Suze Orman Money Matters

Talk about taking a good idea and running it into the ground. Mutual funds are supposed to be the ultimate "simple" solution for investors who don't have the time or interest to choose and track individual stocks. The concept couldn't be more straightforward: invest in a stock fund and you become a shareholder in a diversified portfolio of dozens of stocks overseen by a professional money manager; or, plainer still, you can go with an index fund that merely tracks an overall market barometer such as the Standard & Poor's 500.

Seems simple enough, eh? If only it were so. To invest in a mutual fund these days is to be faced with choosing among more than 4,000 stock funds assigned to an alphabet soup of categories and sub-categories representing an ever-expanding panoply of investment styles.

What the heck is simple about that? No wonder so many potential investors are sitting on the sidelines. It's totally understandable to become paralyzed with such a confusing world to maneuver through.

Until now. Stick with me for a few minutes and I will cut through all the confusion and show you how to choose the right funds for your 401(k), Roth IRA, and regular investing accounts.

The One-Stop Solution: Invest in a Broad-Based Stock Market Index Fund

Okay, I know that even a simple step-by-step explanation of mutual funds is not going to cut it with some of you. You know you need to be investing in your 401(k) and IRA, but you so don't have the patience to do a little homework and figure out the best options. Fine. Here's the cut-to-the-chase advice: Invest in a broad-based stock market index fund. And then fuggetaboudit.

Instead of having to bet on the talent of a professional money manager to pick the right stocks, an index fund is a bet on the market. Period. When the market goes up, your index fund will go up. When the market goes down, your index fund will go down. Plain and simple. So what's so great about an index fund? Well, for starters, consider that over the long term very few mutual fund managers who actively buy and sell stocks manage to beat the most popular broad-based index, the S&P 500, which holds 500 blue-chip U.S. stocks. So over the years simply sticking with an index means you have an excellent chance of doing better than the typical managed stock fund.

And the long-term average annual return of an index like the S&P 500 is about 10 percent. If you simply put $4,000 a year in a Roth IRA invested in a stock index fund that averages a 10 percent return over the next 30 years, you will end up with $723,000. Even if that return drops to an average of 8 percent over the next few decades, you would still finish with a tidy nest egg of nearly $500,000.

Right now, Vanguard and Fidelity are in a pitched battle for your index fund investments. The whole index game comes down to who charges the lowest annual "expense ratio," which is the ongoing fee all investors fork over to the fund each year. (More details on expense ratios in a minute.) Vanguard's index funds, which require a $3,000 minimum investment ($1,000 for an IRA), charge as little as 0.18 percent, which is amazingly cheap when you consider the average actively managed stock fund has an expense ratio of more than 1.5 percent. But Fidelity's Spartan index funds have recently dropped their expense ratios to an even better 0.10 percent, though you need $10,000 to get started, even for an IRA.

If you truly want a one-fund solution, I would recommend investing in a "total" stock market index or an "extended" market index. These funds own an even wider array of stocks than the S&P 500, which is focused on large established companies. The broader total and extended market indexes also hold mid-size and small stocks; it's a great way to get exposure to all strata of the U.S. market.

Now I know some of you may not have index funds in your company 401(k)s. You and your colleagues should bug your HR department to get index funds added. But in the meantime, let's focus on some simple solutions for you. Look for a fund in the plan that says it invests in "large-cap" stocks. If the plan offers both a large-cap "growth" and a large-cap "value" fund, I'd recommend splitting your money between the two. I'll explain growth and value funds in more detail below, but I don't want to get bogged down here since I promised this was the Simple Solution section of the article.

Another 401(k) option to look out for what are variously called "life-strategy," "life-cycle," or "target" retirement funds. Many 401(k)s offer these funds for participants who don't want to spend the time to build a portfolio of multiple funds. With these offerings, you choose a fund that is targeted to your current age, and the portfolio you get is geared to your investment time horizon. If you are in your 20s or 30s, your fund is going to be mostly invested in stocks. If you are in your 50s, your fund will have a more conservative bent that includes a higher stake in bonds. To be honest, I am not the biggest fan of these funds because I really don't like bonds that are held in a fund (full explanation below); but, that said, I would certainly want you to invest in one of these funds rather than not invest in your 401(k) at all.

