Why I Chose Patience over Re-balancing

Investment-Rebalancing

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 time thinking about why I haven’t followed this common advice.  Up until recently, almost all of my invested assets have been equities, equity-based mutual funds or exchange-traded funds (ETFs).  As such, I didn’t need to do any re-balancing across asset classes.

In this post, I’ll explain re-balancing, its specific purpose and examples of its benefits and drawbacks.  I’ll also explain my strategy (which may or may not be right for you).

What is Re-balancing?

Re-balancing is the process of buying and selling securities in your portfolio to meet certain targets.  In the case of asset classes, the primary purpose of re-balancing is to maintain your target risk/reward balance.

Some people have targets that define their desired allocation across asset classes.  One common rule of thumb is that the portion of your portfolio that should be in bonds is equal to your age with the rest in stocks.  In my case, that would mean roughly 60% of my portfolio in bonds and 40% in stocks.  The goal of this rule of thumb is to decrease the volatility of your investment returns as you get older and closer to that age at which you need to draw down your assets in retirement.

How Does Re-balancing Work?

The process of re-balancing is fairly simple.  Periodically, such as once or twice a year, you compare the market value of your investments with your targets.  If there is a significant difference between how much you own in an asset class and your target percentage, you sell the portion of your investments that is above the target and reinvest the proceeds in something different.

Let’s say your target is 75% stocks and 25% bonds.  You start the year with $10,000 of investments – $7,500 in stocks and $2,500 in bonds.  If stocks go up by 10% and bonds go up by 5%, your year-end balances will be $8,250 in stocks and $2,625 in bonds, for a total of $10,875.  Your targets though are $8,156 of stocks (75% of $10,875) and $2,719 of bonds.  To put your portfolio back in balance, you would need to sell $94 (= $8,250 – $8,156) of stocks and buy $94 of bonds.

You can avoid selling any assets if you have money to add to your investments at the end of the year.  Continuing the example, let’s say you have another $500 available to invest at the end of the year.  That brings your total available for investment to $11,375 (= $10,875 of investments plus $500 cash).  Your targets would be $8,531 (= 75% of $10,875) for stocks and $2,843 for bonds.  In this case, you would buy $281 of stocks and $219 of bonds to meet your targets, eliminating the need to sell any of your assets.

What Does Asset Allocation Do?

The chart below compares the average annual returns and risk profiles of several sample portfolios with different mixes between stocks and bonds.  In the middle four portfolios, the first number is the percentage of the portfolio invested in stocks and the second number is the percentage in bonds.

Annual Returns for Different Asset Allocations 1980-2019

Average Returns

In this chart, the average annual return is represented by the blue dash.  When the blue dash is higher on the chart, it means that the returns on the portfolio were higher, on average, over the historical time period.

Volatility

The green boxes correspond to the ranges between the 25th percentile and the 75th percentile.  The whiskers (lines sticking out of the boxes) correspond to the ranges from the 5th percentile to the 95th percentile.   When the box is tall and/or the whiskers are long, there is a lot of volatility.  In this case, it means that the annual return on the portfolio varied a lot from one year to the next.  At the opposite end of the spectrum, when the box and whiskers are all short, the range of returns observed historically was more consistent.

Comparison of Portfolios

I have arranged the portfolios so that the one with the most volatility – 100% in the S&P 500 – is on the left and the one with the least volatility – 100% in bonds as measured by the Fidelity Investment Grade Bond Fund (FBNDX) – is on the right.  You can see how adding bonds to the S&P 500 reduces volatility as the height of the boxes and whiskers gets smaller as you move from left to right.  At the same time, the average annual returns decrease as bonds are added to the portfolio.  Over the time period studied (1980 to 2019), the S&P 500 had an average annual return of 8.7% while the Bond Fund had an average annual return of 7.2%.  By comparison, returns on investment grade bonds are currently generally less than 4%.

Another Perspective

Because stocks and bonds are not 100% correlated, the volatility (spread between tops and bottoms of boxes and whiskers) of owning a combination of both is less than the volatility of owning just the riskier asset – stocks.  As I was preparing the chart above, I noticed, though, that the bottom whisker for the 100% bonds portfolio goes lower than the bottom whisker for the 80% bonds portfolio.

Specifically, there were more negative returns in the historical data (i.e., more years in which you would have lost money in a single year) if you owned just bonds than if you owned the portfolio with 80% bonds and 20% stocks.   The 80% bond portfolio had a negative return only 7.5% of the time while the 100% bonds portfolio had a negative return 10% of the time!  As more bonds are added to each portfolio, the blue bar/average moves down.  This downward shift actually moves the whole box and the whiskers down.

This relationship can be seen in the chart below.

