A Simple Path To Financial Wealth With Just 3 Low-Cost Mutual Funds

by: Minutemen


People who pay financial managers to invest in mutual funds are throwing money away in unnecessary fees and poor performance.

The majority of actively managed equity mutual funds do no beat their benchmark indices.

For those with little time or energy for investment research, I identify two low-cost, high-quality, and passively managed stock funds and one municipal bond fund for all your investment needs.

Recently I've had several people tell me how great their financial advisor is. Curious, I asked what kind of investments their advisor had them in. To my surprise they indicated that they didn't invest in anything other than mutual funds. Now don't get me wrong, I think mutual funds are a terrific way to invest in the market, but why on earth would you pay money to a financial advisor to do something you could easily do yourself for free? The response was typically either a lack of knowledge about what to invest in or lack of time to do the research. Both of these reasons are poor as there is nothing easier than setting up a very simple, diverse, and sound investment portfolio consisting of a maximum of just three mutual funds. Yes, just three! And with just three mutual funds to think about, the only action and time on the investor's part is that which is needed to set up an account and in deciding how much money to invest.

And of course for equities I'm talking about passively managed, low-cost index funds (see my recent article on why index funds provide a low-risk way to invest in stocks). While investment companies will tout the stock picking skill of their fund managers, the simple truth is that most actively managed equity funds, especially over the long-term, fail to beat their benchmark indexes. For instance, Standard & Poor's recently published its S&P Indices Versus Active Funds (SPIVA) U.S. Scorecard in which it was found that, for the five years ended Dec. 31, 2013, 73% of large-cap U.S. funds, 78% of midcap funds, 67% of small-cap funds and 80% of REIT funds underperformed their benchmark indices (see highlighted rows in Figure 1 below).

Figure 1: For the five years ended December 31, 2013, the large majority of actively managed equity index funds failed to beat their benchmark indices. If you can't beat 'em, join 'em!

So not only do most actively managed equity funds fail to beat their benchmarks over the long-term, they also charge you additional money for their failure as these active funds have annual fees and expenses that far exceed those of passive index funds. These additional costs further erode the annualized gains for investors.

Despite this obvious outperformance by the indices, proponents of actively managed funds often claim that it is difficult to outperform an index during a bull market like we had from 2009-2013, and that actively managed funds will protect investors from losses during bear markets. However, according to the 2009 SPIVA Scorecard, 49% of large-cap funds, 74% of midcap funds, 63% of small-cap funds and 52% of REIT funds underperformed their benchmark indices for the three-year bear-market period of 2007 through 2009. And again, these losses would be further compounded by the additional expenses tacked on to actively managed funds for all of the fund manager's "hard work" dedicated to losing your money.

Financial advisors also charge fees for their services, which further erodes total returns. If the advisors are simply just having you invest your money in mutual funds, most of which perform no better than their benchmarks and cost more, then why not just invest in the benchmarks themselves? Passively managed mutual equity funds can be found with extremely low annual fees and that offer broad diversification. In addition, you know that you will always get returns roughly equivalent to the benchmark. Despite the confusing array of index mutual funds and investment companies that sell them, I think that there are only three that anyone really needs, and all of them are from Vanguard (which offers funds with some of the lowest costs in the industry). And for the record, no, I am not a Vanguard employee! But I do own their funds. Two of these funds are passively managed equity index funds, and the third is a low-cost, actively managed municipal bond fund.

The three mutual funds are:

  1. Vanguard Total Stock Market Index Fund (MUTF:VTSMX); Admiral Shares (MUTF:VTSAX)
  2. Vanguard FTSE All-World ex-U.S. Index Fund (MUTF:VFWIX); Admiral Shares (MUTF:VFWAX)
  3. Vanguard Intermediate-Term Tax-Exempt Fund (MUTF:VWITX); Admiral Shares (MUTF:VWIUX)

The beauty of the first two funds is that they give investors exposure to pretty much the entire stock-market world in just two passively managed index funds. My recommendation for these first two stock funds is that investors put most of the principal they want in stocks into the Total U.S. Stock Index Fund and with no more than 30% of their stock exposure in the All-World ex-U.S. Index Fund.