Fund-amentals

Alrighty, now that we've taken care of everyone with a super-short mutual fund attention span, I want to dive into a bit more detail on how to analyze mutual funds. Don't worry, this is not really that hard, nor is it terribly time-consuming. It all boils down to four simple factors...

• Expense Ratio
• Loads
• Portfolio Focus
• Track Record

Oh sure, if you want to dive deeper, there is a ton of analysis you could do -- but I truly believe if you nail these four fund fundamentals you are going to be just fine.

Expense Ratios
Every fund charges an annual fee to cover its operation and management fees. The fee is subtracted from the fund's gross return before you see the net return that your account earned, so it never shows up in any statement as a cost you paid. But precisely because it isn't easy to "see," it's crucial to know exactly what you are paying every year to be invested in that fund.

The average expense ratio for a managed stock fund is about 1.5 percent. But remember that many index funds charge less than 0.20 percent. That difference in the expense ratio is one of the main reasons that the average managed fund has a tough time beating index funds over the long term. Just think about it for a sec. Two funds each post a 10 percent return, but one fund has 1.5 percentage points shaved off to pay the expense ratio, while the other fund has just 0.20 shaved off. That reduces their net returns to 8.5 percent and 9.8 percent, respectively. That's a huge difference. A $10,000 investment that compounds at 8.5 percent for 20 years will grow to about $51,000. If the rate of return is 9.8 percent, the investment will grow to nearly $65,000. I hope that got your attention; the moral, obviously, is that expense ratios are a huge deal!

You can check out a fund's expense ratio by entering the fund's five-letter ticker symbol in the Yahoo! Finance Quote Box, and then click on the Profile link on the left side of the page. The expense ratio information is on the right side of the page underneath the header Fees & Expenses. What's really great is that the Yahoo data tells you how each fund's expense ratio compares to similar funds.

Loads
In addition to the annual expense ratio that every fund charges, there are also some funds that charge additional sales fees. Funds that hit you up with a sales commission are called "load" funds. Funds without the sales fee are called "no-loads."

I can't stand load funds. The load is used to pay the broker or adviser who sells you the fund. But, come on, ask yourself whether the broker who sold you the fund has anything very meaningful to do with the performance of the fund. The answer to that question is no. It is just like a car sales person. Does the person who sold you your car have anything to do with its performance? Nope. It is the manufacturer and the mechanic who determine how well your car operates. The mechanic of a mutual fund is the portfolio manager, not the sales person. Every mutual fund has a portfolio manager whether they are a no-load or a load fund, and these portfolio managers are paid from the expense ratio that we talked about above. My point is that paying a load in no way affects the performance of a fund.

There are two types of load funds: a "front-end" load fund and a "deferred-sales" load fund. You can easily spot both by their names. A front-end load fund will have an "A" on the end of its name. This type of load fund charges you a commission right when you invest. If the fund has a 5 percent load, and you invest $10,000, you will only really have $9,500 put into your account, since 5 percent ($500) went to pay the broker/advisor. A telling way to look at this is that if you buy an A share fund with a 5 percent load, it has to go up about 5.25 percent just for you to break even ($10,000). But if you invest $10,000 in a no-load, all $10,000 goes to work for you, so a 5 percent gain means you will have $10,500.

The other type of load fund is even worse. They are known as B share funds (yep, there's a B at the end of their name). The sales spiel on B share funds usually tries to sweet talk you by claiming that if you just stay invested for a set period -- typically five years -- there will be no sales commission. This is incredibly deceptive. Let me explain.

When the broker sells you a B share fund, he is not doing it out of the goodness of his heart. Even though you don't pay a commission right when you invest, the broker indeed gets paid a commission by the fund company. And you better believe the fund company is going to make sure you pay them back for this expense. How do they get their money back from you? Remember a few minutes ago I mentioned that all funds -- both no-loads and loads -- charge an ongoing annual fee called the expense ratio? Well, with a B share fund your expense ratio is going to be super-big to get back the money they advanced the broker.

