Littlejohn Financial

How To Tell if a Mutual Fund Is Decent

Financial Podcast by Financial Advisors

Curious about a mutual fund? In this video, we dive deep into the structure of mutual funds to help you understand them better. So many options, but we’ve got you covered!

In this episode, you will learn the following :

  • Owning a variety of mutual funds doesn’t guarantee proper diversification.
  • Utilizing Individual Retirement Accounts (IRAs) and 401(k)s can significantly impact your financial future due to their tax advantages.
  • Mutual funds are suitable for investors who are either starting or prefer not to manage their own stock portfolios.
  • Target date funds automatically adjust investment strategies based on the investor’s age and proximity to retirement.
  • Assessing mutual fund suitability requires understanding key investment metrics such as past performance, expense ratios, turnover ratio, manager tenure, alpha, beta and Sharpe Ratio.
  • Be aware of the “phantom index” effect where mutual funds mimic an index fund but with higher fees.
  • The R squared value is a statistical measure that reveals a fund’s alignment with its benchmark index and can be a tool to avoid paying high fees for index-like results.
  • Risk drift occurs when certain assets grow and unintentionally increase the risk in your portfolio.


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00:00:00 I’ve seen this before where someone’s like, oh man, you know, I’ve got all these different mutual funds and my money spread out over so many different areas, but you start breaking it down. And you know, I know we’ve mentioned the S&P before, but I’ve seen it before where they have maybe six mutual funds and all of them are growth oriented mutual funds. And then you look at it and you’re like, well, if the S&P for example, is 20% four or five different companies, and then your mutual funds are tracking that index, and then you add them all up, you still have about 20% of your money tracking the four or five largest companies in the US. And it’s like, well, you actually are not as diversified as you think you are.


00:00:00 Hey, welcome to the True Wealth Radio Show. On this, the greatest Tuesday you’ve had all week. I am back in, studio after a week on vacay with a little bit more of a tan. 


00:01:06 I was gonna say, yeah. 


00:01:08 So it’s nice, went down to Baja, had a good time. Joining me today in studio. 


00:01:12 Matt Dickson. 


00:01:13 And so, yes. 


00:01:14 David, did you have any fish tacos? 


00:01:16 Oh yeah, oh yeah. Actually, you wanna know what I had that I’d never had before? Like I had a first while I was there. 


00:01:21 Really? 


00:01:22 I had a first.


00:01:23 Okay. 


00:01:23 Lobster tacos. 


00:01:25 Oh. 


00:01:26 And they were a really [bland]. 


00:01:28 Were they drenched in butter?


00:01:30 No, I don’t know. I mean, they were just, it was chunks of fresh lobster. 


00:01:34 Yeah. 


00:01:35 And it was like… it was salsa and other stuff in there too. It was like a taco instead of fish. It was lobster. And it was just kind of like, it was literally this, like, family joint. We were, now I gotta remember what it was called. It’s a separate town. We left Cabo, we were hiking, we went up into a river and jumped in waterfalls and stuff like that. But afterwards we went to there. It was… Miraflores is the name of the town. And a small town, but very authentic like, family restaurant. And my Spanish was tested. It turns out I could use some work. 


00:02:11 Okay. 


00:02:12 But we had a great time, great meal. But I will say this, let’s strengthen the US dollar.


00:02:18 Not quite what it used to be. 


00:02:20 It does not have the same horsepower as it’s had other visits. So, you know, there’s a real life example where the exchange rate will play into your world. So, but yeah, no, it’s good time. So glad to do it. Don’t worry, your turn’s coming. Your kids are gonna get older, mad, and then it’s gonna be like, we gotta go do stuff for spring break. Right now doing stuff is like, wait a minute, it’s 10 minutes after normal nap time. 


00:02:45 Right, exactly. 


00:02:48 So, but it comes and then it goes fast. Everybody says. 


00:02:52 First birthday is coming up this weekend. 


00:02:54 That’s why. 


00:02:55 Isn’t that crazy? 


00:02:56 It is. Really a year? 


00:02:58 Yeah. 


00:02:58 Really? 


00:02:59 Doesn’t seem like a year, but it’s been a year. 


00:03:02 So this is the reason that investors, it should be much easier to think long-term because you just blink and it’s over, right? 


00:03:11 Right.


00:03:11 Oh, I thought I was gonna be trading this thing and I’ve been holding it for a year. 


00:03:15 I’m sure you’ve done that yourself. Even though this is like your world, this is your job, you probably bought something as an investment and been like, oh, I forgot I even purchased this. And you come back to it a few years later and you’re like, well, that’s great. 


00:03:27 I bought Amazon years ago when it was like $1,200 a share. But keep in mind, it’s split a couple of times and changed. So like, yeah, that was, and then, and it’s been, I’ve held it now for what, eight, nine years. 


00:03:42 So it’s looking great. 


00:03:44 So it’s made a bunch of money, but it’s, you just kind of forgot about it. And how do you forget about it? So, all right, here’s the example. You have an account, like imagine, oh, I used to work somewhere, and then I changed jobs, and I just kind of let that 401(k) sit there and I forgot about it. It’s kind of like that.


00:04:00 Yeah. 


00:04:00 Right? So anyway. What are we gonna talk about today, Matt? 


