PART 11: How to Research Funds Like a Pro

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Congratulations! In establishing your asset allocation, you have the cornerstone of your investment plan built, and the biggest decision you will make in portfolio planning behind you. Now that we have an allocation that is suitable for you—based on your time horizon and personal risk tolerance—the next step is to look at the fund options in your various investment accounts, and select those that will best fit your plan. Though fund selection can seem complex, the goal here is simple: select the best funds from your options that match the asset allocation you’ve chosen.

Though fund selection can seem complex, the goal here is simple: select the best funds from your options that match the asset allocation you’ve chosen.

So, for example, if your allocation is 60% U.S. stocks, 20% international stocks, and 20% bonds, your goal is to “fill up” those parts of your portfolio using the best funds you have available. To do this, we need to know how to evaluate funds effectively, and I’m going to show you how in five easy steps. I will also give you a list of some of the best index funds (both mutual funds and ETFs) that I’ve found in my own research.

Before We Get Started

Fund menus may differ widely. Depending on the types of accounts you have, the selection of funds you have access to might be limited. Typically, investors will find their options limited inside employer-sponsored accounts like a 401k, 403b or 457, and have a much wider selection inside IRAs (both Roth and traditional) as well as taxable brokerage accounts. If you find your selections limited inside an account, don’t worry: your goal is simply to choose the best options available. Just do the best you can.

Pay attention to transaction fees. No matter where you’re investing, I want you to be on the lookout for fees. Fees, such as commissions or transaction fees, can be downright corrosive to your returns, and you should always aim to minimize them. As we talked about in Part 8, some brokerage firms charge additional fees for purchasing specific funds—especially if the fund is not issued by that firm. For example, let’s say you’d opened an IRA at Fidelity, and wanted to invest in Vanguard’s Total Stock Market Index Fund (VTSAX). While you can purchase the fund there, you would be charged a $75.00 fee for doing so—and this every time you purchase shares. As you can imagine, this adds up quickly. You would be far better off either selecting one of Fidelity’s equivalent index mutual funds (which have no transaction fee, and are very competitive to Vanguard’s), or choosing Vanguard’s Total Stock Market ETF (VTI) instead, as ETFs also trade commission-free at Fidelity. Either of these options will save you $75.00 per buy, and over time, this can really make a difference.

Those considerations aside, let’s now get into fund selection. The best way to do this is simple. First, sit down and write out a list of all of your investment accounts. Leave space under each account for the best fund options you find. Then, as you review the fund options you have in each account, write down the best ones. As you go through your various accounts and start listing funds, be sure to also denote which asset class this fund will fall under (U.S. stocks, international stocks, or bonds). Let’s get started.

How to Research Funds

So, how exactly do you determine if a fund is a good fit for your portfolio? As you can imagine, this question can get very complex, very quickly. There is an entire industry built up around selecting the best funds—one with fun terms such as a fund’s “Sharpe ratio,” “factor profile,” or “price/earnings (P/E) ratio.” While this type of information all has its place (and for a nerd like me, it can be pretty interesting), we are going to keep things simple. This means that we are going to look at two broad considerations:

  1. Composition. The fund tracks an index, is broad-market, and is the right asset class for your allocation.
  2. Costs. The fund keeps costs low. At a minimum, this means no sales loads, low expense ratio, and low turnover.

If you’re not familiar with these terms, that’s okay. We are going to evaluate each of these in-depth, using five easy steps. And to do this, I think it would be helpful to use an actual fund as a running example: Vanguard’s Total Stock Market Index Fund (VTSAX). We are going to pretend that we know nothing about the fund, and are learning about it from the ground up. We’ll go through each of those considerations, and see if the fund is a good fit for our portfolio. It’s important to note that the approach we’re going to follow works equally well for both mutual funds and exchange-traded funds (ETFs).

We are going to look at two broad considerations: composition and costs, using five easy steps.

Several resources exist that will help in the process. One of the best that I recommend is Morningstar Research, which is a fantastic site for researching mutual funds and ETFs. Another phenomenal resource for anything to do with index investing is Bogleheads. This site is packed with useful information on index investing; it has wiki topics on nearly everything, and a message board that boasts active, knowledgeable, and very helpful members. If you have questions throughout the process, posting here will get you quick, knowledgeable answers. And as always, feel free to use the contact form on this site to reach me if you have questions I can help with!

One thing we need to cover before we start: we will be using what’s called a fund’s ticker symbol. Mutual funds and ETFs, as well as individual stocks, all have ticker symbols. Put simply, a ticker is a unique combination of characters that is used to identify an investment on the exchange. For our example fund, Vanguard’s Total Stock Market Index Fund, the ticker is VTSAX. We will be using this to access all kinds of information about the fund, and you will see others as we go.

Now that we’re ready, let’s get started with the first area of consideration: a fund’s composition.

