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Proactive Investor

When Mutual Funds Are Your Only Choice

Russ Allen
Instructor

I recently discussed the idea of diversifying within your 401(k) or other defined-contribution employer-sponsored retirement plan. In most of those plans, mutual funds are your only investment choices.

Mutual funds were a good idea, for their time. They allowed small investors to have diversified portfolios. They offered professional management of the funds, freeing investors from having to do as much work to study their investment choices.

There are now better choices, in the form of exchange-traded funds (ETFs), that do the job of mutual funds but at a lower cost in terms of the management fee extracted out of the fund each year. Exchange-traded funds have other important advantages over mutual funds as well, stemming from the fact that they are traded on stock exchanges.

Because they are traded continuously on exchanges, exchange-traded funds can do some things that mutual funds cannot:

  • Free Trading WorkshopThey can be sold short
  • They can be bought on margin
  • They have put and call options attached to them

But for that money in your current employer’s pension plan, ETFs are probably not an option, and the small numbers of mutual funds offered to you by your employer are your only choices.

In the article referenced above, I explained that the available asset classes usually boil down to stock funds, bond funds, blended stock-bond funds, money market funds and sometimes a precious metal fund or two.

How then can you evaluate them and choose among them? One way is to compare their performance to relevant benchmarks. Even though you may not actually be able to buy ETFs in your pension plan, you can use them as comparison tools to select the best choices from among the mutual funds available.

Here are some ETFs that can provide good comparisons for mutual funds that you are likely to have available:Tweet: Here are some ETFs that can provide good comparisons for mutual funds. //ctt.ec/C95b6+

ETF Index/benchmark Category
SPY S&P 500 Index Large Cap Blend Equities
QQQ NASDAQ 100 Index Large Cap Growth Equities
IWM Russell 2000 Index Small Cap Blend Equities
AGG Aggregate Bond Index Total Bond Market
IEF US 7-10 year bond index Government Bonds
TLT US 20+ year bond Index Government Bonds
GLD Gold Bullion Precious Metals

A mutual fund’s category is usually indicated by its name – the Spartan Long-term Treasury Bond Fund, for example, whose symbol is FLBIX, is clearly composed of long-term treasury bonds and therefore the best ETF to compare it to should be TLT, whose category is long-term government bonds.

If the name alone doesn’t give enough information to determine a fund’s category, this information can be found for any fund from many online sources, including Morningstar.com. Typing morningstar FLBIX  into a web browser search bar will take you to Morningstar’s page on the fund FLBIX and give this information.

Once you know what category and therefore what ETF is comparable for a fund, you can easily make your comparison using another free online resource, this one from Stockcharts.com. In their section called Free Charts there is a tool called PerfCharts, which is short for Performance Comparison charts. There you can type in the symbols of stocks, indexes, ETFs or mutual funds that you want to compare. The resulting chart is an approximate measure of total return, including price appreciation and dividend/interest payments. Below, for example, is a PerfChart for the Spartan fund FLBIX together with its category ETF benchmark, TLT:

Stockcharts.com performance comparison chart
Here we can see that in fact FLBIX (red line) performed just a little short of its ETF benchmark TLT (blue line), and therefore would be a reasonable choice if you wanted to approximate the performance of their common index (20+ year government bonds) with part of your retirement funds. It is common that the mutual fund choice will underperform the similar ETF by some margin where the main difference is the amount of fees extracted over time.

You can do a similar comparison for funds available to you in each category. The idea is to select from three or more categories within your plan; and within each category select the best performers relative to their benchmarks. Although it is always true that past performance does not guarantee future results, it is still useful to know which of the available choices gives up the least performance in relation to its benchmark.

Dynamic Management of your retirement plan is just part of the content of our Proactive Investor course, which helps you build a solid plan for your long-term investments. For more information, contact your local center.

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.