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Mutual funds still a good plan; just stay away from scandals

Sure, they're a bunch of scoundrels. But you've got to love them anyway.

As the mutual-fund trading scandal has unfolded, I have heard individual stocks, exchange-traded index funds and private money managers all touted as an alternative to humdrum mutual funds. And, yes, each of these options has its appeal.

But in the end, funds are still your best bet. The fact is, none of the alternatives gives you the three great advantages that mutual funds offer _ low cost, low risk and a low investment minimum.

Low Cost

Some investors are apparently abandoning funds and instead investing with private money managers through brokerage-firm "wrap accounts."

Snobbery seems to be a big part of the appeal. But there are some genuine financial advantages. With separately managed accounts, you have greater control over your annual tax bill. You can also customize your portfolio to, say, exclude technology stocks. That might be a smart move if you work in the tech industry and thus already have plenty of exposure to the sector's ups and downs.

Problem is, these separate accounts are often no bargain. If you stash $500,000 or $600,000 with a mix of stock and bond managers, a wrap account might cost 2 percent of assets each year and possibly more.

By contrast, you can put together a portfolio of top-notch actively managed funds, and pay less than 1 percent in annual expenses. Better still, you could purchase low-cost market-tracking index funds and keep costs below 0.3 percent. Even if you hire an adviser to help you pick these index funds, your annual cost shouldn't be much more than 1 percent.

But surely private money managers will deliver superior returns, thus justifying the expenses involved? Surely not. "In aggregate, you can't say that mutual funds are better performers than separate accounts, or vice versa," says Ryan Tagal, product manager for separate accounts at Chicago's Morningstar Inc. "The evidence just isn't there."

Low Risk

While private managers can be pretty darn expensive, it doesn't cost much to buy and hold a slew of individual stocks through a discount-brokerage firm.

But even if you're competent enough to pick your own stocks, there's the issue of diversification. One popular rule of thumb suggests you need just 15 or 20 individual stocks to build a well-diversified portfolio. With that many stocks, you will indeed have a mix that isn't much more volatile than the broad U.S. stock market.

But volatility isn't your only risk. There is also tracking error. Suppose you carefully select 15 stocks, in an effort to get broad diversification.

Even then, you should expect tracking error of 5.4 percentage points a year, according to a study by Ronald Surz and Mitchell Price that appeared in the winter 2000 Journal of Investing. In other words, if the market returned 10 percent in any given year, you might earn as much as 15.4 percent _ or as little as 4.6 percent.

To eliminate that risk and build a truly diversified portfolio, you need to own hundreds of stocks and bonds. Most people just don't have enough money to buy that many securities. Instead, they need the instant diversification offered by funds, where a $1,000 or $3,000 investment will buy exposure to hundreds of securities.

Low Investment Minimum

But who says you have to stick with regular mutual funds? Instead, you could purchase exchange-traded index funds, often called ETFs, which are funds that trade on the stock market, just like any other stock.

I think ETFs are a fine innovation. But for most folks, they simply aren't a viable alternative to regular index-mutual funds, because the effective investment minimum is way too high.

To be sure, ETFs don't have a stated minimum, like the $50,000 or $100,000 that's often required by each private money manager in a brokerage-firm wrap account. Instead, at issue is the amount of money needed for ETFs to be cost-effective.

If you pick your ETFs carefully, you can build a portfolio with lower annual expenses than comparable index-mutual funds. But with ETFs, you also have to pay brokerage commissions and other trading costs.

Let's say you plan to buy a globally diversified portfolio of index funds and sell 10 years later. If you trade through a discount broker and lose only a modest amount to trading spreads, ETFs become a cost-effective alternative to regular index funds if you have $100,000 or more to invest.

This, however, assumes you never add money to your account and you never rebalance, to bring your fund mix back into line with your target portfolio percentages. Both strategies would trigger a heap of trading costs, thus wiping out any cost advantage that ETFs have.

Of course, if you shun ETFs and other alternatives, that leaves you at the mercy of fund-company scoundrels. But as I see it, there's a silver lining to the scandal. Suddenly, picking funds has become a whole lot easier.

Thanks to New York Attorney General Eliot Spitzer, we now know which fund companies are bent on making money off shareholders, rather than making money for them. My advice: Avoid any fund family that's been named in the scandal.

Instead, stick with companies that have a reputation for offering sensible funds with reasonable costs. My short list would include T. Rowe Price Associates, TIAA-CREF and Vanguard Group.

_ Wall Street Journal

FEELING IS MUTUAL

Mutual funds are still best for most investors. But pick carefully:

+ Avoid companies named in the fund-trading scandal.

+ Favor no-load stock funds with expenses below 1 percent a year and bond funds with annual costs less than 0.7 percent.

+ Aim to build a globally diversified portfolio that includes funds specializing in large stocks, small companies, foreign shares and bonds.

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