MONEY stocks

What’s Really Going on When Stocks Plunge

Dow Plunges Over 450 Points On Chinese Manufacturing Data
Spencer Platt—Getty Images Traders work on the floor of the New York Stock Exchange on September 1, 2015 in New York City.

Asymmetric emotional responses explain so much of why investing is difficult.

“Global jitters” was used in the media 933 times last week to describe why the market was falling, according to Google. Thanks, that’s really helpful. It’s the equivalent of a doctor diagnosing you with “general illness.”

S&P 500 companies earned something around $38 billion in profits over the last two weeks. Over time, that number will matter far more than what the market did during the last two weeks.

The biggest impediments to a comfortable retirement are impatience, pessimism, gullibility, self-interest of middlemen, ignorance of the exponential function, and overconfidence. All six come out during market downturns.

President Obama was briefed after the market fell 10%. I guarantee you he’s not briefed after it rises 10%. Asymmetric emotional responses explain so much of why investing is difficult.

Daily market prices are determined by computers in New Jersey fighting to be a billionth of a second closer to exchanges than other computers. Business values are determined by 7 billion people waking up every morning trying to better themselves. If you bet on the latter and laugh at the former, you’ve figured half this game out.

If this decline keeps up, it could be as bad as the 2011, 2010, and 2004 downturns that no one remembers or cares about anymore.

When no one knows what the economy or stock market will do next, people say there’s high uncertainty. This is different from low uncertainty, when people think they know what the economy and stock market will do next, invariably followed by being wrong, which they blame on high uncertainty.

U.S. investors have $16 trillion in mutual funds. It sounds huge when they withdraw $20 billion, but it’s a fraction of 1% of what’s outstanding. Even during big downturns, “Nearly all investors do nothing; go about their day; couldn’t care less about yuan devaluation” is the most accurate headline.

“Be greedy when others are fearful” sounds obvious during bull markets, smart during small pullbacks, reasonable during medium pullbacks, and impossible during big downturns.

Your odds of dying in a car accident during your life are 1 in 74. That rarely makes headlines. The odds of an investor experiencing a big market crash during their life are 100%. But we treat it like it’s something rare and dangerous.

Stocks are down a lot in the last month, down a little in the last year, up a lot over the last six years, and up a little over the last eight years. Pick your narrative, and you can tell a persuasive story.

I greatly appreciate your volatility outlook of continued weakness given your prescient forecast of 96 of the last two bear markets.

Ninety-three percent of the world does not own stocks. Zero percent of market commentators can believe this.

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MONEY mutual funds

Millennials in Target Date Funds Got Hit Hardest by Stock Selloff

Market
Andrew Burton—Getty Images A trader works on the floor of the New York Stock Exchange during the morning of August 27, 2015 in New York City. Dow Jones Industrial Average stocks continued their rally, opening approximately 200 points higher today.

Young investors with 2060 target date funds lost 10% of their savings between July 17 and August 24.

As the stock market has whipsawed over the past two weeks, young workers who have all their retirement funds tied up in long-range target-date funds may have been the hardest hit.

The average 25-year-old fully invested in a 2060 target-date fund series saw a 10% decline in account value from the market’s recent peak on July 17 through Monday’s close, according to Morningstar – close to the 10.96% decline of the S&P 500 over that period.

Meanwhile, the average 65-year-old set to retire this year and invested in a 2015 TDF series saw just a 5% decline.

Even if stocks continue to rebound in the days ahead, the experience of watching value shrink may be an eye-opener to new investors who might not have thought about their risk tolerance before.

Target-date funds are designed to adjust an investor’s risk as retirement age approaches, through what is called a glide path. The farther out the fund’s end date, the higher the stock allocation. Investors in 2060 funds have equity exposure ranging from 83% to 94%, says Janet Yang, director of multi-asset-class manager research at Morningstar. In the 2015 funds, aimed at workers who will be retiring very soon, average equity exposure is just 42%.

The popularity of these funds in retirement plans is surging. Vanguard reports that 88% of the 401(k) plans it serves offered TDFs last year, up 17% from 2009. Four out of 10 plan participants are wholly invested in a single TDF, Vanguard says, and 64% of participants use them to some extent.

Many young workers are now automatically enrolled in 401(k) plans and put into a default allocation that typically is a target-date fund.

