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How to Pick a Passive Fund

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For most investors, I recommend a passive investment approach.

Exchange traded (ETFs) and open ended index mutual funds that focus on cost minimization [4] and accurately matching relevant market returns [5].

There are a plethora of ETFs and mutual funds available for investors. So how do you choose the best fund? 

Morningstar provides a good video, Tips on Picking the Best Passive Fund [6]. Some thoughts on the video below.

The Definition of “Index” Keeps Expanding

But now with so many ETFs coming out, there are a lot of ETFs that take some pretty abstract strategies and use the word “indexing” maybe going a little bit too far. We do have a lot of cap-weighted indexes, which are going to be the very passive ones that are going to have low turnover and generally very low costs. But you also have to sort through some of the other names out there that will take an old strategy, say the S&P 500, and do something unique to it, say equal-weight it or put fundamental factors in there to pick the stocks in there. Now technically it’s still in index, but it’s not the same type of index that your grandfather is used to.

Just because an investment claims to be an index fund does not mean that it is as you think it is. Read the prospectus and/or other fund information. Know exactly how the fund invests and what its relevant benchmark is.

Lump Sum or Dollar Cost Averaging?

with mutual funds, oftentimes, if you’re going to be putting in smaller amounts of money very frequently, that’s going to be the better structure for you, so you don’t incur the transaction costs. But if you’re going to move a larger lump sum of money and you can find an ETF that’s going to have a lower cost for you–the lower expense ratio–that probably would be a good bet.

Mutual fund companies often allow investors to initially invest in a fund with a reasonable dollar outlay (say USD 1000). Then subsequent investments can be made automatically on a periodic basis with relatively small cash outlays (say USD 250). Assuming the fund is no-load, you can build a solid portfolio slowly over time quite cheaply.

Of course, if you are paying commissions on purchases, then you will incur costs on each purchase. So stick with no-load funds.

ETFs are purchased from stock exchanges, not mutual fund companies. Each purchase requires paying a transaction fee. The greater the frequency of purchases, the more fees you will pay.

Note that some brokerage houses offer no-fee ETFs as a way to reduce transaction costs.

Portfolio Construction

When you’re building a portfolio of passive funds, generally, it’s my opinion that you should stick within the same index family to minimize that overlap, and make sure you’re targeting the factor that you’re looking for. A lot of people understand the value premium; over a decade or longer, value tends to outperform growth.

Not bad advice for mutual funds. Also, staying within one family of funds is often the most cost effective option with funds. Investors usually can move cash between funds without fees and minimum purchases are often for the fund family rather than simply a single fund.

However, there may still be overlap between funds within the same family of funds. Always review portfolio holdings, especially the top 10 investments, to ensure you do not have too much exposure to any single holding throughout your funds.

Not discussed in the video, but also consider the actual construction methodology of the mutual fund or ETF. If trying to match a specific market, you want to make sure that your investment actually tracks the benchmark index as closely as is possible. Tracking errors impact your portfolio performance.