Mutual funds are a sort of necessary evil.
After all, in a world where individuals accumulate retirement and other investment funds and yet are not permitted to actively manage their investments (401Ks), or do not feel comfortable doing so (IRAs and other non-retirement accounts), someone has to manage all that money.
Unfortunately, due to a number of factors, including short-term performance pressure, having way too much money under management, and being at the mercy of their retail clients who tend to pile more money in near market tops and redeem their shares near market bottoms, actively managed mutual funds on the whole have a terrible track record.
And even mutual funds designed to mirror an index fail to match their benchmark once annual expenses are included in the returns.
So what are some viable mutual alternatives for self-directed investors who are not content with subpar market returns and who reject the notion that professionals with poor track records are good candidates for managing their investments?
In the unfortunate case of U.S. investors locked into a 401K plan in which mutual funds are the only choice available, there are no alternatives. But in situations involving self-directed IRAs and non-retirement investment accounts, here are three broad stock market investing alternatives to mutual funds:
#1 – Exchange Traded Funds – Exchange Traded Funds, or ETFs, have a similar functionality to mutual funds but trade like a stock directly on a stock exchange. Like mutual funds, ETFs are comprised of a basket of stocks. And those baskets can sometimes be very large.
An ETF may mirror a large index such as the S&P 500 or be representative of a specific sector, industry, or foreign market. In fact, the choices and flavors among ETFs are quite vast.
As far as a mutual fund alternative, ETFs provide only a minor structural improvement over comparable mutual funds. With their significantly lower expense schedule, an ETF tracking a specific index will always generate a better return than a mutual fund tracking the same index. Although this is only a small improvement, over time, an extra 1-2% annually will add up,
#2 – Individual Dividend Growth Stocks – Investing in individual, high quality, dividend paying and dividend growing companies, and then reinvesting those dividends into additional shares of the same or a comparable company, is a proven investing model that builds real wealth over time.
In my opinion, it’s also a terrific alternative to most actively managed mutual funds, although it does require a certain educational commitment and discipline. This requirement is far from onerous, however – a little interest and enthusiasm will go a very long way.
There are numerous public companies with multi-decade histories of having increased the dividends they pay out each year. Combining natural dividend growth along with reinvested dividends produces a powerful one-two compounding punch.
It’s much easier to dump all your money into a mutual fund, of course, but dividend growth investing in high quality companies has a rich history and no shortage of practitioners and advocates. In short, there are ample resources and educational materials available to assist the beginning self-directed investor interested in learning everything necessary to improve his or her financial future.
#3 – Conservative Option Trades Used in Conjunction with a Portfolio of High Quality Companies – Requiring a slightly higher commitment to investor education, employing conservative option trades on an already high quality portfolio of individual stocks (such as the high quality dividend growth stocks detailed in #2 above), is my favorite mutual fund alternative.
In the same way that dividend growth and dividend reinvestment produces two compounding effects, moderately boosting your overall returns (or lowering your cost basis, depending on how you prefer to view it) through the strategic and conservative use of trading stock options provides an additional third compounding source that can lead to dramatically outsized returns over the long term.
Isn’t option trading risky, though?
Although options can be used in a high risk manner, they can also be used in a low risk manner. And, when combined with an already proven investing model such as the high quality dividend growth portfolio, low risk option trading is all you need to significantly accelerate your investing success.
You’re essentially using options to enhance your investing returns, not to try to replace them.
I call this style of conservative investing and conservative option trading Leveraged Investing.