Step 1: Benchmark Index and Composition

The first thing we need to understand when we look at a fund is its composition. Remember that funds (both mutual funds and ETFs) are simply collections of other assets—such as stocks, bonds, and so on. So it’s vital that we understand what we’re buying, and how well it fits into our investment plan. At a minimum, this means answering the following questions:

  • Which kind of assets make up the fund? Stocks? Bonds? Other assets?
  • What is the fund’s underlying composition?
  • Does the fund track an index, or is it actively managed? If the former, which index does it track?
  • How well does the fund fit into our asset allocation plan?

When starting to evaluate a fund, a quick way is to look for the word “index” in the fund name. This will generally tell you that the fund tracks an index. And looking at the rest of the fund name can give you more information. For example, here are some phrases you might see, and what they mean:

  • “Small-Cap Index”: This fund tracks an index of small-cap (small-sized company) stocks.
  • “Information Technology Index”: This fund tracks an index of information technology stocks.
  • “Mid-Cap Growth Index”: This fund tracks an index of mid-cap (medium-sized company) stocks that have also been classified as “growth” stocks.

If you’re unfamiliar with the concepts of size, sector, and style, you can refer back to our discussion in Part 7, where we go through each in-depth.

While the fund name will give you a quick starting point, we will still need to dive a bit deeper to look at what’s under the hood. One of the absolute best places to start is by looking at the fund’s prospectus. A prospectus is simply a document that is put together by the fund’s issuer that details the fund’s composition, investment strategy, costs, and other pertinent information. This type of information can also be found by looking at the fund profile at the fund’s issuing brokerage.

How to find it: Let’s walk through how to find this information for our fund, Vanguard’s Total Stock Market Index Fund (VTSAX). Since the fund is a Vanguard fund, I started by heading over to Vanguard’s website. From there, I found Vanguard’s mutual fund profile for VTSAX by searching using the ticker. This page gives you a wealth of information about the fund: current price, performance, costs, information on the fund’s portfolio, distributions, and so on. From here, since I’m looking for information on the fund’s composition, I clicked on the “Portfolio & Management” tab, and found the following information on the fund’s strategy.

Source: Vanguard Research

So, we now know that VTSAX is an index fund, and that it tracks the CRSP US Total Market Index. If we didn’t know what this index is, that’s okay. Vanguard has even been so kind as to explain it for us: it “represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks.” So now we know that it’s a fund tracking the entire U.S. stock market. However, you should know that not all brokerages are as helpful as Vanguard. If you’re not sure about a particular index, you can always just Google it, or ask on Bogleheads. Let’s now go back to our questions from above.

  • What kind of assets make up the fund? Stocks.
  • What is its underlying composition? U.S. stocks—specifically, it has broad-market exposure across the entire market, and includes large-, mid-, small-, and micro-cap stocks.
  • Does the fund track an index, or is it actively managed? If so, which index does it track? Yes, it tracks an index. Specifically, it tracks the CRSP US Total Market Index.
  • How well does the fund fit into our asset allocation plan? Since it is broad-market and covers the entire U.S. market, this fund should be a great fit for our allocation to U.S. stocks.

Our fund is looking pretty good so far. Now that we have an idea as to the fund’s composition, and we know it tracks an index, let’s look at a measure of how well it tracks that index.

Step 2: R-squared (R2)

Though it initially sounds complex, a fund’s R2 really isn’t: R2 is a measurement of the fund’s correlation to its benchmark index. Put simply, using a scale of 0-100%, it indicates exactly how much of the fund’s movements can be explained by the benchmark index. So, a value of 0% indicates that none of the fund’s movements are explained by the benchmark index (or no correlation whatsoever), and a value of 100% indicates that all of the fund’s movements are explained by the benchmark index (perfect correlation). Ideally, we want a fund that will closely track its benchmark index, and this means an R2 value of 95-100%. Let’s take a look using VTSAX.

How to find it: This one is fairly easy to find. Let’s start by heading on over to Morningstar, and searching for the fund using the ticker (VTSAX). This will take us to the fund’s research page. Once there, we can click on the “Risk” tab, and scroll down. We’ll find the fund’s R2 listed under the section named “Risk & Volatility Measures.”

Source: Morningstar Research

So, as we can see, VTSAX has an R2 of 99.44%. Said another way, this means that 99.44% of the fund’s movements can be attributed to the movements of its benchmark index (the entire U.S. stock market). And this is exactly what we want: a high degree of correlation to the fund’s benchmark index.

This wraps up the composition component. By spending a few minutes researching, we now know that VTSAX is an index fund that mirrors the entire U.S. stock market, tracks it nearly perfectly (99.44%), is broad-market, and should fit well for our allocation to U.S. stocks. This is great, but we have one other critical area to consider before green-lighting the fund for our portfolio: costs. After all, it doesn’t matter if we have the best fund composition in the world if high costs are eroding our returns at the outset.

