Switch Out of Funds? December 1, 1998March 25, 2012 "I have several mutual funds (14 to be exact, which I know to be too many), accumulated over the years, most of which way underperform the market. I have recently begun reading an online group that says that the best way to beat the market is with the top 4 or 5 yielding Dow stocks, adjusted annually. This group backs up their theory with 20 year results showing that this would be the way to go. It seems to me that this is like saying that you should bet on the Steelers Sunday since they have never lost to the Jaguars at home (what I call ‘backing into a trend’). Or is it a sound strategy?" – Joan Trawick Picking a mutual fund to outperform the market is even harder than picking a bunch of stocks that will. Why? Because the fund’s performance is dragged down by annual expense charges (not to mention the up-front sales fee, or "load," a majority of fund buyers — amazingly — pay). So when it comes to funds, my advice is to select one or two or three index funds (one for big stocks, one for smaller stocks, one for international stocks), because they charge no sales fees and their annual expenses are typically very low. There’s nothing more obnoxious than a guy who quotes himself, but I’m going to quote myself anyway: "In the investment race, the horse with the lightest jockey — the fund with the lowest expense ratio — wins." Not every year, certainly, but over the long run. An index fund is a horse with a 20-pound jockey (20 hundredths of one percent annual fee); most actively managed funds have 100-pound or even 150-pound jockeys. And this is one of the key reasons your 14 funds underperform the market. Taken together, I would bet your 14 funds more or less ARE the market — except with these huge jockeys weighing them down. (The market itself is a riderless horse — it flies like the wind.) Buy index funds and you will do better than 80% of your friends and neighbors because the jockey is so light. Equally good, buy the securities known as Spiders and Diamonds, which are like index funds for the S&P 500 and the Dow Jones Industrials (they trade just like stocks, with the symbols SPY and DIA) … and/or the similar security that buys a basket of mid-size stocks (symbol MDY) … and perhaps some "WEBS." (WEBS are baskets of stocks designed to represent the market of a particular country. All trade on the American Stock Exchange. Their three-letter symbols all begin with EW — Japan is: EWJ. Barron’s lists the Net Asset Values each week.) Or spice it up with some closed-end country funds selling at a discount. Or kick off the jockey altogether! Cash out of all those funds and split the money equally among the Dow 30 stocks, say. Guess what? From then on, after a one-time $240 brokerage charge (30 stocks at $8 a trade), you’d do essentially just as well or poorly as the Dow. You’d beat the index funds (at least those that invest in the Dow stocks) and you’d beat Diamonds. Of course, if you have unrealized huge taxable gains in your 14 mutual funds, then cashing out and incurring the tax may not be such a good idea. Otherwise, though, dump ’em. In fact, over the long run, taxes are actually another reason to dump them. That’s because when you "do it yourself," constructing your own little index fund (spiced up with some WEBS, say), you get to control the tax consequences. Take a year when the market is flat. No gain, no loss. In an index fund, that would be the end of it. But within that fund there would have been some big winners and losers. Say one of the Dow 30 stocks was up 50% and another down 50%. This does you no good in an index fund. But owned individually, you could sell the loser to get the tax loss (up to $3,000 in losses can be taken against your taxable income each year) and give the winner to charity instead of the cash you had intended to give (giving appreciated securities held more than a year is smarter than giving cash). Then you could just buy back the same positions (waiting 31 days in the case of the loser, or else the IRS disallows the loss as a "wash sale") or substitute something similar. The Dow 5 or Dow 4 strategy you refer to, and others like it, work brilliantly in hindsight, but that has limited bearing on how they will do in the future. Are they reckless or harebrained strategies? Certainly not. They are a basket of a few very big companies — with no rider on the horse — and you are certainly not going to do much worse than you would in your 14 mutual funds; indeed, you might do a good bit better. But I don’t buy the "magic" of the strategy. And sure enough, the year this all got really popular, based on decades of back-testing (what woulda happened) and the publication of a book extolling its virtue, the strategy began dramatically underperforming the broad market indexes. My guess: some years it will do better than average; some years, worse. But the fact that there’s no jockey weighing down your results is a definite plus.