NEW YORK (CNN/Money) -
In Tuesday's column, I discussed the serious problems affecting the mutual fund industry over the past few years. Today, I'm focusing on specific strategies that will help you use mutual funds to your greatest advantage.
Individual investors have grown more skeptical about mutual funds recently -- partly because of stock fund losses during the past bear market and partly because of recent industry scandals.
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But the biggest risks funds pose come not from improper practices but from their investing approach and their fees.
A few star fund managers -- such as Robert Rodriguez and Jean-Marie Eveillard -- stick with positions for long periods of time and are willing to build up larger cash positions (as they have recently).
But most managers try to remain fully invested and, instead of leaning against prevailing trends, generally have to follow the crowd to compete with rival managers.
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Even more daunting are the fees investors end up paying. If the market returns 12 percent or so on average, and a fund charges expenses totaling more than 1.2 percentage points a year, then you're losing more than one tenth of your return.
Owning individual stocks has its own costs, but those average down over time if you're a long-term investor.
Be a better investor
With those facts in mind, here are smart strategies for making the most of fund investing.
- Favor index funds with total annual expenses below half a percentage point, if you have less than $50,000 to invest or plan to build a portfolio from scratch by investing small amounts of money at monthly or quarterly intervals.
- Buy individual stocks for the core of your portfolio, if you have more than $50,000. This core should consist of large, dominant growth stocks with projected average earnings gains of 12 percent to 16 percent a year. If you are more conservative, you can rely instead on growth and income stocks with yields above 2 percent and projected annual growth in the 8 percent to 12 percent range.
- Plan on holding for more than five years, on average, to minimize the annualized cost of buying and selling individual stocks.
- Look for annual expenses of less than one percentage point, if you do want to buy a managed equity fund. Pick a large, established fund company that has remained untouched by scandal.
- Wherever feasible, buy large, individual U.S. stocks to fulfill various pieces of your total portfolio strategy. Use funds for those niches that are otherwise hard to fill.
- Use funds for small aggressive growth stocks, special situations and other research-intensive investment strategies.
- Use funds for foreign stocks, except for shares of multinationals that trade -- either directly or as American Depository Receipts -- on the New York Stock Exchange.
- Use funds for junk bonds. Buy Treasury bonds directly. Corporate bonds can go either way, but consider buying them directly.
- Consider funds for Real Estate Investment Trusts, unless you plan to buy one of the half dozen best-followed REITs.
- Consider funds if you want to invest in a cross section of top gold-mining shares. Your alternative is to buy Barrick Gold or Newmont Mining.
It may sound as though there are lots of funds worth considering -- and there are. But most of your portfolio will probably consist of long-term growth stocks, top growth-and-income stocks, Treasury bonds, high-quality corporate bonds and money-market funds.
You don't need funds for those categories. Pay up only where you're getting real value added that more than makes up for the drag of annual fees.
Michael Sivy is an editor-at-large for MONEY magazine. Sign up for free e-mail delivery every Monday and Thursday of Sivy on Stocks.
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