Step 3: Sales Loads…and Dave Ramsey?

The first cost factor that we need to look at is only applicable to mutual funds (this is not a concern for ETFs), and is called a fund’s sales load. A sales load, simply put, is a commission that is charged to an investor when purchasing or redeeming shares of certain mutual funds. There are several types of sales loads out there. Some of the most common are front-end loads, deferred loads, and redemption loads. As an example, a front-end sales load is a commission you pay up front, right off the top, when you buy shares of the fund. So, if you’re investing $100 in a fund with a 5% front-end load, only $95 actually goes to your investment; the remaining $5 is just…gone, as a commission paid to the broker. And this applies each and every time you purchase shares. We aren’t going to spend much time here looking at the different kinds of sales loads, and here’s why: the presence of any sales load is a hard-stop in our research. A sales load a totally avoidable, unnecessary cost that has absolutely no benefit to anyone aside from the broker. In my opinion, there is never a good reason to pay a sales load. On any fund. Ever.

The presence of any sales load is a hard-stop in our research. A sales load a totally avoidable, unnecessary cost that has absolutely no benefit to anyone aside from the broker.

This may differ from advice you’ve heard before. Dave Ramsey, in particular, is very fond of loaded funds. Please don’t misunderstand: when it comes to encouraging savings and eliminating debt, few in the industry can claim to have changed as many lives as he has. But I disagree with him when it comes to investment recommendations, and here’s why. In his advice on how to select mutual funds, Ramsey writes, “We recommend front-end load funds. With this type of fund, you pay fees and commissions up front when you make your investment. This approach allows your money to grow without being bogged down by expensive management fees.” The suggestion is that, by choosing funds with a front-end load, you get much of the costs out of the way up front, and the remaining ongoing costs (such as expense ratio and turnover, which we will get to next) are much lower as a result.

This is nonsense. In fact, it’s the opposite: index funds (which typically have no sales load) carry much lower costs than loaded actively managed funds. In a news release from March 2021, the Investment Company Institute notes that the average expense ratio for actively managed equity mutual funds is 0.71%, compared to 0.06% for index equity mutual funds. And turnover? In The Bogleheads’ Guide to the Three-Fund Portfolio, author Taylor Larimore points out that the turnover rates for total stock market index funds average 4%; for that same category in actively managed funds, it’s 59% (34). The presence of a front-end sales load has absolutely no connection to lowering the ongoing costs of the fund. And how could it? A sales load is paid to the broker, not into the management of the fund.

Ramsey likes to recommend actively managed funds because they have a chance to beat the market return. This is true. But, as we’ve already covered back in Part 6, that chance is very low. Year after year, research from SPIVA indicates that almost all actively managed funds (about 90%) actually underperform their benchmark index over time periods of 15 years or more. As John Bogle was fond of saying, finding an actively managed fund that actually beats the market, more often than not, is looking for the needle in the haystack. Most investors are better off not trying.

As John Bogle was fond of saying, finding an actively managed fund that actually beats the market, more often than not, is looking for the needle in the haystack. Most investors are better off not trying.

Let’s think about it another way—as the value proposition that’s being put to you when you invest in loaded actively managed funds. Let’s say you were to schedule an appointment with a broker, and on sitting down with them, they told you the following: “Here’s what I’m going to do for you. I’m going use your money to invest in a fund which has the stated objective of beating the market return. The odds of this fund actually beating the market return over your investment horizon are about 10%. I’m sure you’ll agree, these are impressive odds—the fund manager is very skilled. Now, for the privilege of being invested in this fund—and these spectacular odds—you’re going to pay me 5% of every dollar you invest right off the top, and will pay an ongoing expense ratio that is 12x higher and turnover rates that are 15x higher than index fund equivalents. You will pay these costs no matter how the fund performs—whether it beats the market or not—and will lose a large chunk of your potential profits to them over time.” Is there anyone on Earth who would listen to this and not take off out the door at a dead run? Yet this is exactly what you’re being asked to do by investing in actively managed funds.

How to find it: Let’s head on over to Morningstar Research again, and use the ticker (VTSAX) to look up our fund. From there, navigate to the “Price” tab, and scroll down. You will find information on sales loads under the “Maximum Sales Fees” section. Here’s what to do: ensure that there is nothing listed under “Front Load,” “Deferred Load,” and “Redemption Load.”

No sales loads of any kind for VTSAX. Check. Let’s move on!

