Investing can be intimidating. There are so many things we need to seemingly keep in mind. You need to be diversified, you need to make sure you’re invested across segments. Don’t forget about yields. Exchange Traded Funds vs. Mutual Funds. All these words. There are over 10,000 mutual and exchange traded funds in the US. There are thousands of companies you can invest in, globally. Where should you even start? What criteria should you be looking for? It feels impossible to pick the right ones. In this article I’ll break down the criteria for a good fund to be invested in.

Nearly everyone should have a broad based, indexed, passively managed, low cost fund as the backbone for their portfolio. But what the heck does a broad based indexed passively managed low cost fund even mean, and why? In this article I’m going to break down what these string of words mean and the funds I personally invest in.

Its important to note that I’m not providing specific investment advice. I am providing general information and entertainment. The information provided in this article is not specific advice to anyone, just informational.

A good fund to be invested in? One that is broad based.

The first criteria to look for is a fund that is “broad based.” But what’s broad based mean? Broad based means that you want to be diversified, but on a lot of levels. The first level is about having several or many companies, the second level is having those companies in different industries or “segments”. Finally you want some of those companies to be from different countries or do business globally.

Several?

But how many makes several? Experts say having 20 to 30 companies is a good number for diversification. I think 20-30 is just cutting it too close. In the referenced article, the experts say that by picking 20 to 30 well established, researched companies with strong track records in 7 to 8 different sectors (we’ll get to what sectors are in just a moment) you’ll offset your risk (the chances for losing money). I personally feel that owning just 20 to 30 companies isn’t broad based enough. I like investing in funds that have at least 100 companies within it.

Why 100?

What a broad based fund tries to do is throw off risk. Have you ever heard the phrase, “don’t put all your eggs in one basket”? What this phrase encourages us to do is to put our proverbial eggs in several different baskets. It warns against making a single bet and hoping it pans out. Its a bit like how Mr. Moneyaire and my gambling strategies differ. I like picking a lot of numbers, and placing corner and side bets. Mr. Moneyaire plays a very particular set of numbers, hoping one of them will hit. I have a much better chance of staying in the game and walking away with more money than I started. Mr. Moneyaire loses all his money after a few spins, but when he hits, he hits big (though not as often as either of us would appreciate).

When a fund has about 100 companies, the asset manager (the person or team who does the picking) can pick a lot more duds and still make money. 100 is my layperson number. When just 20 or 30 companies make up a fund, there’s a lot more risk that the wrong companies are in the fund. Remember that most expertly, professionally managed funds often are wrong with their picks and they lose money. They will NOT beat the market most of the time.

So pick a fund with lots of companies in it. I like going with funds with at least 100 different companies. The experts like 20 to 30. But another point to make is that these companies should be in several different sectors.

Sectors, Segments, Industries etc.

A sector means the area the company does business in such as healthcare or finance/banking. The words segment, industry and sector basically all mean the same thing. And “sectors” can be made up of several different “sub-sectors.” For example, the healthcare sector can be made up of sub-sectors of hospital groups and pharmaceutical companies. If you’re in a fund where all of the companies are in the same sector, i.e. all 50 companies in the fund are banking companies, that’s a problem. Though it may be diversified in the number of companies, its not diversified in the number of sectors. It means its not a broad based fund. Although the fund has a large number of companies, its only in one sector.

A good fund to be invested in that makes up the backbone of your portfolio should be invested in several companies, AND those companies should come from various sectors, such as healthcare, technology, consumer products/services, financial services, utilities, etc.

Here’s Why

Let’s pretend that it’s 2006 and you decided to go with a fund that picked about 20 companies to invest in, mainly in two profitable sectors of finance and retail. In the finance sector, they’ve slotted in Merrill Lynch and Lehman Brothers as the largest holdings. The other banks/financial institutions included Wachovia, JP Morgan Chase, AIG, and some regional banks. In the retail sector they’ve put in Sears Holdings as the headliner with Macy’s, Kohls, Gap, Nike and a few other smaller brands.

I know what you’re thinking – Mrs. Moneyaire those were stupid picks. But hear me out, back in 2006 those were strong companies. They were prestigious corporate companies. It would have made sense to pick those companies to be part of a strong portfolio. But now several of the above companies don’t exist as they did back then. Sears and Lehman Brothers went out of business, Merrill Lynch was bought by Bank of America and Wachovia was bought by Wells Fargo as they both faced the same fate as Lehman. The fund that invested in them would most likely have vanished.

