A Simple Trick to Boost Mutual Fund Returns

Here is how to capture advertised mutual fund growth.

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As an investor, you are probably frustrated when you read the stellar returns advertised by top performing mutual funds. Even if you owned those funds, your returns are typically far less than those advertised.

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Many studies have demonstrated that investors in actively managed stock and bond mutual funds, where the fund manager attempts to beat the returns of a designated benchmark, capture only a fraction of the returns of the fund. One study looked at the actual returns of investors in bond mutual funds for the 20-year period from 1990 to 2009. It found investors captured only 15 percent of the returns of those funds.

Investors in actively managed stock funds did a little better, but also fared poorly. They captured 39 percent of the returns of their funds. How could this be? Investors don’t have the discipline to stay the course in turbulent markets. They jump from fund to fund, chasing the next hot fund manager.

Here’s the trick to overcoming this dismal track record: Buy a globally diversified portfolio of low cost index funds in an asset allocation appropriate for you. Rebalance your portfolio once or twice a year to insure you remain at your designated risk level.

It’s very easy to implement this advice. In The Smartest Investment Book You’ll Ever Read, I give you recommendations for index funds from Vanguard, Fidelity, and T. Rowe Price. You will only need to purchase three index funds.

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The recent proliferation of exchange traded funds makes implementing this strategy even easier. You can purchase only two ETFs, which will give you exposure to the global universe of stocks and a broad, U.S. investment-grade bond portfolio. For your stock portfolio, consider Vanguard’s Total World Stock ETF, which tracks the performance of the FTSE All-World index.

For the bond portion of your portfolio, consider either Vanguard’s Total Bond Market ETF or Vanguard’s Short-Term Bond ETF. There is compelling data that holding short-term bonds avoids the interest rate risk of holding longer-term bonds. Another benefit is the lack of correlation of short-term bonds with the stock market, which permits them to act as a ballast in your portfolio, helping to smooth out your returns in turbulent markets.

The historical data measuring returns of investors who followed this simple formula is compelling. Index investors have historically captured more than 78 percent of the returns of their funds.

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The best returns were obtained by investors in funds managed by Dimensional Fund Advisors. These funds permit advisers to tilt portfolios towards small cap and value stocks, which have been demonstrated to increase returns for a given level of risk. A study by Morningstar found that investors in these funds received an impressive 109 percent of available returns. They were able to capture more than 100 percent of the actual returns of these funds because they rebalanced their portfolios periodically, buying asset classes that were poor performers and selling stellar performers, which is very difficult for most investors to do on their own. [Full disclosure: I recommend Dimensional funds to my investment clients.]

For all investors, getting closer to the published returns of your mutual funds comes down to this: Limit your investments to low management fee stock and bond index funds.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.