B (3:57)

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A (5:07)

Welcome to month five of our 2026 Financial Planning Challenge, which we're calling a year well planned. So far this year we've talked about how to monitor your budget and your net worth, how to determine your overall asset allocation, how to choose the types of investments for portfolio and in which accounts to hold them. This month is somewhat of an extension of last month's installment because we're going to talk about how to evaluate funds because chances are you own some. You know, there are More than now 10,000 Open End Mutual funds and exchange traded funds otherwise known as ETFs. And according to the Investment Company Institute, more than 120 million individuals in the US own some type of fund. After all, you may not have a choice. The most common way that Americans save for retirement is through an employer plan like a 401k. And in most of those plans, the only investment choices you have are menu of mutual funds. Here to talk about how to evaluate the funds you own or are considering is certified financial planner and Chartered Financial Analyst Amanda Kish. Amanda, welcome back to the show.

C (6:06)

Thank you so very much. I'm glad to be back.

A (6:08)

So when you think about the number of funds out there, it's kind of bewildering. In fact, in some cases it's even more than the number of stocks you have to own.

C (6:15)

Yeah, that's exactly right. You mentioned that number of 10,000 mutual funds and even just in ETFs, exchange traded funds. According to Morningstar data, as of last year, we officially passed the point that there are now more ETFs currently being traded than individual listed stocks. So we have between 4,300 and 4,400 ETFs to around 4,200 stocks. So it's a wide universe and investors definitely need some tools to help them sort through that.

A (6:43)

All right, so we're going to talk about what we think are the most important criteria when evaluating a fund and we're going to start actually with costs.

C (6:52)

Yes. So expenses are definitely one of the most important variables to consider. So if you think about it Fees are the only part of fund investing where the outcome is certain. Performance might surprise you to the upside or the downside. And markets certainly are going to fluctuate from year to year. But those fees, those expenses come out every single year, rain or shine. So the number to examine here is the expense ratio, and this is expressed as an annual percentage of your assets. So an expense ratio that is 0.03% or 3 basis points would cost you $3 a year for every $10,000 that you have invested. And a 1% expense ratio would cost you $100 on that same amount, which doesn't seem like a lot. But when you compound this over long periods of time, 10, 20, 30 years, that gap often translates to tens of thousands of dollars in fees. So one important caveat here is when you're comparing these fees, you want to compare fees within asset classes, not across them. So, for example, a 0.5% expense ratio on something like a small cap emerging market fund, that's fairly competitive, but that same 0.5% expense ratio on an S&P 500 index is pretty crazy because you can get identical exposure for about 3 basis points compared to 50. So as a general rule, the more complex or specialized the asset class, then the higher the expense ratio, because it typically costs more to run something like an emerging markets fund or small cap active strategy than just a plain old S&P 500 index fund. So that's going to be reflected in what you pay. So Morningstar is a great source of fund data, and they benchmark any fund's expense ratio against its category average, which is exactly what you want to compare for the apples to apples comparison. And then again, just keep in mind that most ETFs, which are for the most part generally passive investments, and they're simply tracking a market index, they should have a lower price point than a similar actively managed fund in that same asset class, because you're not paying for that manager stock picking expertise.

A (8:56)

Yeah, the evidence is very clear that fees affect performance. You mentioned Morningstar, Morningstar, some studies on this, as have other folks. And the bottom line is that as a group, the cheapest funds outperform the average cost funds and the average cost funds outperform the high cost funds over the long term. So it's one of those things that the history just shows it's the place to start. Now, the funds do have to charge fees. They don't work for free, and they have to do that to buy and sell the investments, send you the statements. But also that money is going to go towards the people who manage the funds. Which brings us to the next factor that you think people should pay attention to.