00:04:05 I think the plan was to break down what are mutual funds, how do they work, and all the nitty gritty details in between. 


00:04:13 Yeah. So we had a moment where we were trying to figure out how, might we provide some value to our listeners. And so today, we’re gonna go through a little bit of a back the truck up version, get back to some of the basics for investors. There’s some real good reasons for this. One, part of it is, I’m gonna remind everybody out there, right? We’re now officially into April. It’s April 2nd. We’re at the T minus two weeks and dropping to get your taxes lined up or to arrange for an extension. But you’ve also got some critical deadlines to get IRAs funded for last year, right? So it’s not too late to invest in an IRA or possibly Roth IRA for tax year 2023.


00:04:59 Yeah, but we’re running really, really short on time. 


00:05:02 Right. Now here’s why this is relevant. For some of you out there, you’re going, hey, this is, like, I haven’t been investing before. I’m getting started. So maybe you’re listening and you’re not coming to an advisor at this point. You’re just going to do some things on your own, because it kind of makes sense. And because financial advisors like a lot of things, there’s a point at which it’s expensive to have an advisor. And then there’s a point at which it’s worth it anyway. The cost becomes worth it, right? And there’s that threshold, like when should you do something yourself versus when you should use transition? Not talking about what that threshold is. Let’s just say you’re still in DIY camp, right? Then you may be starting an IRA from zero. How are you likely to do that? Probably mutual funds. 


00:05:49 Sure. 


00:05:50 Right. You probably are gonna buy mutual funds. There are some ways that you can buy stocks now. Right, there are–  


00:05:55 You could do fractional trades with some platforms. And so, you know, a diversified ETF that has a low cost to it. You might be able to buy fractional. 


00:06:03 Or you can buy, there are some areas like, I’m not certain because I don’t know all the details about it, right? But like, I think Schwab has a DIY investor account and they have a program called Slice where you can buy fractions of a stock, right? So then you could kind of pick your own stocks. Like Robinhood does this.


00:06:22 Right. 


00:06:23 Oh, I want to buy a share of Apple and Apple’s like $180 a share or something. And you have a hundred dollars in your account. Well, you don’t have enough to buy a whole share of Apple, but you can buy $25 worth of Apple. You don’t own a whole share. You don’t get to vote on the share because you don’t own it, but you do own some representative equity, right? So you still get the value of the movement. It’s just a fraction of that share. And it’s, the custodian in this case is making that arrangement. But let’s not get lost in the weeds of that. For a lot of people that are getting started, they’re not interested in buying the individual stocks and getting really cute and clever. They’re saying it’s, long-term investment. I’m doing this for tax savings. I’m gonna go buy a mutual fund. So the first question is, why buy a mutual fund? 


00:07:07 Well, one of the perks, I guess, to it, is it allows you to have ownership of a, well, I’m air quoting that, but you can buy into a fund that inside of that fund owns a lot of the stocks you might want to own, right? So say a mutual fund has Apple, like you just talked about, it might also have Microsoft in that fund, and it might have maybe four or 500 different companies. And even though you only bought one share of the mutual fund, you now are fractionally invested in all of those companies that the mutual fund holds. So it allows you to diversify, right? You can own a lot of different companies, but you’re able to do it at a cost where you’re able to spread that money out. 


00:07:53 Yeah, basically instead of buying each stock on its own, you’re buying the basket that already has the stocks in it. And so they’re sort of pre-packaged for you. Now, when somebody pre-packages a basket for you, there are some costs associated with it. Because it was packaged. 


00:08:10 And sometimes that fee can be really small or it can be really large.


00:08:16 Yeah, so we’re going to talk a little bit about some of those components today. But just foundationally, what you need to know about a mutual fund is you’re not directly buying the investments the fund owns, you’re buying a package from an investment company. 


00:08:32 Yes. 


00:08:32 Okay. So the investment company takes your money and in exchange, they give you ownership in a certain number of shares or fractions of shares in the basket that they have, that’s the mutual fund. Okay, and there’s different types. The purpose of this show is not to go into the types like, is it a unit investment trust, or is it an ETF or what not. 


00:08:53 Are we even gonna get into like a front loaded, we’re not even gonna get that front loaded. 


00:08:57 We’ll talk, very high level about that in costs. All right, because we’re gonna talk about that, but we’re not gonna talk about that in this segment. We’re gonna just talk about what is the mutual fund built for? And it’s built for people that wanna get started, or even if you have more money, but you don’t want the responsibility of it managing the stocks. You’re paying a company to do it for you. And they are accommodating. 


00:09:21 Because there’s a fund manager. 


00:09:22 Yes. 


00:09:23 Right. 


00:09:24 Well, typically yes. The fund manager might be a computer. 


00:09:28 Sure. 


00:09:28 Okay. Because if you’re gonna buy an index fund, then that’s a passive strategy, right? There are some mutual funds that it’s just, a programmed strategy. There’s not a person steering the ship. There’s just a computer following the recipe, okay? And there’s nothing inherently wrong with that, by the way. Some of these recipes are really good, right? 


00:09:50 Right.


