Many financial advisors recommend re-balancing your portfolio no less often than annually to ensure the asset allocation is consistent with your risk tolerance, as illustrated in this post from Schwab. In the past, I haven’t been one to re-balance my portfolio, so I spent some …
Diversification is an important component of any investing plan. It assists you in limiting your risk either to a single asset class or a single security within an asset class. However, I have seen a couple of graphs from which you could form the wrong …
Mutual fund and ETFs (exchange-traded funds) allow you to invest in securities without having to select individual positions. Instead, the fund manager makes the decisions as to when to buy and sell each security. As such, a fund is an easy way for new or busy investors to participate in financial markets. This post will help you learn about the different types of funds, their pros and cons and other considerations of owning mutual funds and ETFs.
What is a Mutual Fund?
A mutual fund is pool of money collected from the investors in the fund. The investors own shares in the mutual fund itself, but not in the individual securities owned by the fund. However, other than closed-end funds discussed below, an investor’s return is his or her share of the returns of the aggregation of the returns of the individual securities owned by the mutual fund. That is, if, on average, the securities in the mutual fund issue dividends of 3% and appreciate by 2%, fund owners will receive a dividend distribution equal to 3% of the value of their share of the pool plus the value of their ownership share will increase by 2%.
Most mutual funds also issue capital gain distributions once or twice a year. If the mutual fund had a gain on the aggregate amount of securities sold in the year, it will often distribute the amount of the gain to investors as a capital gain distribution in proportion to their ownership shares in the pool.
Mutual funds can be purchased directly from the fund manager or through a broker. Most mutual funds are not traded on exchanges. Purchases and sales of mutual funds occur once a day, with all buyers and sellers receiving the same price which is equal to the net asset value of the underlying assets. (See below for more information and exceptions.)
What is an ETF?
Exchange-traded funds or ETFs have several characteristics in common with mutual funds:
- They are pools of money collected from their investors.
- Investors share in the returns of the aggregation of the individual securities.
- ETFs can hold a wide range of securities, including stocks, bonds and commodities.
These are a few of the ways in which ETFs differ from mutual funds:
- They are exchange-traded securities (as implied by their name), so they can be bought and sold any time the exchange is open. As such, the price you pay or receive when you buy or sell an ETF can vary over the course of a day.
- While many mutual funds have a minimum investment requirement, most ETFs do not.
Types of Mutual Funds and ETFs
There are many features of mutual funds and ETFs that are important in determining the best funds for your portfolio. Almost all of these features apply to both mutual funds and ETFs.
Active vs. Passive Management
An actively managed fund has a fund manager who is responsible for selecting the securities that will be owned by the fund. The manager decides when to buy and sell each security. By comparison, the securities owned by a passively managed fund are determined so that the performance of the fund tracks a certain basket of assets.
Index funds are a common type of passively managed funds. An index fund is a mutual fund or ETF that has a goal of matching the performance of an index, such as the S&P 500, the Dow Jones Industrial Average or the Fidelity US Bond Index.
There are other passively managed funds whose trades are determined so as to produce returns similar to a certain segment of a market, such as a particular industry or region of the world, that may or may not have an index that measures those returns.
Funds can own a wide variety of securities – everything from stocks and bonds to commodities, among others. As you are looking for a fund, you’ll want to decide what type of security you are seeking.
Most funds focus on a specific geography. Many mutual funds focus on US investments, while others purchase securities from within a region of the US, the whole world or segments thereof, such as the developed world excluding the US. While I hold most of my North American equity positions in individual companies, I use mutual funds to diversify my portfolio globally.
Just as funds focus on a specific geography, they sometimes invest in one or more market segments. Some funds focus on a specific industry, such as natural resources or technology or financial companies. If you think a particular industry is going to benefit from trends in the economy, such as healthcare as the population ages, you might want to buy a fund that focuses on the healthcare industry. On the other hand, you might want to avoid healthcare stocks if you think that the healthcare industry might be at risk of significant disruption from changes in the government’s role in healthcare.
Other funds focus on the size of companies. For example, an S&P 500 Index fund only buys positions in companies in the S&P 500 which, by definition, are large. Other funds focus on middle-sized companies (middle-sized capitalization of mid-cap) or smaller companies (small-cap).
Another “industry” on which many funds focus is municipal bonds. These funds invest in bonds issued by municipalities. In many cases, interest from municipal bonds and municipal bond funds is not taxed by the Federal government or in the state in which the municipality is located. For example, if you buy a bond issued by the City of Baltimore, it is likely that it will not be taxed at all if you are a Maryland resident.