On the plus side, especially for young and inexperienced investors, these funds seem to have handcuffed the worst investor behaviors, like frequent trading. Asset-weighted average investor returns in TDFs are 1.1 percentage points higher than the funds’ average total returns, according to a Morningstar study published earlier this year.

“Sometimes, ignoring your investments can be a good thing. You’re less likely to pull your money out after it loses 10%, and then you’re still invested when the rebound comes,” Yang says.

But how will younger auto-piloted investors – now experiencing their first wild market swings – handle the volatility?

“We’re defaulting millennials 90% into stocks without ever finding out what their tolerance for risk might be,” says Michael Kitces, founder of the XY Planning Network, a network of fee-only advisers specializing in serving Gen X and Gen Y clients. (Kitces also is a partner and director of research for Maryland-based Pinnacle Advisory Group, a wealth management firm).

Kitces worries that the current volatility will lead to adverse outcomes for young investors. “We’re taking people who don’t need to be that aggressive and given them more risk than they can tolerate. What we’re going to do is turn them into lifelong bond investors – and that will cause them problems 30 years from now,” he says.

There has been plenty of selling out of target-date funds this week. Aon Hewitt, which administers more than 500 defined-contribution plans covering more than 5.7 million workers in the United States, reports that trading activity on Monday was seven times the normal level, and it was one of the highest trading days on record. 30% of Monday’s selling came from TDFs – equal to the share that came out of large U.S. equity funds.

“That tells us that people are looking at TDFs the same as any other investment,” says Rob Austin, Aon Hewitt’s director of retirement research.

More Options

Default investor options for 401(k) plans, which are regulated by the U.S. Department of Labor under the Employee Retirement Income Security Act, are not limited to target date funds. The Labor Department also allows balanced funds and managed funds, which give workers professional one-on-one portfolio guidance.

Managed accounts also give workers a human being to talk with when things get scary – but just 3% of plan sponsors pick managed account services as a default option, according to a Towers Watson survey.

“When the market gets volatile, you don’t have someone to talk to if you’re in a TDF,” says Wei-Yin Hu, vice president of financial research at Financial Engines, one of the leading firms providing managed account services. “You can’t call your TDF and ask if your allocation is still right for you, or what you should do now that you’ve lost 10% in a downturn.”

Kitces urges target-date investors to assess their comfort with risk by taking a well-designed risk questionnaire like the one offered for $45 by Finametrica. If you are not comfortable with the level of risk in your TDF, consider shifting to a closer-date target series with less equity exposure.

“It’s not too late for young people to dial down their exposure to a level they can tolerate,” he says. “Make a change when things are down 10% instead of 40%. Things can get worse, and then you’ll make really non-rational, emotional decisions.”

MONEY mutual funds

Why Trouble in China is Hitting Your 401(k)

How China's economic turmoil affects your investments.

You aren’t a currency trader. You don’t play in Shanghai’s boom-and-bust stock market. (It was only beginning to open to investors when the crash hit.) But if you have some money in a 401(k) or an IRA, you have a stake in the news coming out of China, even if you hardly think of yourself as a global investor.

The China bet in your mutual funds. If your portfolio includes an international-stock fund, it likely holds some Chinese companies that list shares on the Hong Kong or New York exchanges. For example, Vanguard Total International Stock Index Fund, the biggest foreign-stock fund, holds a bit less than 5% of its assets in China. At least as important are such funds’ holdings in countries like Brazil that sell a lot of raw materials. As China’s resource-hungry manufacturing economy slows, “the No. 1 thing getting shellacked is commodities,” says Robert Johnson, director of economic analysis at Morningstar. That has hurt commodity-producing countries.

Ripple effects close to home. A significant chunk of U.S. investments are closely linked to China. About 10% of the S&P 500—the benchmark followed by most fund managers—is in energy or basic-materials stocks, and those are down sharply this year.

More broadly, China’s surprise move to devalue its currency “reinforced the perspective that all is not well in the Chinese economy,” says Harry Hartford, president of Causeway Capital Management. China may be slowing even faster than investors thought. American multinationals hoping to sell to a rising Chinese consumer, particularly automakers, report that sales are slipping.

The smart move: stay diversified. As big as the events in China may feel right now, that doesn’t mean you have to act. “There’s very little evidence that individual investors are great at timing stocks,” says Research Affiliates chief investment officer Chris Brightman. (Don’t feel bad: pros have a lousy record too.)

