Recently I received the following question from one of my long time readers:
"I have a question about how to select among the funds offered in a 401k/403b plan. My employer offers several funds for each fund category (international, large cap, mid cap, etc...). Every so often new funds are being introduced and I'm not sure whether the new fund would be a better one in that category than the one I have. So how does one choose? By always picking the lowest cost fund? By comparing the fund performances over the past 5 or 10 years? By comparing against an index? (and then which one?)Florin"
First of all, I want to thank Florin for sending me the question. I love getting e-mail - questions, comments or ideas - from my readers. That's a large part of why I blog. I respond to each one of my readers (not so much to commercial solicitations), and if you send me a question and include your website, chances are I will respond to your question on this blog and include a link to your site. Anyway, I already responded to Florin via e-mail, but here is a more detailed answer to his question:
What Florin is facing is the reason that when we redesigned our 401K plan at my previous company our advisers advised us to select a relatively small number of funds, that covered the necessary asset classes. By his questions Florin is clearly a financially literate person, yet such decisions are not easy ones to make and many feel confused or overwhelmed by them.
When selecting funds for my own 401K, I follow a pretty straight forward process that may work for others as well:
Decide on an asset allocation - simply described, an asset allocation is the mix of assets (stocks, bonds etc.) that you own. The way you allocate your assets should be based on two main factors: your investment horizon and your willingness to accept risk. Here is a more detailed post on asset allocation for additional background.
When building my asset allocation plan I do so for my entire portfolio, not just for my 401K - taking into consideration all the different accounts and my wife and I own. It doesn't make sense to optimize my 401K allocation unless the strategy fits our portfolio as a whole. Generally speaking, I try to put my tax inefficient funds in a tax deferred account (e.g. REITs that keep throwing off dividends that would otherwise be taxed, can be sheltered by a 401K).
By the way, our own target asset allocation is approximately 45% US stocks, 30% international stocks, 15% bonds, and 8 - 10% real estate (through REITs). For reference, my wife and I are in our late thirties and are fairly tolerant of risk, i.e. we don't sell our equity positions in a down market...
Find Funds that Fit the Planned Asset Allocation - here's the trick: since we do our asset allocation across the entire portfolio, if I don't find a fund that I am happy with for a certain asset class in our 401K plan, I don't sweat it. I simply buy the appropriate fund in another one of our accounts and balance my 401K allocation appropriately. This is important because many 401K plans offer limited or unacceptable fund choices for one or more asset classes.
Selecting Between Similar Funds - If there are several funds in a given asset class, I typically choose between them according to the following priority:
(i) index funds first - as I explained in my very first post on this blog, I am a big believer in index investing;
(ii) comparing expense ratios - look, the expenses and fees that you pay for investing in a mutual fund may not always be the most important thing about investing, but I have found few exceptions;
(iii) comparing morning star ratings - if we are talking index funds that's not relevant, but if an index is not an option, checking up on the fund rating is a good idea;
Florin also asks a very prudent question: which index should you compare the performance of a fund against to determine the fund's success?
Investors should understand that they can frequently gain a higher return by accepting a higher degree of risk (you can read about this in my advanced portfolio building series). So the fact that a certain fund generates a higher rate of return than a broad stock index does not necessarily mean that it is an appropriate investment for you or that it is actually out-performing the relevant index. To measure the true performance of a fund, measure it against the return of an index that more or less covers the same asset class. For example, a large cap fund can be measured against the S&P 500 while a fund investing in small caps would be better measured against the Russell 2000 index and a real estate fund may be better compared against Vanguards Total REIT index fund or similar real estate benchmark.