The dots correspond to the portfolios in the previous chart with labels indicating the percentages of stocks in the portfolios.  The horizontal or x-axis on this chart represents the average annual return.  Values to the right correspond to higher average annual returns (which is good).  The vertical or y-axis represents the percentage of years with a negative return.  Values that are higher on the chart correspond to portfolios with more years with negative returns (which is bad).

Optimal Portfolios

“Optimal” portfolios are those that are to the right (higher return) and/or lower (fewer years with negative returns).  Any time a point is further to the right and at the same level or lower than another one, that portfolio better meets your objectives if probability of having a negative return is your risk metric.

More Stocks Can Be Less Risky

I have circled two pairs of dots.  The ones in the lower left corner are the two I’ve mentioned above.  The 20% stocks (80% bonds) point is lower than and to the right of the 0% stocks (100% bonds) point.  As you’ll recall, the average return on the 20% stocks portfolio is higher than the average return on the all-bond portfolio so the dot is to the right (better).  The percentage of the time that the annual return was less than zero was smaller for the 20% stocks portfolio so the dot is lower (also better).

There is a somewhat similar relationship between the 60% and 80% stocks portfolios (circled in green in the upper right).  The 80% stocks point is at the same level and to the right of the 60% stocks point.  As such, if average annual return and probability of a negative return are important metrics to you, moving from 80% to 60% stocks or 20% to 0% stocks would put you in a worse position as you would have less return for the same risk.

Re-balancing Can’t Be Done Blindly

Setting a target asset allocation, such as 80% stocks and 20% bonds, allows you to target a risk/reward mix that meets with your financial goals.  As I indicated, the purpose of re-balancing is to ensure that your portfolio is consistent with your goals.  However, it is important that you considering the then-current economic environment when re-balancing.

Interest Rates

For example, interest rates are lower than they were at any point in the historical period used in the analysis above.   Over the next several years, interest rates are unlikely to decrease much further, but could stay flat or increase.  If interest rates stay flat, the returns on bond funds will tend to approach the average coupon rate of bonds which is in the 1% to 3% range depending on the quality and time to maturity of the bonds held.  This range is much lower than the average annual return of 7.2% in the illustrations above.

If interest rates go up, the market price of bonds will go down, lowering returns even further.  As such, the risk-reward characteristics of bonds change over time.  I would characterize them as having lower returns and higher risk (the one-sided risk that prices will go down as interest rates go up) now than over the past 40 years.

Stock Prices

Similarly, the S&P 500 is currently close to or at its highest level ever in a period of significant economic and political uncertainty.  While I don’t have a strong opinion on the likely average annual returns on the S&P 500 in the next few years, I think it is likely to be more volatile in both directions than it has in the recent past.

If you re-balance your portfolio, you will want to form your own opinions about the average returns and volatility of the asset classes in which you invest.  With these opinions, you can decide whether the asset allocation you’ve held historically will still provide you with the risk/reward profile you are seeking.

Re-balancing and Income Taxes

Another consideration when you are deciding whether and how often to re-balance your portfolio is income taxes.  Every time you sell a security in a taxable account, you pay income taxes on any capital gains.  If you lose money on a security, the loss can offset other capital gains.  On the other hand, if you own the securities in a tax-free (Roth or TFSA) or tax-deferred (traditional or RRSP) account, re-balancing has no impact on your taxes.

Re-balancing Example

Let’s look at an example of the taxable account situation.  If you targeted a portfolio of 60% stocks (in an S&P 500 index fund) and 40% bonds (in FBNDX) from 1980 through 2019, you would have made the transactions shown in the chart below.

Rebalancing Stock Transactions

In this chart, the bars represent the amount of the transaction as a percentage of the amount of stocks held at the beginning of the year.  A bar that goes above zero indicates that you would have bought stocks in that year.  A bar that goes below zero indicates that you would have sold stocks in the year.  The proceeds from every sale would have been used to purchase the bond fund.  Similarly, the money used to purchase stocks would come from a corresponding sale of the bond fund.

In every year, you either sell some of the stock index fund or the bond fund.  The difference between the price at which you sell a security and the price at which you buy it is called a capital gain.  You pay income taxes on the amount of capital gains when they are positive.  In the US, many people pay a Federal tax rate of 15% on capital gains in addition to any state income taxes.  The Canadian tax rate on capital gains is of about the same order of magnitude.

Reduction in Return from Income Taxes

Income taxes, assuming a 15% tax rate, would have reduced your annual average return from 8.4% to 8.1% over the 1980-2019 time period.  Put in dollar terms, you would have had just under $250,000 at the end of 2019 if you started with $10,000 in 1980 and used this asset allocation strategy if you didn’t have to pay income taxes.  By comparison, you would have had about $220,000 if you had to pay income taxes on the capital gains, or 12% less.

As you consider whether re-balancing is an important component of your financial plan, you’ll want to make sure you understand the impact of any income taxes on your investments returns.

Why Only Equities?

