Filed Under (401k) by mikerowan on 16-08-2008
By Mike Rowan
Choosing your 401k Mutual Funds should entail more than just closing your eyes and picking a couple of funds. In today’s day and age, most 401k plans have a variety of mutual funds to select and compare. However, I know many investors who have the best of intentions, but still come up with an underperforming 401k plan quarter after quarter. So, eRollover has come up with a brief list of guidelines that should be able to serve the investor well. While 401k plans will always have restrictions and fewer choices than self directed IRA’s, this is a good place to start.
Choosing Funds
1. Choose your Asset Allocation.
In general, if you aren’t thinking of retiring too soon (within 20 years), and are relatively optimistic about the economy,you can afford to invest in an assortment of stocks.. However, if you are bearish about the market or closer to retirement, you’ll want to mix in some bond funds or cash equivilents. You might be able to deal with a 50/50 split with 10 years of the working life left, but would want to be closer to 90% fixed income investments vs. 10% growth investments by the time you retire. Many plans will also offer funds that focus on international mutual funds. Keep in mind that we do live in a global economy, so international mutual funds aren’t just an option any more
Erollover.com has a tool that will go live on our site shortly that should help individual investors to answer a few questions in order to come up with an individualized recommendation based on your risk tolerance.
2. Check past performance.
Past performance does not guarantee future performance, but it’s not a bad place to start. Obviously, you’ll want to focus on funds that are performing better than others, but there are some other things to look out for. Be sure to check how the fund performed during a bad year. How did the fund do in 2001 or 2002? You want funds that will make you money during a bull market and also save your money during a bear market. Another thing to look out for is a good fund that just had a bad year. These guys are going to be fighting extra hard this year; just make sure the bad year wasn’t do to a manager change (see #2 below).
Be wary of jumping on the band wagon of “hot funds”. Often, if a fund has a good year, a bunch of new money will roll in. There is no reason to think that the fund will be as good at running 50 billion dollars as it was at running 5 billion.
3. Check the manager.
Mutual funds have a hard time holding onto their good managers. The reason for this is simple. Say I was a manager good enough to ensure 15% returns every year running funds as large as $10 billion. There are going to be a lot of wealthy people wanting me to quit my day job and concentrate on managing just their money. It’s hard to find a reason why a good fund manager wouldn’t move into the hedge fund business where they can charge higher fees to run less money.
Manager turnover is another reason why that fund that did 20% last year might not do so again. If you’re lucky, you might find a fund with good performance who’s had the same manager over the past 5 years. Don’t shy away from “star” managers like William Danoff, who has run the Fidelity Contrafund since 1990.
4. Check the prospectus.
Somewhere inside the interface your employer provides you to manage your 401(k), there should be a way to access a more detailed view of each fund. Many plans show a Morningstar analysis for each fund. This analysis shows the funds’ distribution in cap-size, sector, and even the funds’ top ten holdings. Other key numbers to look out for are the expense ratio (what the fund charges) and the “total funds assets” (a bigger number here indicates a less flexible fund).
The Morningstar analysis offers excerpts from the fund’s prospectus which can be very useful. One interesting read is the “fund strategy”. Novice investors may glaze over reading this, but more experienced investors will be able to find funds with a philosophy similar to their own.
If you are having trouble getting this information through the application offered by your employer, check out Morningstar.com or go directly to the fund’s website to find the original prospectus.
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