Mutual Fund Supermarkets
With a mutual fund, you get access to a bundle of securities that’s managed by a portfolio manager, which means your money will be well-diversified.
The diversification element of spreading your money out across hundreds or thousands of individual companies is similar to what you’d get with an index fund. But the portfolio manager is basically picking stocks based on his or her own research when overseeing a mutual fund.
So you get the human element of someone picking a bundle of individual investments for you with a mutual fund, rather than just passively putting your money into a group of stocks that track a known index like the S&P 500.
Each of these companies is large enough that you could build an entire mutual fund portfolio just with their funds. Vanguard is the cheapest in the index fund category I mentioned previously, and they are the cheapest in mutual funds as well.
However, there are also tons of great no-load funds with reasonable costs that are not with these three companies. If you wish to build an even wider portfolio of mutual funds, you can use a ‘mutual fund supermarket.’
Both Charles Schwab and Fidelity offer huge supermarkets where you can put your Roth money in one account with either of these choices and then invest in any of dozens of mutual fund companies without loads and at reasonable management fees.
One of the big knocks on using mutual funds to invest is that the tax treatment of them is rotten. That is not a factor if you’re putting your mutual funds in a Roth IRA, which allows you to invest with after-tax dollars that are never be taxed again even in retirement.
However, the other knock on mutual funds is just as true as ever. Mutual funds generally have higher management fees than index funds and almost always will make you less money over longer periods of time.
That is why I believe so much in index funds rather than mutual funds. If you are doing investing outside of a Roth or traditional IRA, you always want to do index funds rather than mutual funds because of the taxman.
I have been asked how many mutual funds make sense to own if you are actively going to build a portfolio, and the most common answer is 12. That way you can cover several different major investment categories and draw on the expertise of more than one manager.
As an example, you could own two or three big company mutual funds to get different stock pickers’ strategies working for you. Just be sure they’re not chasing the part of the market that was last year’s hot part or last year’s hot fund. They should be building for your future looking 10 years forward at a minimum, not one or three years back.
Exchange-traded funds (ETFs)
Exchange-traded funds are the fastest-growing way to invest in Roths or regular investment accounts. If I were starting from scratch building a sophisticated portfolio today, I would build it using only ETFs.
An ETF is like an index fund, but you buy and sell it like a stock. That means there’s typically a lower entry point versus index funds. While a typical index fund may require a $1,000 minimum to get started, an ETF may only require $50 or $100 to buy your first share.
Another benefit of ETFs is that they will usually have even lower management fees than an index fund.
Fidelity, Charles Schwab, Vanguard, TD Ameritrade, Scottrade and others now offer a wide range of ETFs commission-free. There are enough choices with any of them to open a Roth or regular investment account and fully diversify with just commission-free ETFs.
Charles Schwab has more than ETFs that are available commission-free. The management fees are so low that they are almost zero. My favorite starting point is the Schwab U.S. Total Stock Market ETF that charges only 0.03% per year. Remember that the typical mutual fund charges 1.50% per year. That’s 50 times more expensive than this ETF!
With Schwab’s wide range of choices, you can have a total stock market or big company ETF, a small company ETF, an international ETF and a Third World or emerging market ETF. And that’s just the tip of the iceberg in the ETF world.
Fidelity too gives a wide choice of commission-free ETFs with nearly 100 on tap. About 70 of them are from the iShares family. You could easily build a great portfolio from the Fidelity commission-free ETFs. The downside with Fidelity is higher expense ratios. Expect to pay as much as double the annual management expense as with Schwab. However, that’s still so low compared to the typical mutual fund that Fidelity remains a great choice.
Vanguard also has its own strong offerings in the world of commission-free ETFs. You can choose among 70 ETFs that you can buy and sell free of any commissions.
TD Ameritrade has more than 300 ETFs available, making their offerings by far the most varied of the commission-free players. They’ve partnered with iShares, Powershares, SPDR, Vanguard and others for their extensive catalog.
One danger with the proliferation of ETF offerings from all these players is that you could ‘overthink’ your allocations. I believe that ETFs work best when you use wide market sectors. When you have ETFs available by the hundreds, some of the choices get very narrow.
A peek inside my portfolio
Whether you go with Schwab, Fidelity, Vanguard or another of the companies I’ve mentioned here, you’ve got to remember the importance of investing overseas. We in the United States account for only 25% of world capitalism, but most Americans invest almost solely here.
As I built my portfolio, I set it up to work as follows: Total stock market, small cap, international index, emerging market, high-yield tax exempt, long-term tax exempt, intermediate-term tax exempt and short-term tax exempt. Because of my age, I am 50% spread among stock choices and 50% bond choices. My stock funds are 40% domestic and 60% international.
People often ask me why I’m not at 75% international if 75% of capitalism is overseas? The reason is that larger U.S. companies get a huge share of their sales outside the U.S., so 40% domestic ultimately takes me to having money invested in the three-quarters of the world where capitalism is growing.
Know this: My allocation is just right for my situation. You should adjust your allocation for your age and income. The younger you are, the more your portfolio should be stock-based. Remember to keep your long-term focus and invest steady as you go.
On the bond side, I do tax-free options because of my tax bracket. If you are investing inside a retirement account or are not in a high-tax bracket, do traditional bonds — not tax-free bonds.