In fact, the expense ratio on a B share fund can be double that charged on a front-end load fund. And that expense ratio is charged every year for as long as you are invested. It is insanity to pay 1.6 percent or close to 2 percent a year in an annual expense ratio (and that's typical for these B share funds) when an index fund charges under 0.20 percent.

But wait, we're not done with the bad news on B funds. The fund company also wants to make sure it's protected if you sell the shares before it has time to recoup, through the higher expense ratio, the cost of the commission it paid to the broker. So that's where the "deferred" sales commission comes into play. This is charged during what is called the "surrender period" for the fund, which again is typically five years. What this means is that if you sell your B shares at any time within the surrender period, you will be stuck paying a sales commission on the money you pull out. The commission is called a "surrender charge"; it can start at about 5 percent, then declines one percentage point each year until, after five or six years, you are finally released from its clutches.

You get how it works: either from the inflated expense ratio or the deferred sales charge, the fund company is going to get you to pay for that broker's commission. So please, don't fall for the crap that B shares won't cost you anything. They are the costliest fund investment out there! Just look at any fund that has both A share and B share options. The A share fund, when you compare annual performances , will typically outperform the B share fund. Why? Because the expense ratio is subtracted from performance. So if each fund returns 10 percent gross, but the A share fund has an 0.80 expense ratio and the B share fund has a 1.6 percent expense ratio, the net return is 9.2 percent to the A share investor and just 8.4 percent to the B share investor.

And please realize that if you stay in a B share fund past the surrender period you are still going to be stuck paying the huge expense ratio every year -- it never goes away.

The bottom line is that B share funds are just a deceptive way for brokers to try and snooker you into believing they are selling you a "no-load." What a huge lie! In my opinion, whenever you see an A or B after a fund's name I want you to just say N-O. A true no-load fund with a low expense ratio is always the better way to go.

Portfolio Focus
Like the menu at your favorite Chinese restaurant, there are a multitude of fund dishes you can choose from. While funds can own stocks, bonds, or both, I am just going to concentrate on the world of stock funds for now. When you are investing for 20, 30, or more years down the line, your money belongs in stocks, not bonds. Besides, as I explain below, I am not a big fan of bonds inside of mutual funds.

Each mutual fund has two major personality traits: the size of the stocks it owns, and the investment philosophy of the manager.

Let's deal with the size question first. Stocks within funds come in three broad sizes: large-cap, mid-cap, and small-cap. A large-cap stock is a big established company. Think of it as a mature adult. A small-cap stock is a young kid; it tends to be a newer company that still has considerable growing up to do. If the company is successful, those growth spurts can translate into big stock gains. But there is no guarantee that a small-cap fund will be able to grow into a large-cap. That's the trade-off: you tend to have great potential gains with a small-cap, but you also have to stomach more risk than if you were invested in established large-cap stocks. And mid-caps are the young adults; they aren't a kid, but they also aren't a fully grown large-cap either. So you have some of the growth potential of a small-cap, with a bit more of the stability of a large-cap.

Now in addition to those size issues, we have to deal with the manager's investment style. Again, we've got three broad choices: growth, value, and blend. A growth manager invests in stocks that are expected to have strong earnings growth. A value manager invests in stocks that he or she believes are selling below their value. With a growth stock the bet is that it will go from a decent price to a great price. With a value stock you are buying when the price is excellent (meaning low) with the expectation it therefore should rise strongly, even if probably not to the exceptional heights you might get with a successful growth stock. No surprise that growth stocks tend to be more volatile than value stocks, given the higher expectations. Which brings us to blend managers, who strive to achieve a balance between possibility and risk by blending growth and value investments.

Each fund is assigned to a category based on the size of its securities and the manager's investment style. There are large-cap growth funds, large-cap value funds, large-cap blend funds, mid-cap growth funds, mid-cap value funds, etc. One thing to be aware of is that not all mid-cap funds own only mid-cap issues; quite often they own a mix of large, small, and mid-cap issues, so that their average market cap falls in the mid-cap category. For example, the Vanguard Extended Market index fund has 11 percent in large-cap issues, slightly less than 40 percent in small-cap issues, and about 50 percent in mid-cap. The net result is that Morningstar, the mutual fund data company that supplies info to Yahoo, categorizes the fund as a mid-cap blend fund.

