I encountered a big problem when I first started investing. Maybe you’ve encountered it, too. I would read a lot of books on investing. Two of my favorites are Rick Ferri’s All About Asset Allocation and William Bernstein’s The Four Pillars of Investing. These books cover asset allocation, and in All About Asset Allocation, describe specific portfolios using Vanguard funds (I interviewed Rick Ferri in a previous podcast).
I quickly became a big fan of Vanguard funds. I mapped out my asset allocation—how much in stocks, bonds, domestic and foreign–and the Vanguard Funds for each asset class. Then I headed on over to my 401k and of course, none of those funds were available in my employer’s plan. Not a single one of them. And to make matters worse, I would look at the list of mutual funds in my 401k and I had no idea how to select a fund.
An investor can open an IRA at most brokers or mutual fund companies. This flexibility allows you to invest your money however you’d like. With your 401(k), however, you’re stuck with whatever investments your employer decides to include in the plan.
In this article, we’ll address that problem. We are going to cover how to compare mutual funds and even cover some online tools you can use to help in the process. While you may not have access to the fund you want in your 401k, you should be able to find some funds that are at least comparable to the mutual funds you wish were in your retirement account at work.
How Many People Pick Mutual Funds
So let’s first talk about how many people pick a mutual fund. You log into your 401(k), you look at the funds and what do they show you? They show you the performance. One year performance, 3 year, 5 year, 10 year, and maybe even since inception. Then you start comparing them side-by-side. Why not just pick the one that’s got the highest performance? Why would you pick one that’s got the lower performance?
So you pick the mutual fund based on past performance. I know you do it. I’ve talked to so many people who have picked funds this way, and I even took this approach in the early days. It’s an easy approach, and why in the world would you pick a fund that seems to have underperformed in the past?
The problem, as we all know, is that past performance is no guarantee of future returns. If we don’t focus entirely on returns, what do we look at?
How You Should Choose a Mutual Fund
If you go through the 31-Day Money Challenge starting with Podcast 23, I walk through why you should invest like you’re buying a whole business. I walk through asset allocation, how to pick a fund, why fees matter. I tell you my investment portfolio and my asset allocation.
Let’s quickly review three key factors you should evaluate when picking a mutual fund.
The first is the asset class. Before even thinking about specific investments, the starting point is to have an asset allocation plan. How much are you going to have in stocks versus bonds? How much are you going to invest in US stocks versus foreign stocks?
Once you have that plan and you’re going into your 401K to pick mutual funds, you want to make sure you’re buying funds in the right asset classes. So if you’re going to have, for example, 50 percent of your investments in US stocks, then you want to make sure that you find one or more mutual funds that invest in US stocks for 50 percent of your investments.
Think of your asset allocation plan as your investing map. Without it, you won’t know where you are going.
The second thing, of course, is cost. You always want to look at the expense ratios. That’s why I favor index funds, which are typically much less expensive than actively managed mutual funds. My goal is to have the total cost of all of my investments at under 25 basis points.
Active vs. Passive Funds
Finally, you want to look at the investing style of the fund. Is the fund an actively managed fund or an index Fund? While I generally favor the low cost of index funds, I do have some actively managed funds. When you’re picking a fund, it’s important to understand if it is an index fund or not. If it’s an actively managed fund, understand how they pick their investments.
Below we’ll look at some online tools that make these comparisons very easy. I’ve covered the above steps in some detail, however, because we should never use a tool without understanding how it works. Furthermore, the above factors will help us use these tools more effectively.
Morningstar Compare Tool
The Morningstar Compare Tool is free and enables you to quickly and easily compare two or more mutual funds. You simply put the ticker symbols of the funds you want into a box. In the screenshot below I’m comparing to foreign funds: Vanguard Develop Market Index Fund (VDMIX–a Vanguard index fund) and Dodge and Cox International Fund (DODFX–an actively managed foreign fund).
Why have I picked these two funds to compare? Let’s assume you’ve done your research, read books, maybe even listened to my podcast, and you really like that Vanguard Develop Market Index Fund. The problem is that it’s not available in your 401(k). But let’s assume that the Dodge and Cox International Fund is available to you in your 401(k). So you want to compare the two funds to see if DODFX might be a suitable alternative to VDMIX.
The tool gives you a number of ways to compare the funds. The first screen gives you a snapshot of both funds (see image above). The snapshot includes the “Morningstar Category,” which tells you if the funds cover the same asset class. It also gives you each fund’s expense ratio. Then you can also compare the funds based on performance, risk, portfolio and minimum investment requirements (what Morningstar calls the “Nuts & Bolts” of a fund). Here’s a screenshot of the Portfolio tab:
While the tools is a great way to compare two or more funds, you must know the funds you want to compare. What if you want to find all mutual funds that are similar to a particular fund? Morningstar has a tool for that as well.
Morningstar Find Similar Funds Tool
The second tool is a little more sophisticated. It’s called the Morningstar “Find Similar Funds” tool. Access to this tool does require a premium membership with Morningstar.
With this tool, you need just one mutual fund. When you enter the fund into the tool, the output looks like this:
As you can see from the image above, the tool then finds similar funds based on a number of factors. In the case of the Vanguard Develop Market Index Investor Share Fund, Morningstar identified 26 results and provides a ton of comparative data on each fund, along with a “Similarity Score” for each fund. Hopefully, you can find one of these options in your 401(k) that can satisfy your asset allocation plan.
So I hope you find these tools helpful. I think they are a great way to make the research of funds easier and more effective. It will show you funds that, on your own, you’d never find. It can be a great way to research 401(k) options and to compare them to perhaps funds you’d like to buy.
If you use the tools, leave a comment below and let me know what you think and if you find them helpful.