Editor’s note: some charts may not display properly on the web.

3.1. Types of Investment Funds 
There are many types of investment funds. We would break these down into three major categories:

• Mutual funds. By mutual funds, we mean funds which have a fund manager or a team of investment professionals which are choosing specific investments for the fund. The aim of this is to provide a performance return that is higher than that of the overall index (sometimes the S&P 500 for broad-based mutual funds) which can be used to benchmark the style or types of investments the fund is focused on. The advantage of a mutual fund is that it is possible you may see performance better than the relevant index. The disadvantage is that costs are generally higher. A mutual fund only makes sense if it is expected that the extra fund performance will exceed the extra costs.

• Index funds. Index funds are funds constructed to track a given index. For instance a fund may be constructed to track the Standard & Poor’s 500 (S&P 500) index or various indices maintained by Morgan Stanley Capital International (MSCI), which are often country indices. The advantage of an index fund is that transaction costs are low and fund performance is guaranteed to match an index over the long-term.

• Exchange-traded funds (ETF). Exchange-traded funds are similar to index funds in some way in that the constituents of the funds are generally chosen by a system or are meant to track an index rather than actively managed by human decisions. An exchange-traded fund also has the advantage of lower transaction costs as compared to a mutual fund. A further advantage of the exchange-traded fund is that the fund is allocated to investors in the form of tradable shares. Compared to a mutual fund or an index fund, the liquidity of an exchange traded fund may be slightly higher. That is, the fund can be easily sold or bought at any time when trading is being conducted. With mutual or index funds, one often has to wait until the close of trading to really sell or buy the fund. The price of entry or exit would not be known until the close of the trading day. In addition, very large mutual fund redemptions can alter the performance of the fund itself as the fund would be forced to buy or sell underlying securities as the fund size changed. For an ETF, the shares can be traded intra-day, like regular stock purchases and ETF shares can be sold from one investor to another, without resulting in transactions in the underlying securities held by the ETF.

Within each of these categories, it is possible to find funds which are focused on certain investing styles or certain types of investments. There are many investment styles, but the major style categories are the following: value, momentum (most likely labeled growth), large-cap, small-cap.

Here, we would like to outline our preference for the value category but also we would like to clarify our definition of the value category. We believe there is a big mis-labeling going on in the fund industry. Generally, the value category is juxtaposed against the growth category. We believe both categories are actually mis-labeled. First, we would rename the growth category as momentum and then we would make our definition of value more expansive than some funds allow for. Not all funds are mis-labeled, but enough are to warrant caution.

A value fund could mean a fund which looks for shares which it deems to be under-valued and this is the sole criteria. The investments such a fund makes could be in high-technology or it could be in a high price-to-earnings (P/E) ratio stock if the fund thought the stock was undervalued. This is the kind of value fund we generally would prefer. Oftentimes, value may also mean a fund which looks for stocks with a low P/E ratio or which the fund deems cheap on an absolute basis. This kind of fund can work but sometimes, funds which are overly focused on low price limit their investment universe too much and, in the worse case, can find themselves invested in stocks that are cheap for a reason – i.e. – value traps. This is one issue we want to highlight.

Moving onto the fund category usually labeled growth, we want to highlight that this often means momentum. Funds labeled growth are ostensibly invested in high-growth companies. But often the growth category is used to justify purchases of expensive stocks on the basis that an expensive stock is expensive because it is likely to grow quickly and may seem cheap in the future if growth is high enough. If this is truly the case, the stock can be said to be under-valued and the stock could be considered a value stock according to the method which we would like to use to define value.

What can happen in a so-called growth fund, however, is that the justification that expensive stocks can be bought because growth is high ends up being a justification for buying expensive stocks period. The way stocks are often chosen in a growth fund is that companies which have grown quickly in the past are labeled growth. Those companies which have grown quickly in the past have likely seen their share prices rise already. If this is the case, a growth stock really ends up being a momentum stock. That is, it ends up being a stock which is forecast to rise in the future because its recent track record has been to rise. This kind of investment philosophy is not one we would subscribe too, so we would advise caution when evaluating growth funds.

In terms of the types of investments which a fund may focus on, this is quite broad. A fund can concentrate in certain industries – i.e. energy, technology, etc. A fund could concentrate on investing in certain geographic regions – i.e. U.S., China, Japan, Latin America, emerging markets as a whole, etc. A fund might also concentrate on a certain type of asset – i.e. stocks, bonds, real estate, commodities/precious metals, etc.

