Make Sure You Avoid Adding These Mutual Funds to Your 401(k)

Because your 401(k) is meant to provide solid income after your earning years are over, it's important to ensure that you invest in mutual funds that will provide long-term growth with carefully managed risk.

Of course, not all 401(k) plans are created equal. Some have particularly inadequate investment options, while others offer a wide range of mutual funds to suit varying needs. Regardless of the limitations of your particular plan, there are certain mutual funds to avoid at all costs. Aggressively managed high-yield funds, funds with unnecessarily high expense ratios and many bond funds are all poor choices for your retirement account. Even the newest, hottest funds on the market are likely to be inappropriate options, since most star funds fail to produce such high returns consistently.

Expensive Index Funds

Index funds are widely considered to be some of the safest and most stable long-term mutual fund investments available. Because they offer high degrees of diversity and usually generate positive returns over the long term, index funds are an excellent choice for 401(k) investing. However, not all index funds are created equal. Even among funds that track the same index, expense ratios vary widely.

The expense ratio for an index fund generally should be around 0.2%, if not lower. Many well-known index funds have expense ratios that far exceed this benchmark. The Great-West S&P 500 Index Fund has an expense ratio of 0.6%, for example. While this is certainly a higher ratio than is warranted, it seems downright affordable next to the State Farm S&P 500 Index Fund's 1.44% ratio.

Despite the fact that index funds, by definition, simply invest in the same securities as a given index, many continue to charge exorbitant fees. Since the success or failure of an index fund is intrinsically tied to the performance of the index rather than the skill or instinct of its manager, paying high fees for an index fund is a surefire way to drain your 401(k).

High-Yield Funds

Though mutual funds have a reputation for being safe investments, this is not always the case. In fact, some types of mutual funds are downright dangerous. The most dangerous mutual funds are the so-called high-yield funds, because they employ aggressive management strategies that look to pick stocks to beat the market. Alternatively, high-yield bond funds invest in extremely low-quality bonds, called junk bonds, to benefit from their extreme volatility. Fidelity's Capital and Income Fund is one of the top high-yield bond funds, according to U.S. News' ratings.

It may be possible to make a lot of money in a risky high-yield fund, but they are not suitable for the long-term strategy that is typically advised for 401(k) investing. Both high-yield equity and debt funds generate a lot of trading activity, which triggers a greater number of distributions. While those earnings are tax-sheltered within your 401(k), each distribution diminishes the value of your remaining investment. An active management style also means a higher expense ratio, which can eat up a substantial portion of a fund's returns. In addition, the volatile nature of these funds means that you take on a much greater degree of risk than is typically desirable in a retirement portfolio.

Overlapping Investments

Diversification is the key to the investment game. This is one of the chief reasons why mutual funds are so popular. Make sure the mutual funds you choose don't end up leaving your portfolio anything but diverse.

It can be hard to keep track of which funds hold which securities, especially if you choose to invest in actively managed funds with high asset turnover. However, if you invest in funds with identical or nearly identical holdings, you're missing the point of diversification. By selecting very similar funds, you limit your ability to invest in, and benefit from, other sectors or markets. Overlapping investments also prevent you from adequately hedging your bets.

This concept applies on both small and large scales. Investing in several index funds that track the same index ends up costing you if the index does poorly. From a broader perspective, if you invest only in the U.S. market and the American economy flounders, you've set your portfolio up for a beating. Diversify your risk by balancing your index funds with more actively managed value or growth funds, or by tempering your American investments with funds that specialize in foreign debt and equity.

Bond Funds

Bond funds are another tricky area for 401(k) investors. While buying individual bonds and holding them until maturity is a relatively safe investing strategy, mutual funds don't operate in the same way. When you buy shares in a bond fund, you have no control over how and when the fund sells its holdings. In addition, share redemption by other investors may force the fund to liquidate holdings at a loss.

If you choose to invest in bond funds, choose a fund that uses a long-term strategy and holds a wide variety of debt securities until maturity to generate interest payments each year. Though your returns are likely to be moderate at best, the risk to capital is low. Bond funds that sell securities prior to maturity are much more prone to interest rate risk, even if they invest in highly rated debt.

Like stocks, the market value of bonds fluctuates based on many factors. Changing interest rates have the greatest impact. With interest rates hovering near 0% for so long after the 2008 crash, analysts are preparing themselves for the coming interest rate hike in 2016 and possibly beyond. Given the current outlook for the bond market, it is unwise to begin investing in short-term bond funds, at least until rates rise.

Trendy Funds

There is a virtually unending supply of investment advice on the Internet, mostly aimed at telling you which investments are going to make you rich quick. While it may be tempting to jump on the bandwagon of the most recent mutual fund success story, history has shown that most superstar funds are unable to sustain their performances.

In fact, according to the most recent Persistence Report from the S&P Dow Jones Indexes, only 5.28% of the 682 domestic stock funds that represented the top 25% of performers in March 2013 managed to stay in the top quartile two years later. Over a five-year period, none of the large-, mid- or small-cap funds that performed best in 2010 managed to stay in the top 25%. Even worse, more than 21% of those funds that were in the top quartile had moved to the bottom quartile five years later.

Managers of superstar funds often find themselves inundated with more shareholder dollars than they can find legitimate investments for, eventually leading to unimpressive returns down the road. If you are lucky enough to invest in a fund that goes on to have a few banner years, so much for the better. Chasing funds that have already had their time in the sun, however, is a losing bet, statistically speaking.