00:09:50 Grandma’s cookies are fine the way they are, don’t mess with it, okay? The S&P 500 is a pretty good formula for a long-term investment success. Very difficult to outperform that over time because that recipe favors the things that are winning and discards the things that are not, automatically. So it’s a pretty good way to make money. It’s just not without volatility and risk because it’s heavily leveraged to equities. It’s heavily growth oriented. So you’re gonna get a lot of volatility in the S&P 500 sort of by definition. Okay, because that’s the pool that you’re playing in. Here’s the interesting thing about mutual funds. They come in all different shapes, sizes and flavors. 


00:10:31 Right. 


00:10:31 Right. Because they don’t, because it’s a company buying investments and pooling those investments together with a group of investors, right? They’re taking a bunch of investors, pooling the money and buying investments with them. They can buy different types of investments or different strategies. So you might get a fund, it’s really specialized, right? Maybe it’s only buying tech funds that specialize in making semiconductors, okay? Or you might get a general fund that’s trying to be an entire investment strategy in one single purchase. So it’s buying stocks and bonds and real estate and it’s balancing risk and it’s adjusting over time and it’s doing a whole bunch of stuff for you automatically or any flavor in between. And they’re out there, there’s thousands of mutual funds. 


00:11:23 Should we talk today a little bit about what a target date fund is? Because a lot of people own target date funds and they really don’t know what they are.


00:11:31 Why don’t you give just a high level? I wasn’t gonna go deep into it, but I did just kind of describe that. Can you– 


00:11:35 Yeah, you kind of did. Yeah.


00:11:36 Help our listeners understand that target date fund concept. 


00:11:38 So a target date fund is a mutual fund that’s looking at, kind of your age and when it is that you might retire. And so if you are, say, you know, planning to retire in 2065, there’s a target date fund out there that is targeting that date for you. And it’s going to adjust your exposure to stocks versus bonds. As you age, you’re gonna be less in stocks and more in bonds. That’s a really simple way of putting it. 


00:12:12 Yeah, it’s gonna shift from more aggressive to more conservative as you approach retirement. 


00:12:17 Yep, so every year the fund manager is probably gonna go in there and adjust the weightings based on your, as you get closer to that date. 


00:12:26 Right, and the reason it’s important to know this is, target dates are becoming, these target date funds are becoming really, really common in employer sponsored retirement plans. Like 401(k) plans. 


00:12:38 Right.


00:12:39 Really common. 


00:12:40 Especially if you don’t go in and choose your investment. 


00:12:43 Right. 


00:12:43 Like if you say, well, just give me something. Odds are pretty decent. 


00:12:46 You may be auto enrolled, right? They’ll just say, well, you didn’t choose it, so we chose it for you. Here’s your birthday, and we picked a fund that aligns with age 65, which is kind of the generic retirement date that’s chosen by the industry. It’s like, that’s when Medicare and Social Security and stuff kind of align. 


00:13:03 I think it’s important though that we talk about the target date funds because a lot of people have them. They leave their employer, they leave their job, and they probably still remain in that fund. Do you wanna talk a little bit about why you think target funds might be good, bad, or neutral? 


00:13:19 Yeah, I think that that’s gonna come up in all of this. One of the things that we wanna do is help you to evaluate, maybe you are in a retirement plan that has a menu, right, of investment options. Or you’re about to be, or maybe you’ve left a retirement plan behind and you still own one and it has a menu of options. Well, the question is, how do you decide what to order from the menu? 


00:13:44 That’s the ultimate question, I feel like, that we’re always asking ourselves. 


00:13:48 That is the question. And that’s something I really wanna get into. But I think as I look at the clock, we better grab our first break. And why don’t we come back on the flip side of it and we will talk about what are some of the key metrics that you as an investor can look at to help determine whether or not that mutual fund might be a good fit. 


00:14:07 I like it. 


00:14:08 All right, gang, welcome back to the True Wealth Radio Show. Thanks for tuning in today. And a reminder, if you did not catch the beginning of the show, it is available via podcast. Check out our website at and you can find it there. Also, we now are… put these things on YouTube. So if you wanna see us in studio, I’m not recommending that you look at us, but like if that’s how you want it to, then you definitely watch it on YouTube and you can just subscribe and it’ll notify you when stuff comes out. 


00:14:37 I like it.


00:14:38 So, all right, we got another show and then you can, a lot of people use YouTube as, like, a podcast. 


00:14:42 You’re being modest over here, Dave. You’re eye candy, come on. 


00:14:46 Right, right. Yeah, yeah. Just the middle-aged random dude. 


00:14:51 There you go.


00:14:52  That talks money. All right, so where we left off was, we’re talking a little bit about mutual funds today, okay? 


00:15:00 Sure. 


00:15:00 Matt, you kind of gave like the–  


00:15:03 Like a real basic, try and cover what is a target date fund. 


00:15:08 Yep. 


00:15:08 Yep. 


00:15:09 And the reason, target dates, cause you’ll probably see them. 


00:15:11 Yeah, and odds are good that, like you said, if you’re in an employer sponsored plan or something, you’ve probably got that in. 


00:15:19 And you know why we keep calling them that? Probably some of it’s cause that’s industry language like, oh, employer sponsored plan, blah, blah, blah. But because it’s literally what it is. Like, sometimes if you work in government, you don’t get a 401(k) typically, right? You’re going to probably get some kind of pension program. You might get a 457 plan, which is a sort of a deferred plan. It could be pre or after tax.