If you are tempted to bail out of an international fund right now, bear in mind that U.S. stocks are hardly a haven. Looking at prices compared with the past 10 years of earnings, the stocks on the S&P 500 are relatively expensive. On the one hand, bad news about China might be the thing that breaks the bull market’s so-far optimistic psychology. Or maybe the market decides that slower global growth will continue to hold down interest rates, which could support high equity valuations for a while longer.

Instead of trying to guess, make sure you have a portfolio that can handle shocks. Hold many different kinds of stocks, along with enough in bonds and cash to get you through the bad years. China just shows that the markets are full of surprising risks–and they can come at you from the other side of the globe.

Read next: Why Investing in the Stock Market Isn’t Like Gambling

MONEY index funds

Donald Trump Would Be Billions Richer If He’d Invested in Index Funds

Republican candidate for US President Donald Trump
Getty Images Donald Trump speaks to media at a press conference before a town hall meeting in Derry, New Hampshire on Wednesday, August 19, 2015.

The Republican presidential candidate could be worth $13 billion today if he'd played his cards right.

Trump’s net worth has grown about 300% to an estimated $4 billion since 1987, according to a report by the Associated Press. But the real estate mogul would have made even more money if he had just invested in index funds. The AP says that, if Trump had invested in an index fund in 1988, his net worth would be as much as $13 billion.

The S&P 500 has grown 1,336% since 1988.

Other billionaires’ net worths have beaten the stock market’s growth in that time. Bill Gates, for example, saw his grow increase 7,173% since 1988 to $80 billion. Warren Buffet’s wealth grew 2,612% in the same time period, to $67.8 billion.

Another recent Associated Press report found that Trump is a much more cautious businessman than he lets on. “He holds few stocks for someone of his wealth and has grown increasingly dependent on making money by lending out his name to others rather than developing real estate himself,” the AP wrote.

This article originally appeared in Fortune.

MONEY 401(k)s

The Hidden Reason Your 401(k) Fund Choices Are So Bad

Martin Poole—Getty Images

When a fund company both manages your 401(k) plan and chooses the investment options, guess who gets the best deal?

It’s common for mutual fund companies to be paid to administer 401(k) plans for employers while also being paid to select and manage investment funds in the plans. It’s also a clear conflict of interest—one that typically gets resolved in the fund company’s favor, new research shows.

When making plan changes, fund companies add more of their own funds and delete more from outside firms, according to the Center for Retirement Research at Boston College. This bias brings more poorly performing funds onto the menu, researchers found. What’s more, these poorly performing funds tend to remain sub-par. That proves to be a long-term drag on participant returns, since few investors take action to avoid or work around the poor choices they are offered.

Fidelity, Vanguard and most other big fund companies serve in a dual 401(k) capacity by setting the investment menu while also managing funds inside the plan. In all, fund companies manage 56% of the $4.7 trillion in defined contribution plan assets. This is a vast storehouse of Americans’ retirement security—one that, given our savings crisis and public pension ills, must be protected.

A similar conflict of interest between investment advisers and clients is getting a thorough airing this week in Washington. The Department of Labor will hold hearings all week, trying to sort out whether financial advisers working with retirement accounts should be held to the standard of fiduciary, meaning the adviser must put the client’s interests first. The Labor Department believes such a law would keep brokers from putting clients into high-fee retirement savings products. The industry argues it would increase their liability risk and regulatory costs, and discourage brokers from serving small accounts.

The conflict over the dual role of fund companies is not about the fiduciary status of advisers. But the problem persists because employers, who do have a fiduciary role, often fail to take action. That leaves many investors stuck with lousy 401(k) funds, which take a bite out of their retirement accounts. For example, plan administrators remove just 13.7% of their own underperforming funds from the menu every year, the research shows. But they remove 25.5% of underperformers from other fund groups—meaning more of their own poor performers remain. Meanwhile, they are far more likely to add their own sub-par funds compared with choices from another fund company.

The upshot is that 401(k) plan investors must look critically at any changes in their investment options. You can’t blindly accept a substitution on the menu. Look carefully at fees and past performance along with how a fund fits into your portfolio. One good place to start is BrightScope, which can show you the fees and choices of 401(k) plans from comparable companies.

If you find that your plan costs are high—1.5% of assets or more—and your options stink, consider a workaround. You almost always want to contribute enough to get any employer match. But once you have done that, you may find that your spouse has a better plan and you can divert more family savings there. You may find that your company offers a self-directed brokerage option in your 401(k), allowing a more hands-on approach and greater ability to watch fees. You may also be better off contributing additional money to an IRA.

