When Mutual Funds Make Sense

The best thing about mutual funds is that they are an easy way to hold a diversified investment.  The difficult thing about mutual funds is that many mutual funds underperform the broader market, they can be expensive, and there are so many options available that picking among them can be daunting.  But it is possible to pick high quality, low expense mutual funds that are suited to you, and it is important to determine when a portfolio calls for them.

It is our philosophy that in large portfolios, mutual funds are best used to get exposure to international, small-cap, and some mid-cap companies.  This is because the universe of international and small companies is so large, it is best to rely on an active manager who specializes in those areas.  Also, research and financial data is not as readily available on international and small-cap stocks, making active managers all the more important. 

We do believe, however, that we can create a well-diversified portfolio of large-cap, domestic (S&P 500) companies by buying individual stocks.  There is a plethora of research available on these companies, making financial data transparent and easy to obtain.  The trading costs on individual stocks is low enough that this is a more cost effective way to get exposure to this area if your portfolio is large enough to fit 30-50 individual positions of a reasonable size.

In smaller portfolios it becomes less cost effective to buy individual stocks.  To get 40 individual stocks in a portfolio that already encompasses bonds, international and small-cap funds, we would need to resort to very small position sizes.  The smaller the position size, the larger the transaction cost as a percentage of the holding.  Therefore, we believe that depending on the size and the number of accounts within a portfolio, mutual funds may be the best option.

When we choose mutual funds we look for those of the highest quality.  We focus on long-term performance track records, various risk measures associated with the funds, and low-cost investments.  We routinely assess the quality of the funds we hold, and screen for new additions to our fund buy list.  If a fund no longer meets our criteria, we will replace it with a fund we view as better.

To what extent a client has mutual funds in their portfolio is determined on a case-by-case basis.  Sometimes this comes down to client comfort level and perspective.  Other times it is a function of the type and size of accounts in a portfolio.  We work with clients to determine what makes the most sense for their particular situation.

Harli L. Palme, CFP®

Financial Advisor

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