Picking the best mutual fund: Good fund vs Good-for-you fund

Picking the Best Mutual Fund

I am 21 years old and I need some mutual fund help.  I am currently invested in OINCX, OCGCX, and OGHCX.  Are these good mutual funds ? Seems like the expense ratios are high.

-Leonard P.

Hi Leonard,

It’s great that you’re getting started on investing so early in your career.  Time is one of the most valuable things you can give your investment portfolio due to the substantial benefits of compounding returns.

There are a number of factors you should consider when judging whether or not mutual funds are “good” and whether or not they are good for you personally.

Factors that make a mutual fund good

1.  Low expense ratio – This is the percent of assets under management that the fund manager takes each year as a fee for managing the fund.  If a fund has an expense ratio of 1% and you invest $1,000, every year the fund manager will take $10.  This fee is taken by adjusting the price per share of the mutual fund so you won’t actually see a $10 charge, but you’ll still be effectively paying it.  There are great index funds (funds that passively invest in the market index) that charge about 0.10% and great actively managed funds (managers decide which stocks or bonds to invest in) that charge 0.75% or less.  If your fund is charging more, you’re probably paying too much.

2.  Strong Performance – One of the main reasons to choose a mutual fund over picking stocks yourself is to let a professional do the work for you (you’re paying for it with your expense ratio!) so be sure to look at a fund’s performance.  For an index fund, look at how closely the performance of the fund tracks the market index (Beta = 1 means perfect correlation).  For an actively managed fund, look at how much the fund manager has outperformed (or underperformed) the market index.  This measurement is called Alpha.  Risk taken should also be considered when evaluating an active manager’s performance.  The Sharpe ratio looks at a manager’s returns in excess of the index while adjusting for the amount of risk taken.  It’s preferable to have a manager who not only can achieve high returns, but who can do so while keeping risk (volatility) as low as possible.  While past performance is no guarantee of future results, you should probably avoid index funds that haven’t been able to track the index or managers whose returns don’t justify the risk they’ve been taking.

3.  Sticks to their Area of Expertise – When Bernie Madoff was arrested for defrauding investors, it was soon revealed that many funds that were representing themselves as “diversified multi-strategy” funds were actually investing all their money in only Madoff.  While frauds like this are uncommon, what is common is for mutual funds to deviate significantly from their stated strategy.  This mission creep can wreak havoc on your carefully optimized portfolio so be sure to take a look at the actual stocks the funds has invested in previously to be sure your manager is honoring the mandate.  For example, if you are investing in a healthcare mutual fund and see that they have held large positions in Facebook and Apple, you should probably stay away because you have no idea what they’ll invest in going forward.

To judge whether or not a mutual fund meets these criteria, we’ve created a mutual fund screening tool that allows you to screen and sort by Expense Ratio, Alpha, Beta, Risk-adjusted Return, and much more.  We’ve also created lists of top performing mutual funds over the past decade.

Even if a mutual fund is “good,” it may not be good for you.  You need to consider your own circumstances before choosing a fund, including:

1.  Your age – If you have many years until retirement, you can afford to take greater risks to pursue greater returns than someone who only has a few years to go.  This is because if something goes wrong your portfolio will have longer to recover or you can adjust your spending or work harder or longer to make up the loss.  These are not options you have when you are nearing retirement.  A mutual fund that is good for you would be a good risk-reward match for your age.

2.  Your risk tolerance – Do you love to take risks or does having money in the stock market keep you up at night?  Make sure your mutual fund’s risk-reward profile matches not only your age, but also your personal risk tolerance.

3.  Your industry – Do you work in technology?  If so, you may be inclined to invest heavily in technology because of your familiarity with it, but you should probably do the opposite and underinvest in technology relative to other sectors.  Regardless of your industry, if you invest heavily in the industry that signs your paycheck then you are essentially doubling down on the success of that industry.  It could do well and you will reap the benefits, but its an unnecessary risk.  If the industry tanks, you could lose both your job and your investments.  Instead, think of your income as one piece of your global portfolio and make sure you are well diversified.

4.  Your other holdings – Do you have nothing but U.S. index funds in your 401k?  Then maybe the best mutual fund for you is an international or emerging markets fund.  Or maybe you are heavily concentrated in one sector or investment style, making other sectors and investment styles a more attractive addition to your portfolio.

In short, the best mutual funds are both great funds on their own, due to low expense ratios and great risk-adjusted returns, and great for your personal circumstances, meaning that they meet your risk-return needs and fill in the holes in your portfolio to make you well diversified.

So what are some good funds?  You mention three funds in your question:  OINCX, OCGCX, and OGHCX.  Let’s take a look on how they stack up:

Symbol Name Bonds Stocks Expense Ratio 5 year return Volatility Risk-adjusted Return
OINCX JPMorgan Equity Income Fund 20% 80% 1.54% 5.81% 24.01%  0.24
OCGCX JPMorgan Investor Conservative Growth Fund 70% 30% 1.01% 4.30% 6.98%  0.62
OGHCX JPMorgan High Yield Bond Fund 80% 20% 1.80% 8.61% 6.14%  1.40

The expense ratios on these funds are a bit high and the returns lag the market (high yield bonds returned 9% and stocks returned around 8% over the same period).  Since these funds really haven’t justified their above average costs over the past five years, I personally wouldn’t continue to pay for it going forward, but the underperformance isn’t horrible (at least on the bond fund) so it’s really up to you.  Who knows?  Maybe you will roll the dice and stick with these funds and they will more than justify their expense over the next five years.  Unfortunately, the odds are not in your favor and  I personally would opt for a low cost bond index fund like the Vanguard Long-Term Bond Index Fund (VBLTX) which charges only 0.20% expense ratio and achieved a similar 5 year return.  Vanguard also has a great low-cost equity index, the Vanguard Total Stock Market Index (VTSMX), which charges only 0.17% expense ratio and returned nearly 8% over the past five years.

Whether an equity fund or a bond fund is better for you depends highly on your personal circumstances.  You say that you are young so it’s likely you can tolerate a higher than average amount of risk in pursuit of higher returns.  The typical rule of thumb is to subtract your age from 120 or 100 to get the percentage of your portfolio that you should invest in equities.  In your case that would be 79-99% of your portfolio in stocks and the rest in bonds.  Maybe put 85% of your money in a good equity fund like VTSMX and the other 15% in a great bond fund like VBLTX.  Just remember to take into account any other assets or income streams (like your salary) and to construct a well-diversified global portfolio.

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