3.2. Choosing Mutual Funds: Process vs. Outcome
In choosing an actively managed mutual fund, we would de-emphasize the recent short-term track record of the fund (by short-term, we mean less than three years) although it is tempting to use this measure as the primary criterion. Instead, we would focus on the long-term track record, if available, as this is a better indication that the performance was due to skill rather than luck. And, we would especially focus on trying to understand the investment philosophy of the portfolio manager in charge of the fund and the process the fund uses to make investment decision.

A great short-term investment track record for a fund may be due to luck as much as skill. In particular, funds that happen to be focused in a particular industry or focused on a particular style of investing will do very well when that industry or style is hot. However, this may simply be a case of being in the right place at the right time rather than skill. As a result, when looking at investment performance, we would want to look at the portfolio manager’s performance relative to an appropriate benchmark rather than her absolute performance alone. For instance, if a fund focuses on the energy sector, we would want to compare that fund’s performance to other funds focused on the energy sector and an energy sector index. This would help us to determine what value has been added to the fund due to the manager’s skill.

Besides long-term investment performance, we would put a special emphasis on the investment philosophy and process that the fund manager uses to manage her fund. In fact, this process is more important than short-term outcome. Over the medium to long-term, a valid investment philosophy and process is likely to be successful. In contrast, a positive investment outcome over the short-term that is not underpinned by good process is likely to fall apart as time passes.

How do we find out about the investment fund’s process and philosophy? This may be difficult but possible for some funds. To the extent the fund produces any literature outlining the thought process that goes into the management of the fund, this is helpful. Especially helpful are any interviews of the fund managers where the fund manager’s thinking process can be heard in his own words. Barron’s magazine is a good source of fund manager interviews as the magazine generally interviews one or more fund managers per issue. Well-known fund managers may have even written books.

For example, two value managers – John Neff of the Windsor Funds and Bill Miller of Legg Mason – both have excellent long-term track records and also have given interviews and/or written books. While John Neff is retired, an understanding of his thought process and investment philosophy he outlines (a concentration on low P/E and dividend yield) can still be helpful. If one likes John Neff’s investment philosophy, it would make sense to find a fund manager who seems to be making decisions in a similar manner. The writings of Warren Buffet – particularly his annual reports to shareholders (which can be downloaded on the internet at www.berkshirehathaway.com) – are also helpful in that by reading these, one can begin to understand the investment process which Warren Buffet goes through to make investment decisions. If one likes this process, one can either than invest in Berkshire Hathaway (which is like investing in a fund managed by Warren Buffet) or seek out fund managers who share his investment philosophies.

Thus, a good long-term track record and an investment philosophy and process which we agree with are the two criteria we would use to evaluate actively managed mutual funds. An evaluation of investment philosophy and process is especially useful to get beyond the labels which are attached to a fund to simplify description of the fund’s investment style. We highlighted the caution which should be applied when evaluating the labels value and growth in a previous section. We would use an evaluation of the fund managers investment philosophy and process to delve beyond the simple label and to really understand whether the fund is what we are looking for or not.

In deciding whether to buy an actively managed investment fund or a passively managed investment fund, we would narrow this down to two issues: 1) investment return and 2) cost. In this discussion, we would group index funds and exchange-traded funds into the passively managed investment fund category while mutual funds with an investment manager who is actively trying to beat the market indices would be considered an actively managed fund. At the end of this section, we will review the differences between an exchange traded fund and an index fund.

The first key difference between an actively managed investment fund and a passively managed investment fund is in investment return potential. A well constructed passive fund will simply mimic the return of the index which it is trying to mirror. For instance an S&P 500 index fund will give you more or less the investment return of the S&P 500 index in any given year. The same can be said for an exchange-traded fund which mimics the Dow Jones U.S. Oil and Gas Exploration and Production index.

In contrast, an actively managed investment fund is run by a fund manager or a team of investment professionals whose goal is to beat whichever index is the most relevant for comparison’s sake. A broad-based large-cap fund may use as a benchmark the S&P 500 index and the goal of the fund’s manager would be to beat the return of the S&P 500 index. Therefore, the actively managed fund has the potential to show a wider variety of outcomes relative to its benchmark as compared to an index fund which can be predictably relied upon to show the return of its benchmark.

Having said this, an actively managed fund and a passively managed fund can both show good or poor results. The passively managed fund may show a loss for the year or a gain for the year depending on how the index which it was constructed to track has faired. An actively managed fund will, generally speaking, also track the index which it uses as a benchmark but its performance could exceed this benchmark or be worse than the benchmark. In other words, the index it uses as a benchmark could show good performance while the active fund shows poor performance or vice versa.

