ASK DOUG

Should Our Investment Club Invest in Mutual Funds or Exchange Traded Funds?

Q. A group of co-workers and I are planning to invest some of our money in a mutual fund. I am new in this field and any help coming from you will be well appreciated. Doing some research on the Internet, I found a mutual fund that has given its investors an annual return of a little bit more than 23% in the last ten years. The majority of this fund's portfolio has to do with technology, though, which is always changing. Is this still a safe way to go? Do you have an opinion, if not advice, in which direction we should go after today? Small cap, medium cap, large cap, index fund.... I am confused! I understand that there could be a simple correction of the market. But, how am I going to convince my partners that what happened today has happened in the past and if we stay put, we will be ahead of the game five to ten years from now? Your comments, please and thank you for the opportunity.

A. You sure ask a lot of questions in a single paragraph! I think you're really getting at the very essence of why people belong to investment clubs in the first place -- to learn about the markets and where to invest successfully. But let me try to address the issues you raise one by one.

First, most investment clubs invest in stocks. After a club has been investing together for a few years, they will have built a diversified portfolio of twenty or more stocks. This portfolio in many ways functions as a "mini mutual fund" on its own. If the portfolio is spread across companies of varying sizes (small, midsized, and large) and in different sectors and industries, it is likely to provide plenty of diversification to hel0 maximize return and minimize risk (which is one of the biggest advantages of a mutual fund). Club members can invest relatively small amounts in the club's portfolio, and yet the entire portfolio benefits from economies of scale from the pooling of funds of members, other advantages offered by mutual funds. As for the benefit of "professional management" so often touted by funds, most club members are quick to point out that most mutual funds can't beat the S&P 500 index -- while investment clubs routinely do.

If your investment club were to invest in mutual funds or exchange traded funds (ETF), a potential problem arises quite quickly once you own more than a handful of funds. It's quite likely that your various funds will own the same stocks or same asset classes, and this overlap can turn your efforts at "diversification" into mush.

From a recordkeeping and tax reporting perspective, holding mutual funds or ETFs can complicate the treasurer's job significantly depending on the securities owned in the fund. Some ETFs or funds, such as though that own precious metals or commodities, should be avoided in clubs the tax regulations regarding these make their gains and losses be handled differently from stock-based funds.

Now, about the situation in the current market. If you build a portfolio according to BetterInvesting's guidelines, diversified by size of company and industry, and made of up quality growth stocks, you'll be in a position to weather the next five to ten years. But a big advantage of investment clubs is that they invest each month, regardless of how the market is performing. This provides the benefits of dollar cost averaging, and allows the club to continually build wealth over a long period of time. When the market falls back, clubs keep investing, even though it may hurt in the short term. When the market eventually begins to climb once again, the club's portfolio will be driven to new heights. This is why it's so important to invest regularly, and not try to "time" the market.

In fact, one of the universal truths about the market is that it goes up and it goes down. Your club needs to realize that there will likely be bumps in the road to financial freedom, and that there may be times that the club's portfolio will fall. Over the long term, however, the stock market tends to move up more frequently and in bigger steps than it moves down. Once you and your club members understand this, you'll be better off -- and so will your portfolio!

- DOUG GERLACH

Doug has helped countless people get started on the road to financial freedom. A true Internet pioneer, he founded one of the earliest financial Websites, Investorama.com, in 1994, and co-founded NAIC's original website in 1995. In his role as President, Doug serves as ICLUBcentral's product manager and evangelist for tools such as myICLUB.com, MyStockProspector.com, and the award-winning Investor Advisory Service newsletter (for which he also serves as editor). Doug founded several of the tools in ICLUBcentral's toolbox, including StockCentral and the market-beating SmallCap Informer newsletter. He is the author of several books, including The Complete Idiot's Guide to Online Investing, The Armchair Millionaire, and Investment Clubs for Dummies, and maintains his commitment to making personal finance accessible to all, through magazine articles, media appearances, webinars, and speaking engagements.

Got a question about investment clubs? Ask Doug!