People are always asking me if they should buy mutual funds or individual stocks.

There is a perception out there, perpetuated by fund companies and managers, that the professional managers can do it better than you can.

This is the theory. Mutual funds pool your money with that of other investors to buy stocks, bonds or a combination of financial instruments. Because they have large pools of money, they can provide instant holdings of several different companies across many separate sectors. You get diversity, experience and technical expertise in a nice, neat package.

Most funds offer shares to the public continuously, either directly or through stockbrokers and other dealers. Like individual stocks, a mutual fund investment can be converted into cash upon your request. They are easy-in, easy-out investments and don’t require much work on the individual investor’s part once the money goes in.

It's true; the pros have more experience and more training, but they may not have your best interest at heart. Think about this for a minute. How do these fund managers get paid? The investment advisory fee, or management fee, is the money used to pay the managers of the mutual fund. On average, this fee is about 0.5% to 1.0% annually of the fund's assets. The bigger the fund, the bigger the paycheck.

While the management fee is clearly the most visible, it is far from the only fee you will be paying with a mutual fund. There are also the administrative costs which are the costs of recordkeeping, mailings, maintaining a customer service line -- all the little things. These are all necessary costs and can vary in size from fund to fund, running from a low of less than 0.2% of fund assets to more than 0.4% of fund assets. Other fees associated with mutual funds include, but are not limited to, 12b-1 distribution fees, loads, turnover costs and taxes.

Not all funds will have all these fees and charges, nor are the fees and charges outrageous for all mutual funds. And it is true; there are costs associated with managing your own portfolio. Even if you don’t get advice from a broker, you will still have commissions and fees for your trades. The difference is this. When you are in charge, you have greater incentive to control these costs and have better information on just what costs you are paying.

If you have enough time to do the research to find the "best" mutual fund, then you have the time to find high-quality stocks to make up the core of your portfolio. This way you only own the best picks you can find. These are the ones you think will bring in the biggest returns over the long term. This should put you ahead of most mutual funds because they’re only looking for decent returns. That’s because the money funds make doesn’t come from performance incentives so much as fees, so they only need to do well enough to attract more of those fees.

By picking your own stocks, you also only own the stocks you pick. Take a look inside almost any mutual fund, including index funds and ETFs, and what do you see? You see some really nice stocks; the kind you might like in your own portfolio. You will also see some really bad stocks; the kind you probably would not have gotten into in the first place.

These bad stocks show up in funds because, as they grow, funds have to put the money somewhere. Often, once a mutual fund becomes popular, it swells up with investors’ money. There are a limited number of quality companies and a limited number of shares in those companies. If a $50 billion fund found a $900 million company to be a good buy, it could only devote a very small percentage of its asset base into the company. As a result, the mammoth funds sometimes have to lower their standards for investment.

Since most of us don’t have billions of dollars of our own money to invest, this should not be an issue. We can find the best stocks and spread all of our funds out without the market really noticing. It also means if one of our chosen stocks takes a turn for the worse, we can easily get out.

The question now is: what stocks should you have in your portfolio? As core holdings, large, diversified companies are your best bet. It would be better to pick a few diversified stocks and get into them with a hedged trade. Companies with good earnings, decent dividends and a strong international presence would be at the top of my list.

I know this first company has been in the news a lot lately, but it does fit the bill. General Electric Co. (NYSE: GE, Bullboard) is one of the largest and most diversified industrial corporations in the world. The stock is more than 20% of its 52-week high and has some issues to sort through, but it is still one of the biggest players on the block.

Honeywell International (NYSE: HON, Bullboard) is a diversified technology and manufacturing company, serving customers worldwide with aerospace products and services, control technologies for buildings, homes and industry, automotive products and a host of other products. The stock is trading at the higher end of its 52-week range, but has the ability for price appreciation.

Textron, Inc. (NYSE: TXT, Bullboard) is a global multi-industry company with operations in aircraft, fastening systems, industrial components, industrial products and finance segments. This one is not as well known as the others, but is still worth a closer look. The company recently reported that its first quarter net income grew 18%, from $196 million a year earlier, on strong demand across the company's aircraft and defense units.

When looking to hedge a trade on core holdings, the covered call is a very nice option. At-the-money or even out-of-the-money covered calls can give some downside protection while we hold the stocks. As expiration nears, we can also roll the position if we wish to continue holding the stock.

If you are looking for a hedged trade on GE, consider a January '09 Covered Call with a sold call at 35. That's potentially a 12.7% assigned return (17.5% annualized for comparison purposes) and the stock would have to fall 5.3% to cause a problem. The stock also pays a 3.8% dividend.

For a hedged trade on HON, you may want to consider a January '09 Covered Call with a sold call at 65. That's potentially a 14.1% assigned return (19.4% annualized for comparison purposes) and the stock would have to fall 5.8% to cause a problem. You might even catch a little bit of the stock’s 1.9% dividend.

As always, be sure you consider your personal risk tolerance, time horizon and investment goals before entering any trade. The most important thing is to know what you are getting into and how it fits into your plans, and try to have a little fun along the way.

Mutual Funds – What don’t they want you to know?

* Does The Ideal Mutual Fund Exist? + Lee’s take on DIS, BUD, BKC, JWN, JNS, and TROW

* How Can Your Portfolio Mimic a Mutual Fund?

* Can You Do Better Than A Hot-Shot Mutual Fund Manager?

* Mutual Funds: The Good, the Bad, the Ugly and the Alternatives

Click Here to read any of these articles.



Vic Wisemann
Lead Analyst

Vic Wisemann is an equity option strategy analyst with Investors Observer. Mr. Wiseman manages several portfolios for the company and comments weekly on his insights, strategies, and tactics for playing the market to win.

DISCLOSURE: Mr. Wisemann owns and/or controls diversified portfolios of long and short stock and option positions that may include holdings in companies he discusses in his articles.