00:15:43 You might have a 403(b). 


00:15:44 That is another common one, 403(b). A lot of teachers in the area, that 403(b) is part of that benefit package that sort of stacks with PERS. So you may come across these and they have different acronyms, or different number names often, because that’s the tax code that defines them. So section 401(k) of the tax code was part of the definition stuff. But anyway, depending on your employer, the employer picks the plan and picks the details of the plan. And then you as the plan participant operate within it. And so that’s why there’s a menu. The employer assembles a menu of investment options and you don’t choose typically from the whole universe. Meaning like you can’t just go anywhere and say, oh, well, if Amazon’s not in there, you don’t get Amazon in your 401(k). 


00:16:31 Yeah, there’s probably 20 or 30 choices or something like that where you can go pick from the menu that they offer. 


00:16:37 Right. And the design, if you ever wonder is the employer, if they are letting you choose the investments, that means you have a self-directed plan and they need to give you enough options to choose from that you can make a reasonable effort to have a good investment program for your own risk profile, right? So your risk and your time horizon. And we’ve talked about risk on this program a bunch, but like how much are you willing to let an investment whipsaw up and down? That’s kind of what risk means in this case. So the target date funds, it’s a, like just buy the fund and it kind of handles all the details for you. 


00:17:16 Right, and did we even talk about, kind of, some of the positives or negatives surrounding those? 


00:17:21 Well, give me an example. What do you think about? 


00:17:23 I mean, like one of the things I think we’ve talked about a little bit in the past is one of the disadvantages potentially with a target date fund is if you’re nearing retirement, for example, and you are trying to get to a certain spot with your account, it might be kind of de-risking your portfolio a little early, where you’re still maybe seven years out from retirement, but your bond exposure might be a little bit higher than you really want, where the bonds tend to pay a little bit less than the equities given enough time. You might be tilted a little too heavy into bonds based on your objective. 


00:18:02 Right. I’m gonna risk having like a little short clip that somebody nabs and just listens to the side of context for a second.


00:18:08 Yeah.


00:18:08 You just said something that I used to talk about, this all the time, I call it the tyranny of the prospectus. The prospectus is the contract that a mutual fund follows. It sort of sets up the rules that the manager has to follow. And it’s important because investors need to know what they’re buying, right? So it defines what they’re doing, but that contract if you will is that it cuts, sort of cuts both ways because on the one hand, it’s very clear what the manager can do. But it also means there are things the manager can’t do right? And so you can find yourself in circumstances where, like for example a target date fund that is in the middle of a period when we had super low interest rates and rates are rising and it has to own a certain percentage of bonds. 


00:18:51 Yeah.


00:18:51 And bonds become a risky asset class because of the conditions of the market. And now they are contractually obligated to buy a thing that harms their performance. Right? So–


00:19:01 That’s a weird concept. 


00:19:02 I know, right? And so basically they try to buy the slowest sinking ship they can, but they’re stuck because the contract requires it. So the prospectus can not only protect the investor, but it can also structurally trap a manager. So we’ve seen some managers, the sort of companies that will open up the prospectus language and say, well, there’s a lot more flexibility here. But then the investor is less clear about what they’re getting because now the rules are wide open. And so, okay, you’re kind of, a buying and, go anywhere, do whatever they want, fun. And you go, well, I can’t exactly hire you now to handle that section of my investment strategy because you’re gonna run all over the field, right? It’s like, you’re not gonna play the position on the field I’ve asked you to. It’s like, great, you’re supposed to be a defensive tackle and you’re trying to play free safety. It’s like, well, that’s not what we needed. We needed a defensive tackle. So dumb analogy, but you get it. 


00:19:54 Yeah, it’s a double-edged sword is what you’re trying to say. 


00:19:56 Yeah, and so the prospectus can be both good, but it can also sometimes constrain. So we just wanna be aware that those are the rules that we have to play by. And I think that’s a good pivot into some of the things investors ought to look at, right? 


00:20:09 Sure. 


00:20:10 If you’re not buying, or even if you’re buying a pre-built fund like a target date fund, what are some things that people should look at when evaluating a mutual fund?


00:20:20 I mean, one of the things you could look at would be past performance. I mean, how is this fund done over the last, you know, three years, five years or 10 years? So that’s one thing you could look at. You could also look at, like the expense ratio. So what are you paying to be in that fund compared to maybe another mutual fund that has a very similar objective? If one of them is at 1% and the other one is at 0.01% and they’re investing in the same thing, it might not make sense to choose the one with the higher fee. 


00:20:52 Yeah, so let’s break that down for a second for everybody out there. Cause maybe you’re not a financial pro and you’re looking at this going, all right, you just said stuff and I’m not sure what that means. First, I’m gonna tell you, past performance never guarantees the future. Right? 


00:21:05 No. 


00:21:06 And so what you can look for in past performances, has the manager been consistent in different market environments? If they say they’re investing in large value companies, do they continue to do so? Have they sort of stayed true to the prospectus? So that’s a good thing to look at. But the past performance can give you a… There are some interesting studies, suggest. Companies that have high expense ratios and consistently fall in the bottom half of performers tend to persist there. They tend not to get better. So there’s some studies that suggest that. Doesn’t validate it, just suggest it. So what we look for first is expenses are relevant. Okay, imagine if you had to walk around and drag an anchor with you all the time. High expenses are like that. If you have to carry around, if your manager costs a lot, they have to perform well in order to overcome their cost. 