C (9:33)

Yes, and that factor is manager tenure. And this is something that's important, especially if you're investing in actively managed funds. So if you're paying a premium for that active management, at least in theory, you're paying for a specific person or a specific team's skill and judgment. So then that first question is, is that person still there? So manager tenure is publicly available from a couple different sources in Morningstar Funds Prospectus Fund Company's website. But it's important because if a fund, say, had a great 10 year track record, but the manager who built that record left three years ago, that track record really tells you nothing about what you're going to get going forward. So I always recommend checking how long has that current manager been in charge and does the fund strategy depend heavily on one person or is it more, more team based with a documented succession plan? And ideally, you're going to want to see a manager or team that's been in place over a full market cycle. So you want to see results from that manager, that team, in both challenging and positive market environments. And then along those lines, I'd add that even when the same manager is still in place, take a look at whether the fund has grown dramatically in assets under management. So for example, a manager who, let's say ran a more nimble $500 million small cap fund and may have done that very well, may struggle to replicate that edge when the fund has grown, if they're now at 5 billion in assets, 10 billion assets, because at that size that they simply can't move in out of small cap positions without moving the market. But for index funds, manager tenure matters far less. Basically, the, the index is the manager in a sense. So that is one more thing that makes passive investing so attractive because you don't have to worry about manager tenure in the same way.

A (11:20)

Yeah, I'll just double down what you said about when it comes to who's managing the fund, is it a team approach? Right. Because some funds really are. They depend on maybe one or two people. They're the star managers. So you just wonder, okay, if they leave, are they taking the performance with them as opposed to a fund family that really focuses on a committee approach. And I guess the best example for me for that is Dodge and Cox, which is one of the oldest mutual fund families. They really do take a committee approach to managing the funds so that if someone moves off, you can feel pretty confident that the team that remains is still going to be able to follow the same processes that has been followed for many years. And then the other point I'll make is about index funds. As you said, index funds are so much more of a set it and forget it type of investment. Not completely. You still want to make sure that you have an index fund that really is tracking the index. Of course, every year or so, you should be evaluating whether you should be rebalancing. So maybe you should sell a little bit of that index fund or buy a little bit more. But it is, once you've decided on the index fund that's right for you, it takes much less time. Whereas with the actively managed fund, you have to make sure that that person is earning those extra fees, because, frankly, it's challenging to beat a relevant index fund. So you have to stay on top of that and make sure that, you know what, I'm paying more, but I am getting the performance or I'm not getting that performance, and it's time to move on. All right, so we looked at fees and people in charge. What's next, Amanda?

C (12:44)

So next we want to examine the question of what do I actually own or is the fund doing what it says it's going to do? So fund names can be misleading. A fund called Balance growth might be 80% stocks or it might be 50% stocks, and you don't know until you look. A technology fund, for example, might have 40% of its assets in just a few companies. Or a diversified large cap blend fund might have massive sector concentration in financials, for example. So the name is really marketing. It's the holdings that are reality. So a couple things that you want to check here first, top holdings and any concentrations in those holdings. So what are the 10 largest positions in the fund and what percentage of the fund do they represent? So if you have a case where the top 10 holdings are something like 70% of the fund, you're a lot more concentrated than you might otherwise think. And this matters, especially if you hold multiple funds, because you could be doubling up on a lot of those same names without even realizing it. And then you also want to check the sector allocation. So every fund's their fact sheet or their Morningstar page is going to show you the sector weights. So compare those to the benchmark, because you may have a blend fund that's 35% in technology when the benchmark is 28%. So that means it has a meaningful tech tilt, which might be intentional and fine. And if you're paying for that active management, maybe even desirable. But you should at the very least know that it's there and that you're differing from the market in that important way. And then lastly, take a look at the style. So Morningstar is a very famous nine box grid that tells you where a fund sits both on the market cap spectrum. So is it large cap, mid cap, small cap, and then also on the style spectrum, is it a value fund, blend fund or growth fund? So is it actually doing what the label says? Sometimes funds drift from their stated mandate over time. So for example, if a small cap fund has gradually accumulated mid cap names over time, that's something that we call style drift and it's something to watch for. So the practical question to ask is, if I own this fund alongside my other holdings, am I actually diversified or am I just buying the same companies multiple times in different wrappers? So you can't actually know what your portfolio is doing unless you know what your funds are doing. And that really starts by looking under the hood at each of those funds.