How to sort through all that info, without tearing your hair out? Don't worry, there's no rule that says you must own one type of every fund. I recommend that large-cap funds should be the core of your fund portfolio. A fund like the Vanguard Total Stock Market index has about 80 percent of its assets in large-caps. Or if you want a bit more growth potential, the Vanguard Extended Market that I just mentioned tilts more toward smaller and mid-size firms.

And please don't think that more is better with funds. If you have one or two index funds, or you pick a few different types of actively managed funds, that's all you need. The goal is to make sure that each fund you own complements the other, rather than being carbon copies. For example, if you own five funds and all five are large-cap growth stocks you do not have a smartly diversified portfolio. It's like having a closet full of basically the same outfit.

Once you have your core investments in place, it's up to you if you want to add some complementary funds. I think it can be smart to invest 15 percent or so of your fund assets in one that specializes in foreign stocks. We live in a global economy, so it makes sense to have exposure to investing opportunities outside of the U.S. Now, that said, it's also important to realize that if you own a large-cap fund you already have some foreign exposure, since many of the largest U.S. firms make a chunk of their money from foreign sales and operations. Still, adding a pure foreign fund can be a nice complement to your fund portfolio.

Track Record
This is where most investors trip up and make some very costly mistakes. It is perfectly natural to want to size up a fund's performance, but the problem is that investors tend to be ridiculously short-sighted. You get all excited about a fund that topped the performance charts for the past month, or year, rather than looking at what is really important: does the index fund, or its manager, have a long-term history of doing well?

The only performance figures you should ever pay attention to are the three-year, five-year, and, if possible, the 10-year numbers. Funds are a long-term investment, so you want to hook up with a portfolio (and manager) who has shown an ability to make money over years, not weeks. The inevitable list of hottest funds for the year is for suckers who want to chase the hottest hand. I would only invest in a short-term hot fund if it also has a strong long-term record too.

When sizing up a fund's performance you want to see how it rates relative to other funds with a similar investment approach. This is where those fund categories come in handy: if you are sizing up a large-cap fund, you want to know how it has done relative to other large-cap funds.

When you check out a fund at Yahoo (just enter the five-letter ticker symbol), click on the Performance link on the left side of the page. There's a ton of great info right there; you can see the longer-term performance of the fund, and how that rates compared to its category average. And be sure to scroll down to the annual return numbers. One problem with the long-term average annual returns is that they can mask a lot of volatility: a fund with a great three-year average return could in fact have had one phenomenal year and two just so-so years. Looking at the actual annual returns gives you a sense of whether a fund consistently outperforms its peers -- or just gets lucky once in a while.

And at the bottom of that page is a fund's rank within its category. Ideally you want a fund that consistently ranks in the top 40 or 50 percent of its category class over the longer time periods. Notice I didn't say the top 10 percent. That's too high a bar to set. You will do plenty well if your fund has the ability to stay in the top half of its class; it's simply unrealistic to expect that it should always be right at the front of the line.

If you go with an actively managed fund, rather than an index, you also want to check out how long the current manager has been running the show. If a fund with a great five-year record has a manager who has been at the helm for just one year, you need to be cautious. That doesn't mean you shouldn't invest in the fund; rather, you just need to dig a bit deeper. Who's the new manager? Someone with a great track record at another fund? Or someone who was an assistant to the lead manager for a bunch of years? Or is it someone with absolutely no track record or reason to give you confidence? To find out about a manager's tenure, click on the Profile tab on the left side of the Yahoo! Finance Mutual Fund Quote Page (take the Quote Page for Vanguard 500 Index (VFINX), for instance).

What about Bonds and ETFs?

So, you ask, "What about bonds and ETFs?"