The second key difference between an actively managed investment fund and a passively managed investment fund is the cost. Costs can be broken down into three types: 1) transaction costs and 2) ongoing fund management costs and 3) trading costs associated with the funds own portfolio turnover.

We define transaction cost as the cost to buy or sell a given fund. Active funds may have a front-end or back-end load which entails a relatively high cost when buying or selling the fund (sometimes on the order of 5%). Transaction costs for passively managed funds are generally low.

We define ongoing fund management costs as encompassing all costs associated with managing the fund in a given year, not including trading costs. This is basically what’s called the fund’s expense ratio, which can amount to 1-2% per year. The fund’s management fee is used to pay the overhead and salaries of the professionals required to manage and sell the fund. Index funds will generally have much lower expense ratios (less than 1% per year, sometimes significantly less than 1%) while exchange-traded funds often have even lower expense ratios than index funds. Because the composition of ETF’s and index funds is straightforward, the amount of labor required to maintain these funds holdings is limited.

Finally, there is the third category of costs and that is costs associated with the funds own buying and selling of securities. These are primarily brokerage fees paid by the fund for its trading. If an actively managed mutual fund has a high portfolio turnover – that is, it changes the stocks it owns frequently – its total fund management costs, aside from its expense ratio will be even higher, as it pays out more in brokerage fees. Passively managed funds generally have lower portfolio turnover, and thus pay out less in brokerage fees, than actively managed funds.

Given the fact that actively managed funds will no doubt cost more (both on an ongoing basis and oftentimes when entering or exiting the fund), it only makes sense to invest in an actively managed fund over a passively managed fund if the performance of the active fund is expected to exceed the performance of the passive fund by an amount greater than the extra cost incurred. While the cost difference on an annual basis between an active fund and a passive fund may seem small (1-2%), this cost difference can have a major impact on your returns over time due to the magic of compounding, if the performance of the active and passive fund is the same, before expenses.

We show this impact in Chart 1 below. In the chart, we assume that both the active and the passive fund earn a return of 10%, before fees, each year. Excluding transaction costs, but assuming an expense ratio of 1.75% per year for the active fund and 0.25% for the index fund, we see that after 10 years, $1,000 invested in the active fund becomes $2,174 but $2,530 for the index fund. After 30 years, the same $1,000 becomes $10,274 for the active fund and $16,187 for the index fund. The gap in performance will be even greater if differences in transactions costs are taken into account and also if there are large differences in brokerage fees paid out.

Chart 1: Over Time, Expenses Can Take a Big Bite Out of Returns

The purpose of our showing you the chart above is not to say that you shouldn’t invest in an actively managed mutual fund. It is, however, meant to demonstrate that if you decide to choose an actively managed mutual fund, you must really choose very carefully. The majority of actively managed mutual funds underperform index funds after costs. You should only decide to invest in an actively managed mutual fund over an index fund if you have a good reason to expect that fund to outperform its relevant competing passive fund by an amount greater than the cost differential between the two choices.

Among passively managed investment funds, we find two major categories of funds: 1) index funds and 2) exchange-traded funds (ETFs). Index fund and exchange traded funds are similar in that they usually are created to track the performance of a given index. The given index can be either a broad-based index, such as the S&P 500 or Wilshire 2000. The index can also be a narrow or specialized index such as one that tracks the U.S. Healthcare or the U.S. Technology industries. Index funds and ETFs can also track international indices, in addition to industry indices. Index funds and ETFs are not really actively managed – they are, instead, systematically managed in a way to track certain stock market indices. Because index funds and ETFs are more passively managed, they generally have significantly lower expense ratios than regular mutual funds. Since their portfolio compositions are also less likely to change as frequently as a regular mutual fund, index funds and ETFs may also have lower brokerage costs associated with the trading that they do, further lowering ongoing costs.

The primary difference between an index fund and ETF is in the liquidity of the two instruments. That is, in the manner in which they can be bought and sold. ETFs can be traded during the opening hours of the stock exchange on which they trade. In contrast, an index fund can only be transacted at fixed times each day. This is because ETF shares are similar to stock shares and can be bought and sold between investors. A fund’s shares must be created and redeemed by the fund management company itself. Thus, the ETF can be said to have more liquidity.

ETFs may have higher costs at purchase and sales than an index fund if the fund is a no-load fund. This is because you must pay brokerage commissions when you sell or purchase an ETF. However, ETFs also usually, but not necessarily always, have lower ongoing expense ratios than index funds. You will have to do your own comparisons of specific funds to know for sure which is more cost effective.