The 50-50 Mutual Fund Rule

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Every month I receive “In The Vanguard,” Vanguard’s monthly newletter, and scan it cover to cover. It’s a document you can find online (speaking of which, I should change to electronic delivery or cancel the mailings) This month, I was introduced to an idea by Dr. Burton G. Malkiel, author of the famous investing text, A Random Walk Down Wall Street. Malkiel, who also lists Princeton University economist as an accolade, recommends that you follow the 50-50 rule when selecting mutual funds. The 50-50 rule states that:

When choosing a mutual fund or exchange-traded fund, choose one that has an expense ratio under 0.50% and a turnover rate below 50%.

Malkiel warns against the most frequently used alternative, historic returns, because it’s not a reliable predictor (though it has value in terms of discerning volatility).

Expense Ratio

Expense ratios are an often discussed, pretty well known, characteristic about mutual funds. The expense ratio is how much the fund charges you each year to keep your money there. Mathematically, it’s the fund’s operating costs divided by its average net assets; which translate to a deduction from your account. An expense ratio of 1% means that every year a dollar will be taken out for each $100 invested. You can see how that can have a significant impact!

Open the fund’s prospectus, you’ll see expense ratios most often listed under fees. The value can be broken up into administrative and other fees but the end result is the same, the expense ratio is how much the fund costs you each year. While you’re there, check the load, that’s the sales charge when you buy or sell the fund. I always go with a no-load (no sales commission) fund.

Turnover Rate

Turnover rate is a less often discussed characteristic about mutual funds but it refers to the turnover in holdings within the fund. Much like how you may trade stocks, bonds, etc. within your other brokerage accounts, mutual funds are companies are do the exact same thing. The higher the turnover, the greater the number of transactions, and the greater the cost to the fund. Costs associated with turnover are usually not itemized out and not integrated with the expense ratio, they are usually not detailed out at all and only reflected in the fund’s value.

Why a lower turnover rate? All things being equal, the more activity a fund has, the more you will lose to transaction fees (like broker commissions) and taxes (more short term, vs. long term capital gains). In the fund’s prospectus, you will usually find discussion about turnover rates under portfolio management, or wherever they discuss holdings, P/E ratios, and other similar metrics.

The 50-50 rule is just a guideline, there are always exceptions, but I think that it’s a good starting point if you aren’t sure how to go about picking a fund. You can’t control returns, but you can certain minimize costs.

{ 9 comments, please add your thoughts now! }

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9 Responses to “The 50-50 Mutual Fund Rule”

  1. Typically the easiest way to hit the 50-50 rule is to invest strictly in index funds. They will have low turnover (except perhaps in 2008 when there are so many redemptions by scared investors.)

  2. katy says:

    he’s great!

    In the random walk investing guide, he suggests buying stocks; bonds; real estate and having cash.

  3. Miss M says:

    No surprise they would tout this in Vanguard’s newsletter, as home of the index fund they automatically meet this criteria. I don’t think there are many (if any) actively managed funds with an expense ratio below 0.5%.

  4. Cap says:

    Miss M: the same probably applies for funds with high turnover rate too, which is something I dont see mentioned too often (or either that I’m not reading at the right places)

  5. Eric N. says:

    Thanks for the post Jim. I knew about expense ratios but turnover was something new. I tried looking at a fund’s prospectus but couldn’t find anything specifically on turnover. Where the P/E ratio is listed, it’s just a table of stats without any word explanations to them.

  6. jim says:

    Eric – Which fund were you looking at?

  7. Gates VP says:

    Yeah, Malkiel basically founded the Vanguard-style index fund with the first printing of Random Walk in like 1980 or something.

  8. TStrump says:

    I am embarassed to say, I own one mutual fund right now, and I don’t even know what the MER is!?
    I also never considered the turnover rate before and will now rush off to the website and go through the prospectus.
    Great tips!

  9. Eric N. says:

    Sorry for the late reply Jim…I was looking at a specific target retirement fund in my sibling’s 401K. The fund is SSgA Target Retirement 2045 Fund. For some reason, Google doesn’t show much so I’m not sure the fund is available outside of specific 401K plans. I got the prospectus from my sibling’s company 401K website.

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