A Bonding Moment
Earlier I mentioned that I am not a big fan of bond funds. Here's why: The beauty of owning bonds directly is that if you choose a high-quality bond you are pretty assured that when the bond matures you will be repaid your entire initial investment, or "principal." So not only do you get the periodic interest payments from the bond, but there's an extremely high probability you will get your principal back. In fact, if you invest in a U.S. Treasury bond, you are guaranteed to get your principal back at maturity. And when you buy a bond directly, you lock in the interest rate for the entire length of the bond. If you buy a 10-year bond with a 5 percent yield, you will get 5 percent for the next 10 years.

But a bond fund is different. That's because there's a manager at the helm who is actively buying and selling bonds rather than buying and holding them until maturity. So you lose the certainty of getting your principal back. And by the way, you have to pay that manager; the typical expense ratio on a bond fund is about 1 percent. You're lucky to get a yield of 4 percent on a high-quality Treasury bond fund and you're going to give back one quarter of that performance in a fee? That just doesn't make sense to me.

Granted, with a talented manager all that buying and selling can produce returns that exceed the buy-and-hold strategy of owning a bond directly. But there's no guarantee of that. Moreover, there is no locked-in interest rate. The yield on the fund will fluctuate based on what the manager happens to own at any particular time. When rates are falling, a bond fund's yield is going to fall too. Whereas if you owned a bond directly, your higher rate would still be locked in for as long as you owned the bond. Back in the days when I was a financial advisor, I had clients buy 30-year Treasury bonds in 1980 yielding more than 14 percent. I guarantee that no long-term bond fund today has a 14 percent yield -- you're lucky to get 5 percent -- but anyone who bought one of those 30-year bonds is still getting their 14 percent!

Of course, there's the reverse scenario that can work against you when you own directly: when interest rates are rising, the interest rates of a bond you own directly is not going to rise. You will be locked in at your same lower rate. That's why you want to have a laddering strategy where you own a few different issues that mature every few years; then you can periodically reinvest at higher rates. Between laddering and having the assurance of getting your principal back, direct investment in bonds beats bond funds any day. After all, the whole point of bond investing is to not take risks. Bonds are designed to bring safety and stability to your overall investment portfolio. So I wouldn't use bond funds. Instead, go to www.treasurydirect.gov; it's a great site that will walk you through how to buy U.S. Treasuries directly.

A Smart Fund with a Twist
I think low-cost no-load mutual funds are a terrific investment, but I've got an even better alternative I want you to consider: Exchange Traded Funds (ETFs). An ETF is an index fund that has an even cheaper expense ratio. The other difference between a regular index fund and an ETF is in how you buy and sell them. An index fund is priced just once a day, after the market closes at 4 pm EST. You can call your fund company at 11 am and request to buy or sell shares, but your trade will not be processed until the end of the day when the fund is "priced." So let's say you see the market is down 5 percent and you want to sell some of your fund shares. You call at 11 am and place the order. But between your call and the market close, the market drops another 5 percent. The loss on your trade is going to reflect the entire 10 percent drop, because the fund price will be calculated at the end of the day. There is no ongoing pricing while the market is open.

With an ETF you get constant pricing throughout the day. An ETF is basically like a stock, but you are invested in an entire index. Just like a stock, you can buy and sell based on the market price at the time you request a trade. You sell at 11 am and you will get the market price when your order is placed. No waiting until the bell at 4 pm.

Now I hope all of you are focused on the long term and aren't trying to time every little twist and turn in the market, but even for a patient investor the extra flexibility of ETFs can be very useful at times. And they are cheaper, which is why I really love them. The biggest ETFs are iShares funds. And Vanguard also has ETF carbon copies of its index mutual funds. You can learn more about ETFs at the Yahoo! Finance ETF Center.

The one ETF catch is that you must buy them through a brokerage or discount brokerage. So every ETF trade is going to cost you a commission. Even if you use a terrific low-cost discount brokerage, I wouldn't recommend an ETF if you are investing every few weeks or once a month; those brokerage costs are just going to eat up your investment. An ETF is best used when you have a lump sum to invest once or twice a year. If you are making periodic investments -- what's known as "dollar cost averaging" -- I would stick with an index mutual fund.