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 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 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.