The third fund is an actively managed but very low-cost municipal bond fund that is free from federal taxation. This fund is recommended primarily for those in higher tax brackets as a way to reduce one's effective federal tax rate, and for those seeking tax-free income. As a more conservative fund, and thus providing lower growth potential, it is not recommended for younger investors with decades of investing years in front of them. The municipal bond fund is also a nice vehicle to move money into as one gets older in order reduce exposure to riskier equities and for providing tax-free income. And in case you're wondering, this actively managed fund has either equaled or exceeded its benchmark index over the past 10 years (the outstanding 10-year performance, management team, and low-cost give this active fund the edge over passive management in this case).

All three mutual funds can be purchased as "Investor Shares" or as "Admiral Shares." Both share types have very low annual costs, but the Admiral Shares offer even lower annual expenses, although they do require a larger investment amount to qualify (Investor Shares are automatically converted to Admiral Shares by Vanguard when the threshold qualification amount is reached). Following is some information on these three funds.

Vanguard Total Stock Market Index Fund (VTSMX/VTSAX)

This passively managed index fund provides investors with exposure to the entire U.S. equity market, including small-cap, mid-cap, and large-cap growth and value stocks. Although the Vanguard S&P 500 Index Fund (MUTF:VFIAX) is also an outstanding choice, the Vanguard Total Stock Market Fund has outperformed the S&P 500 fund over the long term (see Figure 2 below). Morningstar rates this fund's past performance with a 4-star rating (5 is highest) and an analyst gold-medal award, indicating that it is deemed likely to outperform its peers over the next five years. The fund consists of 3,722 stocks and has an annual expense ratio of 0.17% for investor shares and 0.05% for admiral shares. The current SEC Yield is 1.73% for Investor Shares and 1.85% for Admiral Shares. The extremely low expense ratio of the admiral shares gives it a 1% advantage over the average blended mutual fund, and it has outperformed 84% of large-blend mutual funds over the past decade.

This fund is very tax efficient and is ideal for taxable accounts. Because it covers nearly all U.S. stocks, it is not forced to sell stocks as they move in and out various categories (e.g., in out of small-cap, mid-cap, large-cap fund categories as other categorical funds must do). Thus there are fewer capital gains taxes distributed, which is one reason why this fund has outperformed the S&P 500 index fund (also a tax efficient fund).

Figure 2: While both outstanding and low-cost index funds, the Vanguard Total U.S. Stock Market Index Fund has outperformed the S&P 500 fund in total returns over the past ten years, primarily due it being a more tax efficient fund.

Figure 3: Average annual return history for VTSMX. Top row is the mutual fund's performance. Bottom row is the benchmark index. Source: Vanguard

Figure 4: Risk/reward potential for VTSMX/VTSAX fund on a 1-5 scale. Source: Vanguard

Vanguard FTSE All-World ex-US Index Fund (VFWIX/VFWAX)

This cap-weighted index mutual fund seeks to track an index that consists of companies located in developed markets, including Europe, the Pacific, and Canada, and in emerging markets. It invests in 2,453 large-cap and mid-cap companies outside of the U.S. While most of the portfolio consists of stocks in developed countries, it does give investors a 20% exposure to emerging markets. The fund has a 3-star rating from Morningstar and an analyst gold-medal rating. The expense ratio is 0.30% for Investor Shares and 0.15% for Admiral Shares. The trailing-twelve-moth yield for Investor Shares is 3.12% and for Admiral Shares is 3.38%.