00:21:59 Exactly. 


00:22:00 Okay. So expenses absolutely are relevant, but they’re not the total story, interestingly enough, because mutual funds report their investment performance net of fees. So we care because it’s an indicator, but the result is what really matters. 


00:22:18 Right. 


00:22:18 Okay. Here’s another one that people don’t necessarily look at. There’s something called a turnover ratio. 


00:22:25 Ooh, that’s a big piece. 


00:22:26 Okay, what do you think that means? 


00:22:28 It’s looking at how long the person that’s in charge of that fund has been in charge of it, right, like if the fund, no. 


00:22:35 No, sorry, I’m gonna, you’re talking about manager tenure. 


00:22:38 Right. 


00:22:38 This is just swapping a term here. So the manager tenure, definitely. Turnover ratio inside of the fund is actually how frequently the investments are bought and sold. 


00:22:50 Oh, so are they constantly trading in it? 


00:22:53 Yeah, churning. 


00:22:54 Okay. 


00:22:54 Think about it, right? Now, the fund may not actually, they’re not making commissions by churning. Churning is kind of a dirty word in investing, right? That was the idea when a stockbroker used to buy and sell things to profit themselves, but not the customer. So churning was not legal, right? You’re just turning the account over to make money for the brokerage firm instead of the customer. So a mutual fund swapping in and out of funds or in and out of the investments inside of it isn’t churning like that, but it does mean it’s less likely to be tax efficient, right? Lots of buys and sells. And so higher turnover tends to include higher expenses and lower tax efficiency. 


00:23:36 Just because of the volume of the trades. 


00:23:37 Yeah, because it’s frequently changing. Now some strategies have to have high turnover. 


00:23:42 Yeah.


00:23:43 Right. I mean, maybe you’re in like an option strategy or something where options expire every 30 to 90 days. So there’s–


00:23:49 Right, they need to expect it.


00:23:50 Yeah, but the turnover ratio and sort of the metric is does more than 100% of the portfolio turnover? So if you have more than 100%, you expect that the stocks basically are held less than a year. So you can count on having capital gains distributions during the year. And we’re not gonna go into deep explanation there. Just know that it’s part of how efficient a fund is and your taxes are higher if you get short-term capital gains distributions. So that’s a consideration. So now talk to me about that manager tenure though. I mean, the turnover of managers is separate, right? And I know that’s what you’re kind of angling towards. So what do you mean? What do you mean? 


00:24:25 Well, I mean, you wanna look and see how long has someone been in charge of the fund because I mean, even though we talked about this before, past performance might not be a great indicator of the future. If you are looking at past performance and you’re saying, wow, this fund has crushed it over the last 10 years. But six months ago, the person who ran it for 10 years is gone. And someone new is in charge of maybe managing that fund or orchestrating how things are bought and sold. You don’t want to go buy the fund hoping for similar performance if that person isn’t there. Or maybe you do, but that’s something that you need to look at and just at least be aware of.


00:25:07 Well so let me give you just a couple of other metrics that are really relevant to the manager themselves. If there’s a manager, right? If there’s no manager, then it’s just whether or not the strategy does this thing right, okay? One of them is alpha, okay? One of our favorites, right? Alpha, let’s think of it, it’s a statistical measurement, but it’s oftentimes reported as just alpha. So like if you go to a lot of the free research sites, so whether you go to Yahoo or you go to Google or you go to like Morningstar is a really common one. It’s a long name, but right. Morningstar is a research firm. They will report how these different investments perform and they will track something called Alpha. It’s a measure of how much outperformance a manager is generating.


00:25:59 That’s a really good way to look at that and try and gauge it as an actual number.


00:26:04 So you want a positive alpha. That means that the manager is actually adding benefit for their decision making. If you have low to non-existent or even negative alpha, then the manager’s not helping the performance. 


00:26:17 Right.


00:26:18 So then if they’re trying to sell you on the idea this manager is really great, but the alpha’s negative, you go, well, one or two years here or there might be an anomaly, but if they’re consistently not generating alpha, then that’s a problem. Another metric you’re gonna see that you should know is beta. 


00:26:33 Right. 


00:26:34 Okay. Beta is just a volatility measurement. That’s like how much does that investment whipsaw around relative to a benchmark? 


00:26:44 Sure. 


00:26:44 Typically it’s the S&P 500, but it might not be depending on what they’re benchmarking the fund against. So alpha and beta are two biggies. There’s another one called the Sharpe ratio. 


00:26:57 Yeah. 


00:26:58 Okay. You just want a positive Sharpe ratio. Okay, so that’s again an indication that you’re getting positive returns for the asset class. 


00:27:08 For the volatility underlying the asset. 


00:27:11 Yeah, yeah, so if you’re gonna have a high beta, you better have a high Sharpe ratio too, right? 


00:27:15 Yeah, you wanna see, return in comparison to how much, you know, volatility is like. 


00:27:21 Yeah, you don’t wanna go get in the boat, have it rock like crazy and go nowhere. 


00:27:25 Yeah, exactly. 