Step 4: Expense Ratio

Costs are typically expressed for mutual funds and ETFs in a term called an expense ratio, which is the annual fee that funds charge their shareholders. And this one is critical: a fund’s expense ratio is perhaps the most significant factor we will be looking at. Just how important is it? Well, Morningstar Research has noted that a fund’s expense ratio is the single best predictor of a fund’s future performance. In a white paper from May 2016, they note: “The expense ratio is the most proven predictor of future fund returns. We find that it is a dependable predictor when we run the data. That’s also what academics, fund companies, and, of course, Jack Bogle, find when they run the data…investors should make expense ratios their first or second screen.”

Here’s the deal. Funds that keep costs low have a much greater likelihood of higher returns than funds with higher costs. This just makes sense. If the market is returning 8%, a fund with an expense ratio of 2% has to earn a return of 10% just to match the market. Funds with high expense ratios have a greater burden in the form of costs right out of the gate. This is why the vast majority of actively managed funds fail to even match the performance of their benchmark index: these funds have to meet a higher standard of performance just to keep pace.

Morningstar Research has noted that a fund’s expense ratio is the single best predictor of a fund’s future performance.

So what should a fund’s expense ratio be? As low as possible. Remember, every basis point (meaning every 0.01%) that you save here adds directly to your own rate of return. Here’s what’s important to remember: while these numbers may seem small on paper, when compounded over decades, they can make a massive difference in what you end up with. You might remember our example regarding costs from Part 6, where we evaluated the performance of two investors over 25 years. One chose the average index fund (with an expense ratio of 0.06%), and the other chose the average actively managed fund (with an expense ratio of 2.27%). How did they look after 25 years? Our index investor ended up with an ending balance that was 37% higher than our active investor. Further, the index investor saw only 1% of profits eaten up by costs, compared to a staggering 42% for the active investor. Costs matter—even ones that appear small. I would recommend keeping to funds with expense ratios of 0.20% or lower. Some funds, such as Fidelity’s ZERO funds, have expense ratios as low as 0%!

How to find it: Back to—you guessed it—Morningstar! As you’re used to doing by now, let’s find our fund using the ticker (VTSAX). The default tab open is “Quote,” and you can find the expense ratio listed here on the front page.

As we can see, the expense ratio for VTSAX is 0.04%. This is right where we want it to be. We have one more cost factor to evaluate, and we’re done!

Step 5: Turnover

When a fund “changes out” the assets that comprise it, the frequency of this is reflected in a measure called turnover. Funds with high turnover indicate that the stocks within that fund are changed out frequently; for actively managed funds, where the fund manager is constantly chasing performance, this measure can be quite high. Because index fund composition is largely static, these types of funds do not change out the stocks within them very often. This is important, because as I said before, every time a stock is bought or sold within a fund, this incurs costs within the fund. These expenses can be large for some funds, and reduce an investor’s overall rate of return. This also has a direct impact on the tax efficiency of a given fund; funds who maintain lower turnover are far more tax efficient than those who trade the underlying securities frequently.

Because there is a direct correlation between turnover and costs, we want to keep this number low. Most funds that I recommend have a turnover rate of 10% or less. The sole exception to this is bond funds, which may have a higher number here due to the regular maturity and replacement of bonds within the fund. If you see a higher turnover rate with bond funds, it’s usually nothing to worry about.

How to find it: Let’s go back one final time to Morningstar, and find our fund by searching the ticker (VTSAX). On the fund’s research page, click on the “Portfolio” tab, and then scroll down to the “Holdings” section. Once there, look for “Reported Turnover.”

We can see that the turnover rate for VTSAX is 8%. Perfect. And with this, we’ve covered the important cost factors within a fund: sales loads, expense ratio, and turnover rate. Keeping these three areas under control ensures that you will not pay anything more in costs than you absolutely have to. And with that, you’re already ahead.

Recap—and the FFWF Index Fund List

Congrats, you just researched your first fund! Not too bad, right? We’ve covered a lot of ground, but that’s all there is to it! If you’ve used this guide to research a fund of your own, leave a comment below with the fund name and what you discovered about it!

Let’s do a quick recap. You can research any fund by following these five easy steps:

  1. Composition: Correct asset class for your allocation; tracks a broad-market index.
  2. R2: Aim for 95-100%.
  3. Sales Load: None.
  4. Expense Ratio: 0.20% or less.
  5. Turnover: 10% or less (unless bond fund).

Before we wrap up, I have one final tool for you. Below, you’ll find a list of some of my favorite index funds (both mutual funds and ETFs), sorted by brokerage firm. Note that this list is by no means exhaustive; it’s only intended to give you a sample of some of the leading funds, and shouldn’t preclude you from doing your own research. All funds listed are no-load funds. You can view the list by clicking below, or use the download button to save a copy.

Now that you’ve learned how to research funds, and you have a list of the best fund options in your various investment accounts, we have one final step to take before we are ready to pull the trigger on your plan. This means giving some thought to how assets will be placed inside your portfolio. We will do that next, in Part 12. See you there!

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