Emerging markets have been hammered this year on global economic concerns. For long-term investors, this downturn presents a buying opportunity to get shares at a discount, especially considering the run-up in U.S. equities (see Figure 5 below). However, it is advisable that investors hold no more than 30% of this fund as it does have a higher risk profile than U.S. equities (Figure 7), and a 2012 analysis by Vanguard concludes that international allocations exceeding 40% have not historically provided any diversification benefits. In terms of equity allocation amounts between the U.S. and All-World funds, a starting point of an 80% in the U.S. fund and 20% in the All-World fund is reasonable to provide a diverse allocation to global market capitalization.

Figure 5: Like other emerging market equities, Vanguard's FTSE All World ex-US mutual fund has taken a beating year to date (YTD). For long-term investors, this presents a terrific opportunity to purchase international shares on sale. The fund is down 5.18% YTD and is down 10% since its YTD high on June 19.

Figure 6: Average annual return history for VFWIX. Top row is the mutual fund's performance. Bottom row is the benchmark index. Source: Vanguard

Figure 7: Risk/reward potential for the VFWIX/VFWAX. Emerging market exposure gives this fund a higher risk potential, but also greater growth potential. Expect higher volatility with this fund. Source: Vanguard

Vanguard Intermediate-Term Tax-Exempt Fund (VWITX/VWIUX)

This actively managed and low-cost municipal bond fund seeks to provide federally tax-exempt income and typically appeals to investors in higher tax brackets. While there are other municipal bond funds with higher yields, management of this fund does not purchase higher-risk municipal bonds and largely selects bonds rated AA or higher (76% of the portfolio). Vanguard's low fees are an important driver of performance for the fund as its net-of-expense return ranks it in the top 15% of its peer group on total returns. The fund has a 4-star rating from Morningstar as well as an analyst silver-medal award. There is a minimum investment of $3,000 required for Investor Shares (0.20% expense ratio) and a minimum of $50,000 for Admiral Shares (0.12% expense ratio).

The SEC Yield (30-day yield) is currently 1.56% for Investor Shares and 1.87% for Admiral Shares. And keep in mind that since this distribution yield is free from federal taxation, that 1.87% yield for Admiral Shares translates to 2.79%, 2.88%, and 3.10% for investors in the 33rd, 35th and 39.6th percentile tax brackets. Not too shabby!

Figure 8: Share-price returns (blue line) and total returns with tax-free distributions reinvested (orange line) over the past 10 years. Note that the share price has not increased much over the past 10 years, indicating the lower volatility and lower risk with this fund. However, with the tax-free distributions reinvested (distributions are paid monthly), the total returns have been much better. This fund provides a nice way to reduce tax burden for investors in high-income brackets.

Figure 9: Top row is the mutual fund's performance. Bottom row is the benchmark index. Source: Vanguard

Figure 10: Risk/reward potential for the VWITX/VWIUX. The municipal bond fund provides a lower risk to principal loss than the equity mutual funds, but also has less growth potential.

Conclusion: For those that have no time or energy to devote to financial investments, there is no need to pay someone to simply invest your money into mutual funds. As the data above have shown, very few actively managed equity mutual funds outperform their benchmark indices over even just a five-year period (they do even worse over longer periods of time). Paying money for a financial advisor and then even more money for the high-fees of actively managed equity funds erodes performance and investor returns.

I have provided information on just two passively managed, low-cost mutual index funds that cover the global equities market, and a third actively managed, low-cost municipal bond fund that provides investors with tax-free income as a way to reduce tax burden and/or to provide a regular monthly tax-free income stream. The only decision an investor has to make is how much to allocate to the three mutual funds.

Opening an account and setting up regular, automatic payments is a simple, hassle-free way to invest in the market. Regular contributions are important to long-term growth as it provides for dollar-cost-averaging to ensure that one is purchasing more shares when the market is lower and fewer shares when the market is higher. While all of these mutual funds are from Vanguard, one can certainly find similar low cost products from other companies as well.

Disclosure: The author is long VFIAX, VTSAX, VWIUX.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.