out of Morningstar, check out the Morningstar User’s Guide.