00:27:25 Okay, that’s a terrible thing to have happened. If the boat’s gonna rock a lot, it better be headed somewhere. So that’s the Sharpe ratio concept. So those are just a few. And then what we’re gonna do, let’s do this. I wanna take a break and we’re gonna come back and we’re gonna talk about a weird one. And you care, right? Like the term is R squared. And if you’re wondering, why do I care about R squared? It’s one of the most common mistakes that investors make in mutual funds. And this one can help you sniff it out. And we’re back live again. 


00:27:57 We are. 


00:27:58 And we’re still getting used to the new music, but hey, we can do this, people, we got this. Thanks for hanging out over the break. We’ve been talking today about mutual funds. I would suggest that you check out the podcast and check out the YouTube channel because some of what we’re covering today, good for, like, people that if you’re just getting sort of started in investing or if you’re a mutual fund investor. This is stuff that even a more sophisticated mutual fund investor, it’s good to review, this stuff. Okay. So what have we covered today so far, Matt? 


00:28:33 Oh man, we covered so much stuff. We talked about fees a little bit. We talked about some of the different performance metrics that are out there, how mutual funds work, some of the intricacies inside of a mutual fund. And I think when we left off, we were talking a little bit about R-squared. You kind of gave a little bit of a teaser there. 


00:28:55 I did.


00:28:55 Where did you wanna, what did you want to talk about regarding R squared and how that affects a mutual fund? 


00:29:00 So this is a common mistake. It’s an accident, right? But when I say common, it can happen because it sort of sneaks up on you, right? It’s the frog in the water thing where the water just gets warmer. Then you realize, like, huh, look at that. So imagine that you see a mutual fund and it’s doing well. You buy into it and it keeps doing well and other people take notice and they start throwing money at the manager because they want to participate in this good performance. 


00:29:28 Then the manager has to go, figure out where to put the new money. 


00:29:30 Correct, that money, because there’s a prospectus, says I gotta keep doing this. And that manager has to start buying more stuff. And at first they just got to buy their very best ideas. But now they’ve run out of the ability to keep buying those because at some point, mutual funds can’t become more than a majority shareholder. So 10% is typically the limit of ownership in a company. 


00:29:55 Right.


00:29:55 Right. The mutual fund can’t own more than that. 


00:29:57 It can actually be easier than you think. A lot of people are probably like, well, there’s no way you could own 10% of a company. But if you’re a–


00:30:04 If it’s a smaller company, you can. Small caps for sure. So companies got a billion dollars and they have to go buy small caps that are worth 500 million. It’s like, well, you put $50 million in that thing and you’re capped out. 


00:30:18 Yep.


00:30:18 Right. And you’ve still got $950 billion you gotta put to work somewhere. 


00:30:23 Yeah.


00:30:23 So it can happen. 


00:30:24 It can go faster than you think. Yeah.


00:30:26 So you start going to your plan B, they’re still okay ideas, but not as good. So that’s… the issue is that funds, as they attract money, they get bigger. So a couple of things can happen. One, they may close the fund. No more money. Believe it or not, there are funds that they did well. And in order to protect their existing investors, they had to shut off the money from coming in. I said, you’re grandfathered in, you get to keep it if you already own it, but nobody else can come in. 


00:30:53 Right. 


00:30:53 That’s one. The other is they just keep getting bigger. They may have to change the perspectives to accommodate for more. But what will happen sometimes is they will become what we’ll call a phantom index. 


00:31:04 How do they do that? Kind of walk us through. 


00:31:07 You just keep having to buy more and you become more diversified as you do until what happens is your performance as a manager– 


00:31:17 Closer and closer to a given index. 


00:31:18 It starts to mimic an index. This is where R squared is really important. It’s the statistical measure that says how much of the investment return can be attributed to its underlying benchmark, right? And so it’s really common with large growth funds to say, well, how much does that large growth fund look like the S&P 500? 


00:31:42 Right, so if I’m invested and I have a set of mutual funds that are kind of walking and talking. 


00:31:48 Yeah, and then you start to see an R squared value above like 0.92, 0.93, 92, 93% of the fund’s performance can be explained by the S&P 500’s performance. So you’re going, wait, you’re gonna pay an active manager a fee to get you a 7% differentiation between the index? That’s pretty statistically small. That 7%, even if it… but you don’t have to do extremely well. Cause imagine 7% of the portfolio outperformed by 10%. 


00:32:18 We could run the numbers. If you have a million dollars invested, right? And what were the numbers you just used? You said 93%? 


00:32:27 Yeah, and that R-squared of 93, 0.93, right? 


00:32:31 If you’re–


00:32:32 It can only go to one. 


00:32:33 So if only 7% of your money is differing from the index on a million dollars even, I mean. 


00:32:38 Well, it’s not just that too, cause you may only have like a hundred stocks and the index has 500 stocks. But the hundred stocks you have behave so much like the index that it’s still basically 95, 90 plus percent the same as the index from a performance perspective. So why not just buy the index and save the expense? 


00:32:59 Exactly. 


00:33:00 And that’s the key here. And that’s why we tend to with really big funds, really like mega caps, we wanna look at R squared value and it can sneak in there.


00:33:11 Mm-hmm. 