Don’t look for the inherent conflict of a fund company that both manages funds and chooses the funds on your menu to disappear anytime soon. Given the fiduciary discussion in D.C. this week, this issue is nowhere near resolution. As ever, your retirement security is mostly up to you.

Read next: Here’s What to Do If Your 401(k) Stinks

MONEY mutual funds

Dar es Salaam Is the New Brewery Hot Spot

148715184
Tom Cockrem—Getty Images Street scene in Dar es Salaam, Tanzania.

Roughly 45% of Tanzanians are between the ages of 15 and 45, prime ages for drinking beer.

Lagos and Dar es Salaam are the new brewery hot spots, according to U.S. mutual fund managers as they tap Africa’s emerging beer companies in pursuit of long-term returns on investment.

U.S. fund managers who originally entered the African market by investing in infrastructure said the continent’s youthful demographics – large swaths of the continent are at prime beer-drinking age – and favorable economics brought by local production are a recipe for a profitable outlook.

“It would cost four or five times more for Tanzanians to import beer than to make it domestically,” said Babatunde Ojo, portfolio manager for Harding Loevner’s $600 million Frontier Emerging Markets strategy.

His fund has added in recent months 730,000 shares of Tanzania Breweries Limited and 900,000 shares of East African Breweries, also a Tanzanian company, according to Lipper data.

The Templeton Frontier Markets Fund noted that it added $3.58 million to East African Breweries and $11.80 million to Nigerian Breweries.

Roughly 45% of Tanzanians are between the ages of 15 and 45, prime ages for drinking beer, said Ojo.

Those demographics are reflected elsewhere in the continent. Cities including Dar-es-Salaam and Lagos, hubs for young professionals, are expected to experience rapid growth of their young populations, according to a 2015 trends report by Ernst and Young.

Africa is expected to see the largest increase in the legal drinking age population by 2018, while in western Europe and North America, the cumulative decline in beer volumes since 1998 has been between 5% and 10%, according to Rabobank Research.

Mark Mobius, executive chairman of the Templeton Emerging Markets Group, is particularly enthusiastic about Nigerian Breweries Plc, which is majority owned by Heineken Holding NV. Templeton Asset Management Ltd. holds 0.83% of the company.

“Relative to its competitors, the company (Nigerian Breweries) imports considerably fewer raw materials – reducing its exposure to the depreciating naira, and lessening the impact on profit margins and turnover – and also has the strongest distribution capability among its peers,” Mobius wrote in an email to Reuters last week.

To be sure, share prices in Nigerian Breweries and other African peers have been falling this year as some countries suffer from decreased revenue and other commodities and in part because of uncertainty among minority investors about how and whether large global liquor companies Heineken and Diageo PLC will take their interests in Africa.

Should they choose to deemphasize beer at the expense of spirits, that could hurt the brewers.

Furthermore, some of these stocks are thinly traded and investing in Africa is still considered risky by many.

“If you invest in Africa, it will be a rocky ride between the possibility of economic and political instability, but if you look at the long-term potential, the rewards you can reap are very interesting and worthwhile,” said Francois Sonneville, Director in Food and Agribusiness Research at Rabobank International, a Dutch banking company.

Sonneville also said governments could impose tough taxes on beer companies if economic growth remains low this year.

Furthermore, not all of Africa may be equally ripe for beer sales. North African countries with large Muslim populations have some of the highest abstention rates in the world, according to the World Health Organization’s 2014 global status report on alcohol and health.

MONEY strategy

The Top 3 Reasons Never to Chase Investment Returns

539235813
BraunS—Getty Images

#1: The past is too late.

You hear advisors on TV talking about how they research and pick the securities with the highest returns. That sounds good since who doesn’t want the best? Why not jump in and catch the wave? Here are three reasons why not.

1. The past is too late. Those returns did happen, but the investment isn’t already in your portfolio. Regardless of how good they were, you don’t get the past returns of the investments you weren’t in.

If you take an old investment out and put a new investment into the portfolio after you notice it had better return, you get the returns of the lower performing investment. So you see the shell game? Switching out a lower performing investment gives you an illusion that your returns improve.

2. The future is unpredictable. Past performance does not guarantee future returns. You see this in every disclosure. Yet many still have the misperception that they can look at past returns to determine the future return of that investment.