Appreciation vs. Dividends
Some funds focus on high-dividend investments, while others focus on appreciation in the value of the securities they own. You can learn the focus of a fund by looking at its details either in a summary or its prospectus. Funds that focus on high-dividend yields often have “high-dividend” in their name, but not always. The type of return targeted by funds you purchase will impact the specific securities owned by the fund. In addition, the type of return impacts the taxes you will pay (discussed below).
Growth vs. Value
Companies are often categorized between growth and value, reflecting the two primary reasons that stock prices increase. The stock price of a growth company is expected to increase because the company will increase its profits. By comparison, the stock price of value company is expected to grow because its valuation, often measured by the price-to-earnings or P/E ratio, is considered low and likely to return to normal.
Closed-end vs. Open-end Funds
Most funds are open-end funds. The price you pay for these funds is equal to the market value of the securities owned by the fund divided by the number of shares outstanding. This price is known as the Net Asset Value. You can buy shares from and sell shares back to the fund owner at any time at the net asset value.
A closed-end fund differs in that the number of shares available is fixed when the fund is first created. When you buy and sell shares in a closed-end fund, the other party to the transaction is another investor, not the fund owner. In fact, closed-end fund shares trade in the same manner as if the fund were a company. As such, the price is not the net asset value, but rather has a market value that reflects not only the net asset value but also investors views of the future performance of the fund.
Advantages and Disadvantages of Mutual Funds and ETFs
The biggest advantage of mutual funds and ETFs is the ease with which you can diversify your portfolio, especially in asset classes or market segments with which you are unfamiliar. I think index-based ETFs are a terrific way for new investors to participate in markets. As I mentioned above, I use mutual funds for international stocks, as I don’t know enough about economies and market conditions outside the US, much less about individual companies, to make informed buying decisions.
A drawback to actively-managed funds is that they tend to underperform the market. That is, there are not many money managers who can consistently produce returns that exceed their target benchmarks. This difference is even greater when returns are reduced for fees paid by investors (discussed later in this post).
There are many sources for statistics about mutual fund returns. CNBC states that, in every one of the nine years from 2010 through 2018, more than half of actively managed large-cap funds produced returns less than the S&P 500. The same article also indicates that 85% of those funds underperformed the S&P 500 over a ten-year period and 92% underperformed over a 15-year period. As such, care should be taken when investing in actively managed funds. If you are looking for funds that will produce returns similar to broad market indices, such as the S&P 500, an index fund might be a better choice.
There are four types of returns that are taxed when you own mutual funds or ETFs that hold stocks or bonds held in taxable accounts. Funds held in tax-deferred or tax-free accounts will have different tax treatment. The taxable returns on other types of funds will depend on the types of returns generated by the underlying assets.
When you sell your ownership position in a fund, the difference between the amount you paid when you bought it and the amount you received when you sell it is a capital gain. The taxation of short-term capital gains (related to securities owned for less than one year) is somewhat complicated in the US. Long-term capital gains are taxed in the same manner as dividends in the US, at 15% for most people. In Canada, capital gains are taxed at 50% of the rate that applies to your wages.
When you own a bond fund, interest paid by the issuers of the bonds owned by the fund is taxable in the year the interest payment was made. In the US and Canada, interest held in taxable accounts is taxed at the same rate as wages, except for certain municipal and government bonds which may be exempt from state or Federal taxes.
Dividends paid by companies owned by a fund are taxable in the year the dividends payments are made. For most people in the US, there is a 15% Federal tax on dividends from investments held in a taxable account plus any state taxes. In Canada, dividends are taxed at the same rate as wages.
Capital Gain Distributions
Over the course of a year, a mutual fund may sell some of its assets. The capital gains earned from those assets are distributed to owners as capital gain distributions. Capital gain distributions are taxed in the same manner as capital gains.
There are generally three types of fees that can affect your returns on ETFs and mutual funds: front-end loads, operating expenses and commissions. Schwab identifies two other hidden costs that are a bit more obscure, so I’ll refer you to its post on this topic if you want more information.
Some mutual funds require you to pay a fee when you make a purchase. The fee is usually a percentage of your investment. For example, you would pay $10 for every $1,000 you invest in a fund with a 1% front-end load. If you purchased this fund, its total return on the underlying investments would need to be 1% higher over the entire period over which you owned it than the same fund with no front-end load for you to make an equivalent profit.