Not that your money would have entirely vanished with it – whatever was left of your investment might have been rolled into another fund. Mutual funds every year “disappear” because they did so poorly the managing companies would rather dissolve them than report how terribly they performed.

Although the fund was invested in 20 companies, they weren’t in enough sectors. Investing in various sectors helps spread the risk of losing money.

How Many Sectors?

According to the Money article, experts say 7 to 8 sectors is a good number of sectors to spread the companies around in. I believe that to be fair and that spreads your risk around a bit. I wouldn’t limit it to that number though. 7 to 8 is a good starting point. And what should those sectors be? Good question. I’ll get to that more when we talk about indexing.

Indexed

An indexed fund basically means that it buys, holds and eventually sells shares of companies based on specific financial or economic data. Typically, its based on company market size.

So for example, let’s say we want to create our own fund. We want our fund to be made up of all companies in our fictional stock market based on their market capitalization. Market capitalization means how much a company is worth based on how many shares its issued or put out on the market and what the price of that share is going for.

So if a company named Gala has 1,000 shares it’s issued and they currently sell for $100 a share, it’s market cap is $100,000. If the entire market has a value of $1,000,000 then Gala makes up 10% of the market. So we would want Gala to make up 10% of our fund. If McIntosh Company made up 8% of the market, we’d want it to make up 8% of our fund and so on and so forth until our fund reflected the entire market. In a very basic sense, this is how indexed funds figure out how much and which companies to invest in when they index.

When a fund indexes on a market, the fund will buy more of the big companies and less of the smaller companies in regards to the parameters it sets. Its an important criteria for a good fund to be invested in. I would rather have lots of exposure to the big successful companies rather than the smaller unproven ones. However, I still want exposure to them. You never know when the next Amazon will surface.

So why is indexing a good thing?

I personally like (truly) indexed funds that track the S&P 500. A lot of my personal investments are there. Why? well a few reasons:

• It automatically includes larger percentages of the bigger more stable companies.
• When a fund indexes a large portion of the market, i.e. is a market index fund, it’s probably going to be diversified globally, sector-wise and on the number of companies.
• Most importantly, indexing takes the human emotion out of buying and selling.

Human Emotion

There is a popular saying that investors should buy low and sell high. However, in reality most investors, both professionally and amateur do the opposite. They buy high and sell low. The excitement when a stock is going up and up and up… that’s when people buy. I’ve gotten caught in it myself. We get FOMO – the fear of missing out. When stocks are going up, most people only think of the upside. They worry about sitting out on the sidelines while everyone else is getting rich. We get caught up and buy. Then, when stocks start falling, people get scared and sell, many times at a loss. They worry about getting back into the market for fear it’ll go down further and miss the recovery.

Most funds that aren’t indexed suffer from this bias. Typically, most non-indexed funds won’t beat the market consistently in the long run. In 2008 the world’s most successful active fund manager, Warren Buffet, bet hedge funds (a company specializing in picking stocks for superior results and for superior costs) that they wouldn’t be able to beat the market. The hedge fund company, Protege, took Warren up on the offer. By 2015 the hedge fund admitted defeat, ahead of the 2017 deadline. Hedge funds are the ultimate in stock picking hubris and are good reason to stick with passively managed funds. This gets me to my next criteria for a good fund to be invested in.

Passively managed

It could be the case that an entire sector or kinds of business will have a challenging time. For example, during COVID-19 the entire travel and leisure sector came to a near standstill because people weren’t traveling, globally. During that time there was fear, for example, that some of the big cruise lines, like Royal Caribbean Group, wouldn’t stay in business. Certain hotel groups, airlines etc. were looking for government assistance just to stay in business.

Though travel and leisure eventually rebounded, it was a scary time. Even if you as investor rode through the turmoil and didn’t sell shares of your actively managed funds, the fund manager may have sold shares within the fund. They may have gotten spooked and sold shares to stop their losses. Fund Managers have to report how well their fund is performing quarterly. They certainly don’t want to show losses, especially in comparison to their peers. A lot of people, even professional investors, get scared and sell at the worst time. When professional investors sell, they’ll incur costs like having to pay taxes on any gains. So not only are they selling for less profit (if they made any) but then they have to pay taxes on the profits they did make. This all equates to you earning less money.