Numerous studies have found that funds that did well in the past do not consistently go on to do so. The Standard & Poor’s ongoing reports on funds performance show that managers don’t year after year outperform the indexes.

I agree with advisor Daniel Solin’s article that we need a stronger disclaimer to better remind investors of this fact. A study he cites found that a more effective disclaimer would be: “Do not expect the fund’s quoted past performance to continue in the future. Studies show that mutual funds that have outperformed their peers in the past generally do not outperform them in the future. Strong past performance is often a matter of chance.”

3. Outperforming is not your goal. The real objective of investing is achieving your life goals, such as a sustainable retirement. That has more to do with your savings and spending rates that it does with returns. And unlike the returns the markets deliver, you can control how much you save or spend.

So how should you invest? Rather than chasing returns, simply invest in broad indexes and get what the markets give you – good and bad. This approach allows you to dial in the level of risk. You don’t get the occasional outperformance, but you also don’t underperform, either. Unless there are systematic risks – when the economy tanks, like it did in 2008 – you get consistent returns that match the markets.

One can wish for good returns all the time. But that is not how the markets work. Unexpected news and all participants’ expectations and reactions to it move prices. Your part is to let the markets work over time.

Larry R. Frank Sr., CFP, is a Registered Investment Advisor (California) in Roseville, Calif. He is the author of the book, Wealth Odyssey. He has an MBA with a finance concentration and B.S. cum laude in physics with which he views the world of money dynamically. He has peer-reviewed research published in the Journal of Financial Planning.

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MONEY mutual funds

The Simplest Way to Safeguard Your Investments Before a Market Selloff

highway signs with bear crossing and fever chart
Taylor Callery

If you're living in fear of a bear market, so-called Alt funds aren't your only alternative.

With all the talk of a possible bear market lurking just around the bend, it’s no wonder that investors are terrified of stocks. In the past 12 months they’ve yanked $110 billion from U.S. equity portfolios.

So if you’re a mutual fund company, what do you do? You promote funds that promise a big cut of the current bull market’s gains while claiming to have a secret sauce for protecting investors when a selloff strikes.

Enter alternative funds, or “alts,” which use strategies pioneered by hedge funds that will, theoretically, lessen a bear’s bite. “Long/short” equity funds try to do that by betting on parts of the market while simultaneously betting against, or short-selling, other shares or sectors. “Market neutral” funds are similar, but they make equal-size bets on and against equities, neutralizing the impact of overall market swings. Gains come instead from the fund manager’s ability to pick the right stocks to invest in or to short.

Is this bear protection worth it? Probably not, and here’s why:

The Track Record

Relatively few alt funds have even a five-year record, and that makes it tough to evaluate their efficacy—especially in a bear. Schwab Hedged Equity SCHWAB HEDGED EQUITY SWHEX 1.09% is one of the few such funds with a long record, having beaten most of its peers over the past one, three, and five years. In the 2008 crash, it lost 17 percentage points less than the S&P 500. But the following year the fund trailed the market by 11 points, and over the past five years it has lagged by eight points annually.

One reason alts struggle over time is expenses. The average long/short fund charges 1.87%. The Schwab fund charges 1.33%, but that’s still one point more than the fees on many stock index funds.

Read next: Higher Interest Rates Are Coming. Here’s Who Wins and Who Loses

The Simpler Alternative

If dampening potential bear-market losses is your aim, adding exposure to bond funds or cash may be just as effective as hedging. And you may not even need to add that much more ballast if you’re a diversified investor. A Vanguard study found that a simple 60% stock/40% bond portfolio can provide much of the same type of protection you’re seeking from a hedge-fund-like strategy.

A 60/40 strategy held its own against many types of hedge funds in the 2007–09 bear, and it trounced long/short- and market-neutral-style hedge funds by more than 10 percentage points from March 2009 through the end of 2011.

Just remember: If you are living in terror of a bear market now but are investing for the next 20 years or longer, the last thing you want to do is hedge your portfolio in such a way that it leaves you poorer in the long run.

John Waggoner has written three books on Wall Street and investing.

Read next: The Simplest Way to Safeguard Your Investments Before a Market Selloff

MONEY stocks

Get Ready for the Market’s Sugar High to End

milkshake and green detox shake
Yasu+junko

Investors still aren't thirsting for high-quality companies with fit finances.

