How To Build Your Own Mutual Fund

By Stephan Abraham AAA

Mutual Funds have become a popular investment vehicle for many investors over the last few decades. Investors who are part of a company-sponsored retirement plan or an individual investment portfolio have to choose which funds to select, even without understanding the overall value of their investment. Here is a sobering fact: industry sources vary on an actual number, but the vast majority of mutual funds underperform the overall stock market.

TUTORIAL: Diversified Portfolio

What does that really mean? Think of it this way: If you hire a personal trainer to help you with weight loss, you expect better results than you could achieve on your own. In other words, spending your hard-earned dollars should return something of value. Managing your finances should be approached with similar reasoning and scrutiny. Why pay someone unnecessary fees and commissions if you could potentially make it happen on your own.

Let's examine how you can build your own mutual fund and, hopefully, pave a path toward outperformance, not mediocrity. (For related reading, see How To Outperform The Market.)

Understanding Mutual Funds and Loads
Mutual funds are essentially a basket of several, or sometimes hundreds, of individual stocks. As a mutual fund investor, you are paying the portfolio manager to buy and sell stocks and/or bonds on your behalf. These investors are passing on their expenses to you in the form of an expense ratio. They don't stop there: some funds charge you a "load" based upon the class of fund shares you purchase. Loads are fees, sometimes for buying and/or selling funds. The load on a mutual fund is highest if the fund is bought and then sold in the short term.

Typically, fund managers want control over your money for longer periods of time and discourage trading or hedging of mutual funds. Regardless of whether you are buying a fund for one year or twenty, avoiding funds that have a load will save you dollars. These expenses, albeit disclosed and transparent, eat into your potential return, particularly over longer investment horizons.

Before You Begin
You can start building your own basket of stocks by doing some homework. Your time investment will save you dollars in the long run. Your only expense is your time and the transaction fee to buy and sell your stocks. Most discount brokerages today charge below $20 a trade.

Picking good stocks initially is critical to avoiding recurring trading expenses: good stocks are ones you hold, while stocks you dump are called "losers." Browse through Investopedia and sites like Yahoo Finance, Motley Fool or CBS MarketWatch, and start a watch-list of companies that you're familiar with.

Companies such as Wal-Mart (NYSE:WMT), Microsoft (Nasdaq:MSFT), Target (NYSE:TGT) and other icons of American business can form the basis for a core stock portfolio. If you know very little about stocks, take a basic investment class at a community college, consider buying books on basic investment choices or go through the investing tutorials located on the site. (To learn more about basic investing, see Investing Tutorials.)

Keep in mind that not all mutual funds are created equal. If you do not have the time or inclination to build your own portfolio, then target mutual funds that have an expense ratio of less than 1% and avoid loads at all costs.

Staying Ahead
Perhaps the most critical factor in deciding if a fund is worth your investment dollar is its relative performance: how do your prospective new funds compare to the index and its peers? Each fund has a benchmark that it is compared to in performance and expenses. Most common is the Standard and Poor's 500 index, but there are several others that are prominent.

If your fund is underperforming that index and the fund manager is charging you money to underperform, it may be time to move up and move on. Yes, there is some truth to the adage that past performance does not guarantee future results, but you can help optimize future performance by minimizing unnecessary costs such as loads and high-expense ratios. Sites such as Morningstar and Lipper do a good job of depicting relative performance and costs. Simply enter your fund symbol and relevant data should be readily available for your analysis.

Another option investors should also seriously consider is investing in what is called an index fund, or a fund that is strictly correlated to a particular index such as the Dow Jones 30 or the Nasdaq Stock Market. These funds do not trade or turnover stocks frequently, therefore expenses are minimal and these are typically no-load funds. Industry experts credit Jack Bogle and his Vanguard family of funds as being leaders in low expense index investing for life.

One of the downsides or inherent risks of investing in index funds is that you are at the mercy of the composition of that index. In other words if the composition of the S&P 500 stocks or the Dow Jones changes, you are locked into what money managers refer to as rebalancing effect. Also, many argue persuasively that these indexes are slow to adapt to the overall economy.

For example, one of the most successful companies and stocks over the last decade has been Apple Inc. (Nasdaq:AAPL). If you owned a mutual fund that was indexed with the Dow Jones 30 stocks, you would not own Apple shares and still do not. Whether it should be included in the Dow 30 is certainly debatable, but the fact is that your investment in what is alleged to represent a broad basket of American companies may in fact not be. (To learn more, read Why The Dow Matters.)

The Bottom Line
Traditional mutual funds are not necessarily bad or inept at meeting your financial goals, but most do cost you out-of-pocket dollars for sub-par performance. Building your own mutual fund or at least minimizing unnecessary expenses is a key strategy to optimizing returns for the long-term. Beginning investors may want to consider index funds as a low-cost alternative before venturing out and buying individual stocks. Keep in mind, building your own fund requires additional effort, but the tools are readily available on the web more than ever before.

Research and persistence are critical to building a successful mutual fund. This may require some time, but the rewards can include higher returns, lower costs and the personal satisfaction and confidence that come with a job well done. (To read more about building your own portfolio, see Create Your Own U.S. Equity Portfolio.)

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