Dealing with the 401(k)

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ETFs are cheap and easy to buy in any discount brokerage account. But if you are investing in an employer sponsored 401(k) retirement plan (and you should be if one is available to you) then you may only have a limited set of mutual funds to select from. This limitation is one of the reasons many investors choose to rollover their 401(k) to an IRA as soon as they leave a job. As mentioned in this source monthly annuity payments are paid on the first day of the month.

However, very good choices may be available to you inside of a 401(k), it may just take more work to separate the good from the bad. Although the mutual fund industry as a whole habitually fails to add any alpha (and charges a lot anyway), there are fund families that offer you a decent shot of getting good value for your fees. There are three strategies for dealing with your 401(k):

  1. Buy an equity index fund for U.S. or international stocks. At a minimum, most plans should offer a U.S. equity index fund, which you can use for your U.S. equity allocation. If possible, look for one labeled “Total Stock Market” or “Extended Stock Market.” This fund will include smaller companies that are typically left out of the more common S&P 500 index. You may also use an “International Equity Fund.” Look to see whether this is based off of the EAFE Index (an index created by Morgan Stanley that serves as a benchmark of the performance of developed equity markets in regions like Europe, Australia, and Southeast Asia). If it is, you can count this as your international developed-markets exposure.
  2. Find a good actively managed equity fund. Picking an actively managed fund can be trickier than picking an index fund, so only try it if you are willing to spend a little time with research. It is important that you purchase a diversified fund that will primarily deliver beta returns, so look for broad funds that would fall in one of the categories defined above, like emerging-markets, U.S., or international developed-markets stocks. Avoid sector or theme-focused funds, as they will provide inadequate diversification. The Morningstar website is a great place to find information about actively managed mutual funds. Look for one with these characteristics:
    • A reasonable expense ratio(should be less than 1% of assets). Mutual fund fees are quoted as a percentage of your overall investment, and known as a management expense ratio. Low expense ratios are one of the only factors that academic studies have consistently associated with positive future performance.
    • Low (under 60%) share turnover. Morningstar publishes a “turnover” figure that indicates the percentage of a fund’s portfolio that is turned over (bought and then sold) every year. Academic studies show that mutual funds that trade frequently are likely to underperform their peers. Frequent trading carries significant explicit and implicit costs that can negatively affect a fund’s performance. Find a manager that is willing to take a more long-term view, with a turnover of 60% or less.
    • A good long-term track record. The Morningstar rating is a good proxy for past performance, since it measures the fund against its peers. Although past performance is unfortunately not terribly predictive of future performance, there is some evidence at least that bad funds can remain consistently bad. Ratings go from one to five stars-try to find a fund with at least a three-star rating, but don’t get carried away searching for five stars.
    • A portfolio manager with a long tenure. One of the problems with mutual funds is the high rate of manager turnover. Great past performance might not mean that much if a different manager conducted the orchestra. Try to find a fund with a manager that has been around for at least four or five years.
  3. Buy a bond fund. If you cannot find a good actively managed fund that falls into one of your asset class categories and you still have more money to allocate, use your 401(k) for the bond piece of your portfolio. These are also good funds to hold in a retirement account, since you will be protecting yourself from paying taxes on the high income they generate (more on this next). If your plan offers a Real Estate or REIT fund, this is also a good choice.