At this point in a recovery—when anxiety is on the rise because the economy and stocks have been advancing for years and the Fed is about to raise rates—”investors often seek shelter in quality,” says Mark Freeman, chief investment officer at Westwood Holdings. That usually means companies with stable earnings and reliable (though not necessarily dazzling) growth.

Yet instead of favoring the Steady Eddies, Wall Street still has a taste for flashier fare. The S&P 500 Low Quality Rankings index—made up of headline-grabbing companies such as Amazon.com and Salesforce.com, both fast-growing firms that are having trouble generating reliable profits—has beaten high-quality stocks in four of the past six years.

While it’s normal for speculative parts of the market to lead the way coming out of a bear market, as in 2009, the fact that they’re still outperforming after more than six years is rather unusual.

This is especially true because high-quality shares generally do better over long periods. The Leuthold Group ranks the 1,500 largest stocks it tracks based on quality measures. Since 1986 the top 20% of shares based on quality rankings have generated annualized returns of 13.1%, vs. 9.7% for the lowest-quality stocks.

What’s more, market and economic factors are shifting now and could soon give high-quality stocks a new tailwind.

Why Tastes Could Change

The Fed factor. For years the Federal Reserve’s effort to keep a lid on interest rates to spur the economy has benefited lower-quality companies that rely on debt to finance their operations. For starters, heavily indebted corporations have been able to refinance their debt on the cheap while borrowing greater amounts at attractive rates.

At the same time, cheap money has encouraged investors to take risks and chase higher returns, pointing them in many cases to lower-quality stocks offering fatter yields, notes John Fox, research director at FAM Funds.

That’s a gambit that has paid off—at least until now. “As the Fed begins to raise rates, the equation should change,” says Fox. After all, investors may sour on low-quality stocks once cheap money dries up.

The 800-pound bear in the room. Something else to keep in mind is that this bull market has already run 2½ years longer than the typical rally—and has produced more than double the typical bull’s gains. So it’s not a stretch to think that equities are due for a pullback.

High-quality stocks are likely to lose less when the next downturn or bear market strikes, as the chart below shows. And while “it’s not always obvious, generating the highest excess return in periods when the market is down is how you can outperform over the long term,” says Brian Smith of Atlanta Capital Management, which invests in high-quality stocks.

How to Build a Moat

It used to be that fund investors seeking quality stocks had to go with actively managed portfolios such as the Yacktman Fund AMG YACKTMAN FUND YACKX 1.35% , which generates strong long-term returns by focusing on stable cash-generating cows.

Today there are several lower-cost index funds that cater to this strategy. For instance, PowerShares S&P 500 High Quality ETF POWERSHARES EXCHAN S&P 500 HIGH QUALITY PORT SPHQ 1.83% tracks blue-chip stocks with the most reliable earnings and dividend growth. When the market has been on the rise during the past five years, this ETF has managed to nearly keep pace. And when the market has fallen during that stretch, it has lost 17% less than the benchmark.

Market Vectors Morningstar Wide Moat ETF MARKET VECTORS ETF MKT VECTORS WIDE MOAT ETF MOAT 1.7% is another fund that will give your portfolio a tilt toward quality. The ETF tracks an index that focuses on the 150 or so companies that Morningstar analysts believe have strong sustainable competitive advantages, and thus are well positioned to churn out reliable earnings and profitability growth. Each quarter the index is reconfigured to hold the 20 stocks in this group that are trading at the steepest discounts.

Current holdings include Exxon Mobil and Berkshire Hathaway. The ETF’s 4% gain in the past year is less than half that of the S&P 500. But in 37 of the past 38 five-year rolling periods, this index has beaten the S&P 500.

And ultimately, isn’t that the best gauge of quality?

READ ALSO: The Simplest Way to Safeguard Your Investments Before a Market Selloff

MONEY mutual funds

Can You Beat the Vanguard 500 Index Fund?

John C. Bogle, founder of Vanguard and president of its Bogle Financial Markets Research Center, in his office at Vanguard’s headquarters in Malvern, Pennsylvania, Jan. 25, 2012.
Jessica Kourkounis—The New York Times/Redux Pictures John C. Bogle, founder of Vanguard and president of its Bogle Financial Markets Research Center, in his office at Vanguard’s headquarters in Malvern, Pennsylvania, Jan. 25, 2012.

It's the epitome of the low-cost mutual fund.