00:33:12 Right? And so that’s also something that’s not, I don’t think a lot of people are trained to look for. And it’s not the end all be all, right? I mean, it’s just another statistic. It’s just that maybe you don’t need to pay that expense. You can keep that money invested and working for you rather than going into the managerial cost of the fund. So if you have a mutual fund, sometimes it’s tricky because you may have a mutual fund in a 401(k) and the ticker symbol isn’t a ticker symbol you’re used to. It’s a long string of numbers. You might have to look at the name of that fund and then go look it up by name and then look at the different share classes of that fund. Cause this is the other thing, right? 


You can have one mutual fund and it’s really weird. Imagine like if we did this with, we’ll just pick a car company. Let’s say that we went, the only one that’s coming to mind is like a Toyota Camry, right? Like a Camry is a Camry, okay? But what if you bought the same Camry, except one of them gets 50 miles a gallon, one of them gets 30 miles a gallon, one gets 10 miles a gallon. Same car. And you’re gonna go, huh? It’s like, well, one of them, some of the gas gets siphoned off and given to somebody else. That’s kind of how mutual funds work. You have the same mutual fund, but the share classification, like you have an A share mutual fund, or B share, or C share, or L share, or M share, all these different types. They’re different expense structures. 


00:34:36 Right.


00:34:36 So you go and look for what has a similar expense structure to your fund and then go look at the R squared and see if that is, if you can get something else that has similar performance with a lower fee. 


00:34:50 Right. 


00:34:51 Right, and so that would be a way to do some homework around these metrics. 


00:34:56 Are you where you need to be? Yeah.


00:34:57 Yeah, and again, will it break your investments? It turns out overpaying investments, if you’re a passive investor and you’re, buy and hold for a long, long time, yeah, that’s fiscal drag. It’ll just add up over the years. And there’s lots of people that will quickly tell you, well, if you, like, Vanguard will say, well, you can buy our index fund at 0.1% or you can pay a manager 1%. And that 0.9% difference over 30 years is gonna be hundreds of thousands of dollars. And they’re probably not wrong. But there are some significant assumptions in there. Rates of returns, sequence of returns, that nothing else is gonna change within the funds. But there’s a lot of things that you go, that scenario doesn’t really exist. 


00:35:46 Right, it’s a sales tactic. 


00:35:47 But if it did like that, it would in fact cost more because you’re basically paying a toll, an extra toll along the way. So it’s gonna come out of your pocket from somewhere. So what are a few other common mistakes that we see? Talk to me about this idea that when mutual funds, one hand isn’t watching the other. 


00:36:08 Say that again. 


00:36:09 One hand isn’t watching the other, right? The overlap thing that we talked about. We talked about it during the break. So when you think you’re diversified. 


00:36:18 Yeah. I mean, you can go into this thing. And I’ve seen this before where someone’s like, oh, man, you know, I’ve got all these different mutual funds and my money spread out over so many different areas. But you start breaking it down. And I know we’ve mentioned the S&P before, but I’ve seen it before where they have maybe six mutual funds and all of them are growth-oriented mutual funds. And then you look at it and you’re like, well, if the S&P, for example, is 20% four or five different companies, and then your mutual funds are tracking that index, and then you add them all up, you still have about 20% of your money tracking the four or five largest companies in the US. And it’s like, well, you actually are not as diversified as you think you are. 


00:37:07 Yeah. The issue is sometimes you can buy mutual funds and you don’t see what’s in the basket. And if the baskets own the same stuff, you’re not really getting diversification, you’re just getting two baskets that own the same thing. And so we call that overlap. The idea that, oh, I own Amazon in this fund and in that fund, they’re common holdings. So if your mutual funds have a lot of common holdings, if you have 70% holdings in common, then you really have 70% the same fund, you just bought it in two different places. So the 30% better be a real differentiator, or you may have, it may not be doing what you think it’s gonna do. 


00:37:47 One of the troubling things I think I look at this and say is if you don’t have anyone in your corner to bounce ideas off of and get advice from, you could be in a situation where maybe you’re really close to retirement, and you’re not really aware of how much volatility you’re actually willing to accept, and you don’t know how your investments align with your risk tolerance, right? Like how much volatility you are willing to accept. And by not knowing that, you might be in some type of fund where you’re taking on more risk than you really want to.


00:38:20 Yeah.


00:38:21 And I think that’s one of the, kind of, dangers of just saying, I’m gonna buy it and forget it until I need the money. And it’s like, well, what if the market’s in a down cycle and now you need to access your money? So I think there’s some importance in having someone in your corner so that you can bounce ideas back and forth and know really where you stand. 


00:38:41 I think there’s a thing that happens a lot. People don’t even realize it as investors. It’s again, it’s a common error.


00:38:49 Okay.


00:38:50 Right? It’s not that it’s huge, but it’s preventable and it’s unnecessary. And I know you want to hear what it is, but I’m gonna totally take the last break first. All right, gang, home stretch here. Just last few minutes of the True Wealth Show. Thanks for tuning in today. Just one more plug. Hit us up at our website at Lots more information, lots of the prior podcasts if you wanna hear other shows. And now they’re on YouTube, so you can grab all this stuff. Matt?


00:39:20 Yes.


00:39:20 You were just walking us through a mistake that you’ve seen a lot. We’ve talked about it, where investors just kinda, they own stuff and–


00:39:31 They might not know what it is, what it is that they’re doing, and then they accidentally maybe take more risk than they thought that they were taking. 