A (15:08)

I'll just add a couple of points on this. I think it's good to look at the fund's objective because it will lay out the parameters that a fund manager must stick with. If it's an index fund, it'll tell you which index it's following. But with actively managed funds, sometimes, you know, a manager has the ability to go beyond what you would think would be the state objective. Like it may say it's a US Stock fund, but it may be able to invest up to 20% in international stocks, for example, or if it's more like this balanced or all asset type of fund, it might give a range, saying like, the fund could invest up to 90% in stocks or as little as 50% in stocks. So it's just good to understand that. And when you look at that style box on Morningstar and some of the other information, it does provide, some historical information. So you'll see how much the fund is maybe jumping around a little bit in terms of its allocations and its style drift. And then I'll just. The other thing I want to add is before you add a fund to your portfolio, really do look at the holdings and the sector breakdown because as you said, Amanda, a lot of these funds overlap. And if you look at a fund and you're like, you know what, I own most of these stocks already, or I already have enough exposure to these sectors that it's probably not worth adding that fund to your portfolio because you're not getting any added diversification. All right, now let's move on to the numbers that I suspect most people actually start with, which is performance.

C (16:25)

That's exactly right. For most folks, this is kind of the starting point. But I think this should be a factor that's examined only after you look at those other aspects of determining whether a fund is suitable. So now we're looking at performance, and that's very important to do. But I do want to reframe a little bit how we look at it. So one of the biggest mistakes people make is comparing a fund's return to the wrong benchmark. So if you own, for example, an international small cap value fund, and you're comparing it to the S&P 500, that comparison is pretty much meaningless. You really need to compare it to funds in the same category, investing in the same type of assets. And Morningstar's category system is great for this. It puts funds in peer groups and tells you what percentile fund ranks in its category over various timeframes. And then the second mistake related to performance is chasing recent performance. So research is pretty unambiguous that past performance, especially short term performance, is a pretty weak predictor of future results. In fact, funds that are top quartile performers over, let's say, three years frequently end up reverting back to the middle and to that mediocrity over the next three year period. So what you want to see is that consistency across market cycles in both good and bad environments, and not necessarily hanging everything on a single banner year. So the time frame that you should look at for actively managed funds, I would want to see a full market cycle, if possible. So again, both good and bad market environments, but ideally somewhere around seven to 10 years. So if you're looking at Morningstar returns, you're going to be focusing more on the five year return number, that 10 year return number, three years is typically too short to get a good sense. Again, if you want to see those returns benchmarked against the category, not the S&P 500. So for index funds, the performance evaluation factor is a little bit simpler. So you can look at tracking error here, and that measures how closely the fund actually replicates its index. So a good index fund should track its index almost perfectly, and that tracking error will tell you if there's any deviation. And that's something that Morningstar reports.

A (18:33)

I also think it's important to look at how a fund performed in a really good year and a really bad year. And more recently, we'd say maybe 20, 22 would be the bad year for both stocks and bonds. One of the worst years for bonds ever, to be quite honest. And that gives you an idea of like, okay, in a bad year, this is the downside I could expect. And then in a good year, and that could be 2023 was really good for stocks, kind of mediocre for bonds, but still gave you a good idea a couple years later. Probably were better for bonds. But whenever you're looking at a fund, it just gives you an idea, okay, this is what I can expect. And I think it's also important when you are considering asset classes that you are unfamiliar with. Every once in a while we'll get questions like, I'm thinking of adding a high yield bond fund to my portfolio or a preferred stock fund. And if you've never invested in those types of asset classes, again, I think it's good to look at the good years and the bad years just to give you proper expectations of what you might experience. Alright, so performance is what you get, but that may not be what you keep, because Uncle Sam may want his share, especially if this is an account that is not a 401 or an IRA. So, Amanda, tell us about fund investing and taxes.

