How to build your own mutual fund

Over the past few decades, mutual funds have become an increasingly popular investment vehicle for the masses. Investors who take part in a company-sponsored retirement plan or who have an individual investment portfolio are often faced with a dizzying choice of funds without understanding the implications for the overall value of their investment. The sobering fact is that most mutual funds underperform the stock market as a whole.

What does this mean? Think of it this way: If you hire a personal trainer to help you look and feel better, you expect better results than ones you could achieve on your own. In other words, spending your hard-earned dollars should beget you something of value. Paying someone fees and commissions to grow the value of your portfolio, when it's something you could do on your own, is at best unnecessary and at worst a foolhardy extravagance.

Let's examine how you can build your own mutual fund and pave a path toward outperformance, not mediocrity. (For related reading, see "How to Outperform the Market.")

Mutual funds are essentially a basket of several, or sometimes hundreds, of individual stocks. As a mutual fund investor, you are paying the portfolio manager to buy and sell stocks and/or bonds on your behalf. These investors are passing on their expenses to you in the form of an expense ratio. They don't stop there: some funds charge you a 'load' based upon the class of fund shares you purchase. Loads are fees for buying and/or selling funds. The load on a mutual fund is highest if the fund is bought and then sold in the short term.

Typically, fund managers want control over your money for longer periods of time and discourage the trading or hedging of mutual funds. Regardless of whether you are buying a fund for one year or twenty, avoiding funds that have a load will save you dollars. These expenses, albeit disclosed and transparent, eat into your potential return, particularly over longer investment horizons.

You can start building your own basket of stocks by doing some homework. The investment of your time will save you dollars in the long run. Besides your time, your only expense is the transaction fee to buy and sell stocks. Most discount brokerages today charge less than $20 a trade.

Picking good stocks to begin with is critical to avoiding recurring trading expenses: Good stocks are ones you hold, while stocks you dump are the "losers." Browse through Investopedia and sites like Yahoo Finance, Motley Fool, or CBS MarketWatch, and start a watch-list of companies with which to become more familiar.

Companies such as Wal-Mart (NYSE:WMT), Microsoft (Nasdaq:MSFT), Target (NYSE:TGT) and other icons of American business can form the basis of a core stock portfolio. If you know very little about stocks, take a class on the fundamentals of investing at a community college, buy a book or two on basic investment choices, or browse the investing tutorials located on this site. (To learn more about basic investing, see our Investing Tutorials.)

Keep in mind that not all mutual funds are created equal. If you do not have the time or inclination to build your own portfolio, then target mutual funds with an expense ratio of less than 1%, and avoid loads at all costs.

Perhaps the most critical factor in deciding whether a fund is worth your investment dollar is its relative performance – how your prospective new funds compare to the index and its peers. Each fund has a benchmark that it is compared to in performance and expenses. Most common is the Standard & Poor's 500 index, but there are several others that are prominent.

If your fund is underperforming that index and the fund manager is charging you money to underperform, it may be time to move on. Yes, there is some truth to the adage that past performance does not guarantee future results, but you can help optimize future performance by minimizing unnecessary costs such as loads and high-expense ratios. Sites like Morningstar and Lipper present a good picture of relative performance and costs. Simply enter your fund symbol, and relevant data should be readily available for your analysis.

Another option investors should seriously consider is putting money into an index fund, which is a fund strictly correlated with a particular index – say, the Dow Jones 30 or the Nasdaq. These funds do not trade or turn over stocks frequently, therefore expenses are minimal; in addition, these are typically no-load funds. Industry experts credit Jack Bogle and his Vanguard family of funds as being the leaders in low-expense index investing for life.

One of the downsides or inherent risks of investing in index funds is that you are at the mercy of the composition of that index. In other words, if the composition of the S&P 500 or the Dow Jones changes, you are locked into what money managers refer to as a rebalancing effect. Also, many argue persuasively that these indexes are slow to adapt to the overall economy.

For example, one of the most successful companies and stocks over the last decade has been Apple Inc. (Nasdaq:AAPL). If you owned a mutual fund that was indexed with the Dow Jones 30 stocks, you would not own Apple shares. Whether Apple should be included in the Dow 30 is certainly debatable, but the fact is that your investment in what is alleged to represent a broad basket of American companies may in fact not be sufficiently representative. (To learn more, read "Why the Dow Matters.")

Investing in traditional mutual funds is not necessarily incompatible with meeting your financial goals, but most such funds do saddle you with an out-of-pocket cost for sub-par performance. Building your own mutual fund, or at least minimizing unnecessary expenses, is key to optimizing returns for the long-term. Beginner investors may want to consider index funds as a low-cost option before venturing out and buying individual stocks. Keep in mind that building your own fund requires additional effort, but the requisite tools are readily available on the web – more so than ever before.

Research and persistence are critical to building a successful mutual fund. It will take time, but the rewards can include higher returns, lower costs, and the personal satisfaction and confidence that come with a job well done. (To read more about building your own portfolio, see "Create Your Own U.S. Equity Portfolio.")