Basic mutual fund investment questions

Question

I am a complete newbie to investment and have already gone through a lot of reading materials. I now have some basic idea about terminology etc. but still have a couple of questions for which I couldn't find answers:

1. High Expense Ratio - High Returns (Mutual funds) vs Low Expense Ratio - Low returns: If I understand correctly, index funds are best suited for beginners as they have low expenses and moderate returns. For example, VFINX is one of the most recommended ones. Its return is pretty good with low expense of .17%. Other mutual funds like JAGLX have almost double the return of VFINX but with an expense ratio of .90%. There are many others like JAGLX. Which category should I go with? Would high expense ratio and other costs offset return by an amount so that final return is same as an index fund?

2. Different Accounts for different funds: Is it advisable to buy the fund from the company that owns it in order to avoid transaction fees? For example VFINX from Vanguard and SWTSX from Schwab.

3. High turnover rates on bond funds: As per my understanding, one should also buy a percentage of bond funds apart from stock funds. One example is: SWLBX (Schwab Total Bond Market) but I see that these bond funds have a high turnover rate of 50+%. Any idea why it is so high compared to equity funds?

Answer 1

You asked 3 questions here. It's best to keep them separate as these are pretty distinct, different answers, and each might already have a good detailed answer and so might be subject to "closed as duplicate of..."

That said, I'll address the JAGLX question (1). It's not an apples to apples comparison. This is a Life Sciences fund, i.e. a very specialized fund, investing in one narrow sector of the market. If you study market returns over time, it's easy to find sectors that have had a decade or even two that have beat the S&P by a wide margin. The 5 year comparison makes this pretty clear. For sake of comparison, Apple had twice the return of JAGLX during the past 5 years. The advisor charging 2% who was heavy in Apple might look brilliant, but the returns are not positively correlated to the expense involved. A 10 or 20 year lookback will always uncover funds or individual stocks that beat the indexes, but the law of averages suggests that the next 10 or 20 years will still appear random.

Answer 2

@JoeTaxpayer gave a great response to your first question. Here are some thoughts on the other two...

2) Transaction fees for mutual funds are tied to the class of shares you're buying and will be the same no matter where you buy them. A-shares have a front-end 'load' (the fee charged), and the lowest expenses, and can be liquidated without any fees. B-shares have no up-front load, but come with a 4-7 year period where they will charge you a fee to liquidate (technically called Contingent Deferred Sales Charge, CDSC), and slightly higher management fees, after which they often will convert to A-shares. C-shares have the highest management fees, and usually a 12- to 18-month period where they will charge a small percentage fee if you liquidate. There are lots of other share classes available, but they are tied to special accounts such as managed accounts and 401-K plans. Not all companies offer all share classes. C-shares are intended for shorter timeframes, eg 2-5 years. A and B shares work best for longer times. Use a B share if you're sure you won't need to take the money out until after the fee period ends. Most fund companies will allow you to exchange funds within the same fund family without charging the CDSC.

EDIT: No-load funds don't charge a fee in or out (usually). They are a great option if they are available to you. Most self-service brokerages offer them. Few full-service brokerages offer them. The advantage of a brokerage versus personal accounts at each fund is the brokerage gives you a single view of things and a single statement, and buying and selling is easy and convenient.

3) High turnover rates in bond funds... depending on how actively the portfolio is managed, the fund company may deliver returns as a mix of both interest and capital gains, and the management expenses may be high with a lot of churn in the underlying portfolio. Bond values fall as interest rates rise, so (at least in the USA) be prepared to see the share values of the fund fall in the next few years. The biggest risk of a bond fund is that there is no maturity date, so there is no point in time that you have an assurance that your original investment will be returned to you.

Answer 3

In summary, you are correct that the goal of investing is to maximize returns, while paying low management fees. Index investing has become very popular because of the low fees. There are many actively traded mutual funds out there with very high management fees of 2.5% and up that do not beat the market. This begs the question of why you are paying high management fees and not just investing in index funds.

Consider maxing out your tax sheltered accounts (401(k) and ROTH IRA) to avoid even more fees on your returns.

Also consider having a growth component of your portfolio which is generally filled with equity, along with a secure component for assets such as bonds. Bonds may not have the exciting returns of equity, but they help to smooth out the volatility of your portfolio, which may help to keep peace of mind when the market dips.