One of the simplest ways to invest, and get close to market-level returns, is with low-cost index funds. Of these kinds of funds, the Vanguard 500 Index Fund, which tracks the S&P 500, is one of the best-known and one of the largest, trailing only the Vanguard Total Stock Market Index Fund in total assets.

In short, lots of people have decided, since they can’t beat the market, they might as well be the market. Is that the right move for you? Furthermore, are there funds that follow other indices that offer better long-term potential? In short, there are other index funds — as well as individual stocks — that may be better-returning alternatives, but there’s still a lot to like about the Vanguard 500 Index Fund.

Let’s take a closer look at the fund itself (and the three share classes), as well as those alternatives.

Returns depend on which shares you own
Vanguard has long been the stalwart in low-cost index investing, since it was first started by Jack Bogle in the 1970s, and the Vanguard 500 Index Fund was the first of its kind. And while it remains one of the lowest-cost funds, it’s important to understand that there are actually three share classes within the fund, and depending on which shares you own, your returns will differ slightly:

Screen Shot 2015-07-23 at 2.07.07 PM

On the surface it looks like the ETF is a no-brainer, right? The best answer is, “it depends” because it varies by how much you’ll be able to invest up front, if the share class is even available to you (Admiral class shares aren’t typically available in most brokerage accounts), and how often you plan to reinvest new money, due to the impact of trading fees, especially for the ETF (which is traded on a stock exchange).

Here’s a look at how the expense ratio — which is the annual cost Vanguard charges to run the fund — alone has affected returns:

Screen Shot 2015-07-23 at 2.05.10 PM

Since just after launching the ETF shares, you can see that the difference in the expense ratio has affected total returns, while the ETF shares have also been affected by the more volatile nature of its trading on a stock index. Over a longer period of time, this would likely normalize, since it has the same intrinsic value as the other share types.

Which share class is best?
It’s largely a product of how much you have to invest, where you are investing it — i.e. 401(k) through your employer, a personal account with a discount broker, or directly with Vanguard — and how much/how often you will invest new money.

For example, a fund balance of below $10,000 in either mutual fund share class will cost a $20 per year service fee, while there’s no such fee for ETF shares. But you’ll be subject your broker’s commission rate if you buy ETF shares. As to the mutual fund shares, your broker may or may not even offer them for sale, limiting your options. The Admiral shares, as an example, are typically only available either directly through Vanguard, or through a Vanguard-managed relationship with your employer.

If you’re planning to invest less than $10,000, that $20 annual fee makes the “effective” expense ratio much higher, so if you’re not going to be able to get above that threshold, the ETF might be cheaper, unless you’re planning to invest new money regularly. If you are, then trading commissions would end up costing a lot more than $20 per year. In short, if you have the $3,000 minimum to invest and plan to add more on a regular basis, the investor shares are probably the best bet. If you will start with less, or buy new shares only occasionally, the ETF shares would be cheapest as long as your trading fees don’t break $20 per year.

Basically, figure out which share class will result in the least cost in fees and expenses based on how much you’ll invest, and invest in that class.

Make it part of a diverse portfolio
Even though the Vanguard 500 Index Fund is already diversified with exposure to the 500 largest U.S. public companies, you will improve your chances of the best long-term returns by not putting all of your eggs in this one basket of stocks.

It’s worth considering also investing in funds, like the iShares Russell 1000 Growth Index ETF ISHARES TRUST RUSSELL 1000 GROWTH INDEX F IWF 2.13% , adding exposure to more small companies, or the Vanguard Growth ETF VANGUARD INDEX FDS GROWTH VIPERS VUG 2.08% , (also available in mutual fund classes like the 500 Index Fund) which tracks the CRSP Large-Cap Growth Index — a collection of almost 400 more growth-oriented businesses than the S&P 500. Over the past several years, both of these funds have outperformed the 500 Index Fund, and there’s a lot of evidence that exposure to more companies with growth potential, versus just the S&P 500 components, can improve long-term returns.

Furthermore, there’s nothing wrong with investing a portion of your portfolio in index funds like these, while still investing in individual stocks. It will guarantee that you get market-level returns with at least a portion of your portfolio, while also trying to beat the market on your own. It’s hard to beat the market — most investors won’t. But it’s not impossible.

Either way, the Vanguard 500 Index Fund, after 40 years, remains one of the cheapest ways for the average investor to get market-level returns. If you’re looking for a low-cost, simple way to track the market’s returns, you could do worse.

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