Actively costing you more

Most broad based indexed funds are going to be passively managed but its worth calling out. I personally stay away from actively managed funds and prefer passively managed funds. Why? Because study after study has shown that actively managed funds, over the long term perform WORSE than their passively managed funds. PLUS, they are more expensive. Actively managed funds need teams of researchers and access to expensive software and/or developers. They also have to market themselves so that potential investors know about the fund. Advertising, marketing, attracting financial advisors to push their funds – it all costs money. A passively managed fund will incur a fraction of the costs an active one will, which gets me to my next criteria.

Low Cost

When a fund is passively managed, indexed and broad based, it’s most likely going to have a super low fee. Fees are super important when making investment decisions. The saying “you get what you pay for” which implies you get poorer performance when you pay less does not apply to investing. We’ve already shown that actively managed funds in which stocks are painstakingly selected aren’t likely to beat the market year over year. Paying more money to have your money in a higher cost fund won’t net you better investment results.

But let’s do the math. Let’s pretend that we put $100,000 in Fund A, a low cost .03% fee fund and another $100,000 in Fund B, a fund that charges 1%. Let’s assume a 10% rate of return for 20 years for both funds.

After 20 years an initial $100,000 investment earning 10% a year gets you $608,430 when charged a .03% fee versus $514,166 when charged a 1% fee. That’s a $94,000 difference! The lower fee fund did nearly 20% better based on fees alone.

Fees on top of fees

If you’re working with a financial advisor, they’re probably charging you an AUM fee, or assets under management fee. In this cost structure, your financial advisor will charge you a percentage fee based on how much you have invested with them.

My fee with my old financial advisor was .75%. The funds he had invested me into charged around 1% in fees. Between his advisory fee and the fund fees, I was paying nearly 2% in fees every year, or about $2,000 on every $100,000. When I asked him to move my investments into low cost broad based indexed passively managed funds, he balked. He said I didn’t need him if that’s the route I wanted to go. So, I left him, his .75% a year fee and the high fee funds he had invested my money into. This one move has saved me tens of thousands of dollars. The money I have saved has grown exponentially without him.

What is a good fee?

No fee! If you have accounts at discount brokerage houses like Schwab, Fidelity or E*Trade you’ll have access to NO FEE funds that track the S&P 500 or the entire US Market. That’s something you should entirely take advantage of! By taking advantage of these funds you get the benefit of growing with the top 500 companies or the entire market for free!

If your brokerage doesn’t offer fee free funds, honestly, consider moving brokerage accounts. Otherwise, I typically stay away from funds that have more than a .20% expense ratio and target ones that charge .05% or less. The index funds I’m currently invested in charge about .03% in fees or less. The less you pay in fees, the more money you’ll have to invest and make more money for you. We’ve already covered that more expensive actively managed funds don’t do as well as the passive ones. If you invest in an actively managed fund that doesn’t beat a fund that indexes against the S&P 500 its a double whammy of having spent more for less performance. Yuck! I want you to be an unapologetic cheapskate when it comes to investment fees.

A good fund to be invested in

When you’re trying to figure out which fund to be invested in these are the criteria to zero in on:

• Broad based – look for a fund that’s diversified in the number of companies, segments and countries those companies do business in. Remember to look for at least 100 companies and 7 segments
• Take out one of the biggest killers of wealth, I.e. human emotion, and pick a fund that’s indexed. This will also help achieve segment diversification.
• Pick a fund that is passively managed and has low fees. Investing on emotion and paying fees will drag on your wealth.

I personally am invested in IVV, VTI and FZROX. IVV tracks the S&P 500 or the top 500 companies in the US stock market. It’s indexed in over 10 segments and many of the companies in it operate globally. VTI and FZROX track the entire US market. These three funds are ultra low cost; IVV and VTI are at .03% and FZROX has no fees.

Why VTI, FZROX and IVV? Why didn’t I just pick one?

You might think investing in these three funds is redundant. It is. I’m invested in these three very similar funds because of the various platforms we’ve used and are still using over decades of investing and from just learning and testing out the funds. I’ve focused most of our future investments into IVV and FZROX. This is because our accounts are on two different platforms and FZROX isn’t available on both. VTI is just a legacy holding I don’t want to change. It’s held in a non tax-advantaged account and selling and buying into IVV would cause a tax consequence I don’t want to incur. Either one of these funds would be a good fund to be invested in.

Get in to a good fund to be invested in

If you select a broad based, indexed, passively managed low cost fund to invest in, you’ll be on your way to successfully building your portfolio to out perform most professionally handpicked ones.

Cheers!

Mrs. Moneyaire