Funds that don’t have a front-end load are called no-load funds.
Mutual funds and ETFs, even those that are passively managed, have operating expenses. The operating expenses are taken out of the pool of money provided by investors. Every fund publishes its annual operating expense load, so you can compare them across funds. Funds with higher expense loads need to have higher returns on the underlying investments than fund with lower expense loads every year for you to make an equivalent return.
ETFs tend to have much lower operating expense loads than mutual funds. Similarly, passive funds tend to have lower operating expense loads than actively managed funds. Operating expenses can have a significant impact on your long-term total return, as discussed in this post by Accessible Investor.
If you purchase a mutual fund or ETF through a broker, you may pay a commission both when you buy the fund and when you sell it. A commission is a fee paid to the broker for the service it provides allowing you to buy and sell securities. Many brokers have recently reduced or eliminated commissions on many ETFs. If you purchase the mutual fund or ETF directly from the fund manager, you will not pay a commission.
Many funds allow you to automatically reinvest distributions (i.e., interest, dividends and capital gain distributions). Although it includes all types of distributions, it is often called dividend reinvesting or reinvestment. It is a great way to ensure that all of your returns stay invested, as you don’t have to keep track of the payment dates on any distributions so you can reinvest them.
I have a few cautions about dividend reinvestment.
First, you want to reevaluate your choice of fund periodically. If you blindly reinvest all of your dividends and something changes that makes the fund a poor fit for your portfolio, automatic dividend reinvestment will cause you to have more money invested in something that you don’t want.
Second, you’ll want to be aware of the tax implications of dividend reinvestment – one of which is helpful and one of which requires some care – if you hold the fund in a taxable account.
Increased Cost Basis
As indicated above, when you sell a fund, you pay capital gains tax on the difference between your proceeds on sale and what you paid for the fund. The distributions that you reinvest are considered part of what you paid for the fund. You’ll need to take care to keep track of the amounts you’ve reinvested, as they increase your cost basis (the amount you paid) and decrease your capital gains tax.
Taxes on Distributions
Even if you reinvest your distributions, you need to pay taxes on them in the year in which they were paid. As such, if 100% of your distributions are automatically reinvested, you’ll need to have cash available from another source to pay the income taxes on the distributions.
Selecting Mutual Funds and ETFs
There are thousands of mutual funds and ETFs from which to choose. Here are my thoughts on how you can get started.
Set your Goals
- Determine what type of fund you are seeking. Are you trying to focus on a small niche or the broader market?
- Narrow down the type of fund that will meet your needs. Do you want an actively managed fund or a passive one? Are you interested in an open end or closed end fund? Do you want the fund to look for growth companies or those with low valuations?
Identify Some Funds
- Once you’ve narrowed down the type of fund you’d like, you can use a screener to help you further narrow down your choices. Most large brokerage firms, as well as many independent entities, have mutual fund and ETF screeners. For example, Morningstar, a global investment-research and investment-services firm, has a free screener (after you sign up at no charge) at this link.
- Look at the ratings of the funds that are identified. The entity assigning the ratings usually expects higher rated funds to perform better than lower rated funds.
- Look at the historical returns. While past performance is never a guarantee of future performance, funds that have done well in the past and have consistent management and strategy may do well in the future.
- Read the details of the fund either on the fund manager’s web site or in the prospectus. Look to see if the objectives of the fund are consistent with your objectives. Make sure the types of securities the manager can purchase are in line with what you would like to buy. The names of some funds can be much narrower than the full range of securities the manager is allowed to buy. Find out if the fund management and objectives have been stable over time. Some funds can change their objectives on fairly short notice, potentially exposing you to risks you may not want to take or lower expected returns that you desire. To learn more about reading a prospectus, check out the article on Page 9 of this on-line magazine.
- Compare the fees among the funds on your list. If the underlying assets are similar and are expected to produce the same returns, funds with lower fees are more likely to provide you with higher returns (after expenses) than funds with higher fees. Don’t forget to look at both front-end loads and annual operating expense ratios.
- Select a strategy for buying your mutual funds or ETFs, such as dollar-cost averaging, waiting for a price drop or buying at the market price.
Make a Decision
- Buy a position in the fund(s) that best fit your requirements. As indicated above, you can buy most funds either through a broker (which can sometimes add a commission to your expenses) or directly from the fund manager.
- Last, but not least, be sure to monitor your positions to make sure that the fund objectives, holdings, management and fees remain consistent with your objectives.