C (19:40)

Yes. So as you mentioned, this point applies only to taxable accounts. So if we're talking about 401k or an IRA, you can largely tune this out. But in a taxable brokerage account, this is a big deal. So every time a fund sells a holding at a gain, it distributes those capital gains to shareholders and you're going to owe taxes on them even if you didn't sell a single share and you never saw that cash. So high turnover funds are funds that have experienced large redemptions which would then force them to sell holdings, can generate significant taxable distributions. And there's two ways that you can assess that tax efficiency. So the first signal is portfolio turnover. This is the percentage of the fund's holdings that are replaced each year. So a turnover rate of, say, 10 to 20% is fairly low. On the other end, 100% means the fund is essentially replacing its entire portfolio every year. And that higher turnover oftentimes means higher trading cost embedded in the fund. And again, that's separate from the expense ratio. And it also means the fund is likely generating more taxable events. And the second thing to check is Morningstar's tax cost ratio. And this is going to be the more precise tool. So what this measure does is estimates how much of a fund's return was lost to taxes each year. So a tax cost ratio of 1.5% means that if the fund returned 8% pre tax, investors in taxable account might have netted closer to 6.5% after taxes. And those aren't trivial numbers. So for taxable accounts Also index funds ETFs tend to be more tax efficient than actively managed funds because of lower turnover. And also important to note that ETFs have a structural advantage called in kind creation redemption that allows them to avoid realizing capital gains internally. So that's an important note that if you are building a taxable account, this is a structural advantage that is a meaningful reason to lean toward ETFs when building that portfolio.

A (21:42)

I'll just point out that you find out that tax cost ratio on the price tab. So when you go to morningstar.cob, you enter the ticker and then click on the price tab and that's where you'll find that tax cost ratio, which is very important for any fund you own or are considering for a taxable brokerage account. All right Amanda, what are your final thoughts on how fools should pick their funds?

C (22:00)

So I'll leave listeners with one item on their Fund to Do list. Start with what you already own. So if you have just a few minutes, pull up your 401k or your brokerage account, find each fund and look it up on Morningstar. It's free to use for basic data and just check three things. Check the expense ratio, the category ranking for 5 and 10 year performance, and the top 10 holdings. So that maybe 15 minute exercise is going to tell you a lot. And if you only remember one thing from today, remember that low fees are the one guaranteed advantage you can give yourself. Everything else involves some uncertainty, but fees don't.

A (22:39)

And I'll just add that if you follow Amanda's advice and evaluate the Funds in your 401k and you find there are some lousy funds relative to others in their category. Let your HR department or whoever's in charge of your 401k. Now both Amanda and I are on the 401 committee here at the Motley fool and we regularly meet to evaluate the funds in our plan and consider maybe there are some funds or asset classes that should be added. We just met yesterday talking about this, so really you should not be stuck with mediocre or worse funds or maybe lack sufficient choices within your plan. So do some research and politely advocate for better investments and perhaps even ask for a brokerage account within your plan. Well Amanda, this has been educational as always. Thanks for joining us.

C (23:19)

Thank you. Hey, it's Parker Posey. How did I get here? I love improvisation when it comes to acting, but when it comes to a real life plan, I stick to a script. Cue the music.

B (23:30)

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A (23:52)

it's time to get it done, fools. And as April ends and May begins, we're now already a third through 2026. So this week I encourage you to revisit those financial New Year's resolutions you made way back in January. Because if surveys are to be believed, you may have already abandoned some or most of them by now. Getting caught up with our year well planned is a great way to get back on track. So go back and listen to the first Saturday episodes of every month and get some ideas for tracking your spending net worth and portfolio. If you find any gaps in your portfolio, buying a low cost finder ETF is a quick and easy, easy way to get diversified exposure to just about any kind of asset class. And that, my friends, is the show. Thank you so much for spending part of your weekend with us, and thanks to Bart Shannon, the engineer for this episode. As always, people on the program may have interest in the investments they talk about, and the Motley fool may have formal recommendations for or against. So don't buy or sell investments based solely on what you hear. All personal finance content follows Motley fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show Notes. I'm Robert Brokamp. Full on everybody.