00:39:37 Yeah, but I love this concept of what I call risk drift, right? You just, you had an idea what you were taking, but over time, by not changing anything, the winners got bigger, the losers didn’t, but the winners may be the next thing that becomes volatile in another market cycle, right? Because oftentimes the things that grow a lot, they’re the things that whipsaw a lot. So you have now taken on more risk unintentionally. I told our listeners that at the break when we come back, a common mistake that I see, and I know we’ve talked about this, Matt, what is something that investors could do to take that risk drift and sort of invert it? And the mistake being, you own the risk and you don’t have to. 


00:40:26 Right.


00:40:26 What could they do instead? 


00:40:28 I mean, there are ways that you can try and target the same type of return, but with less risk, right? And it’s a matter of knowing what options are available to you in the investment landscape, because there’s so many different things to invest in, and you might not be in the area that you need to be in, and you could be, and you could be getting the similar type returns that you want, but with a lot less risk. 


00:40:57 Yeah, and here’s something, I didn’t prep, Matt for this by the way, this is a sneaky thing that I’ve observed over the now 24-ish years of my career. We have seen asset classes emerge that weren’t necessarily asset classes 20 years ago. 


00:41:14 I think fixed income’s a good example right now because if you look back four or five years ago, fixed income products might’ve been at one, 2%. And now you have bank CDs at five something. And so that’s a change where it wasn’t an opportunity before, it is an opportunity today, but it doesn’t necessarily mean that it’s gonna be an opportunity in the future. 


00:41:35 And I’m gonna take it a step even further. And these are asset classes that rise and fall in and out of favor. And fixed income is a really good example. But I’m talking about the alternatives landscape that didn’t even exist 20 years ago. We didn’t see things like long short funds or absolute return funds or low beta strategies or factor-based strategies. Those didn’t exist. And the question is, why did they come into being? 


00:42:02 Because people always want to create another avenue to try and achieve a goal. 


00:42:11 Yes. And because the market sort of necessitated it. 


00:42:14 It’s innovative. 


00:42:15 What we started to see, and this happened really, like 2008 was where I really noticed this. And I didn’t realize this a long time ago, okay, but it gives you an idea how long I’ve been, you know, in the industry. So in 2008, we saw correlation across multiple asset classes that has, historically, they hadn’t been highly correlated, right? So the fancy way of saying, hey, a bunch of stuff that used to be diversified stopped behaving like it was diversified, right? The big companies and the small companies moved together, stocks and bonds moved together, even real estate started moving together. So we saw assets that used to be positioned opposite each other to balance the boat start behaving similarly. And in order to reintroduce low correlation, new asset classes emerged and new ways to design investments to reintroduce low correlation and better diversification. 


00:43:12 It’s one of the most wonderful parts about investing. There are so many different avenues, different lanes that you can get into. 


00:43:19 And the point is very simply the landscape changes. The tactics, I’ve said this before and I’ll say it again, the tactics of war are what have changed. The principles haven’t. Investing principles are still really similar, but over time, war evolved, right? Investing evolves. And so that’s where we’re at. And so what I would like to just say with the closing moments here is if you don’t do this often and you would like just some insight, I would encourage you to work with a financial professional. If this is not something that’s your interest of when you’re not gonna do it yourself, find somebody that you like and trust and work with them to help you navigate this.


00:43:59 Or at least get a low pressure type thing where someone’s gonna look at it and tell you what you’re in and maybe how you could either do it differently or continue on the same path. 


00:44:11 Right, Matt, how can they reach us if they don’t have that person? 


00:44:14 Yeah, so call us 541-375-0898 or just go to our website and send us a little chat. It’s Little John Financial.


00:44:24 All right guys, well we’re out of time. Thank you as always for tuning in. Until next time, I’m Dave Littlejohn. 


00:44:30 And Matt Dickson. 


00:44:30 You’ve been listening to True Wealth on News Radio, 93.9 FM and 1240 KQEN. 


00:44:35 Well, hopefully this one was more useful for you guys. We did kind of cater a little bit to the video market today. The idea being that, you know, it’s a live show, right? But we wanted to cover some topics and sometimes we just have fun and, you know, horse around. ‘Cause it’s kind of fun and we can do that on the show. And a lot of what we’re showcasing is, hey, we’re pretty approachable. That’s the whole point of this thing. And so, but we wanted to steer into the topic of like, so many people, mutual funds are gonna be the thing that you’re gonna end up with. Like almost everybody, I mean, I own mutual funds, right? And I own a lot of individual stocks and we build our own strategies too. And we still own mutual funds. Why? ‘Cause sometimes it’s the cheapest way to access an asset class, right? 


So there’s still a use case for them to this day. And so I don’t want to demonize them at all. Instead, let’s figure out how to navigate them well. And let’s give you the tools so that you can do it too. And if you don’t have that person in your world, give us a shout and it doesn’t matter where you’re at. We actually work with people literally around the globe. We’ve got time zones all over the place and we’d love to talk to you. So thanks for the time. Give us a shout, put some comments down if you need anything that you want an explanation about. It always helps us to just know what you’re looking for and we’ll get back to you. So until next time, be good.


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