You may have been wondering why I was invested almost solely in equities for all of my working life and not in a combination of asset classes, such as stocks and bonds.   My philosophy was that I preferred to use time to provide a diversification benefit rather than an array of asset classes.  By keeping my invested assets in stocks, I was able to take advantage of the higher expected returns from stocks as compared to bonds.

The chart below helps to illustrate this perspective.

Annual Returns - 1980-2019 - Time vs. Rebalance

It compares the volatility of the annual return on a portfolio of 100% stocks over a one-year time period with the same portfolio over five years and with a portfolio of 60% stocks and 40% bonds over one year.

The blue bars on the first and second bars (100% stocks for one year and five years, respectively) are at the same level, meaning they had the same average annual return.  Both the box and whiskers on the second bar are much more compact than the first bar, indicating that the annual returns fell in a much narrow range when considered on a five-year basis rather than a one-year basis.

Cost-Benefit Comparison

Comparison of the first and third bars highlights the cost and benefits of diversifying across asset classes.  The box and whiskers on the 60/40 portfolio are both shorter than the 100% stock portfolio.  That is, there was less variation from year-to-year in the annual return for the 60/40 portfolio than the 100% stock portfolio.   However, the average return (blue line) on the 60/40 portfolio is a bit lower because the 60/40 portfolio had an average annual return that was less than the 100% stock portfolio.

My Focus

The comparison on which I focused in selecting my investment strategy is the one between the second and third bars.  That is, I compared the volatility and average returns of a 100% stock portfolio over five years with the volatility and average returns of a 60/40 portfolio over one year.  As can be seen, there has been less volatility in annual stock returns when considered in five-year time periods.  Yet, the average return on stocks is higher than the average return on the blended portfolio.  Because I didn’t anticipate that I would need to draw down my investment portfolio, I was willing to look at risk over longer time periods and tolerate the year-to-year fluctuations in stock prices in order to expect higher investment returns.

Your time horizon until you might need the money in your investment portfolio and your willingness to wait out the ups and downs of the stock market are important considerations as you decide whether this strategy or a more traditional blended portfolio is a better fit for you.

Diversification: Don’t Get Misled by these Charts

Investment Diversification: Don't Get Misled by These Charts

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 conclusions about diversification.  In this post, I show you the charts, identify the wrong conclusion that could be drawn from them, and explain and illustrate the correct conclusion.

Diversification Fallacy #1: A Combination of Stocks and Bonds Provides a Higher Return than just Stocks

I first saw a chart[1] in a post on Schwab’s website a couple of years ago.  It is the first graph on this page.  It was prepared in 2018 and compares the cumulative return on the S&P 500 and a portfolio that is 60% stocks (as measured by the S&P 500), 35% bonds and 5% cash from 2000 to 2017.  I’m not sure why Schwab chose to use an 18-year period for this chart, other than the beginning of the time period corresponds to the turn of the century.  The portfolio is re-balanced annually.  In that chart, the total return on the re-balanced portfolio is slightly higher than the S&P 500 (167% versus 158% or 5.6% vs 5.4% per year).

My Version of Chart

Because I can’t include the Schwab chart here, I created a chart (shown below) that shows a similar result for the same time period.  It compares the cumulative returns on the S&P 500 with those of a portfolio of 60% stocks and 40% 20-year US Treasuries (using an approximation I derived for older years).  The mixed portfolio is re-balanced annually, similar to the calculations in the Schwab chart.

Cumulative returns on S&P 500 and mixed portfolio
Cumulative Returns

In this graph, the ratio of the value of the S&P 500 at each year end to its value on December 31, 1999 is shown in purple.  The blue line shows the corresponding ratios for the portfolio of 60% stocks and 40% bonds.  The S&P 500 never makes up the losses it experienced in the first few years of this 18-year time period.

Incorrect Inference about Diversification

At first glance, these charts appear to imply that you can earn more if you hold a 60%/35%/5% mix of stocks, bonds and cash (or 60% stocks/40% bonds) than if you invest in just the S&P 500.  That conclusion confused me, as bonds tend to have total returns that are lower than stocks over the long run and cash has close to no return.   If you re-balance your portfolio annually, as assumed in the graph, your total return in each year will be 60% times the return on stocks plus 35% times the return on bonds plus 5% times the return on cash.  Since the returns on bonds and cash are less than the return on stocks, I was sure that the weighted average of the returns would have to be less than the return on stocks alone.

The Reality

It wasn’t until recently that I figured out why the chart looks the way it does.  The analysis was performed in 2018, so it used the most recent complete 18-year period available.

Historical Perspective

It turns out that period was a rarity in recent history – it was one of only three 18-year periods in which bonds had a higher total return than stocks when considering all such periods from the one starting in 1975 to the one starting in 2002!  If we go back all the way to 1962, the mixed portfolio had higher returns in about a third of the 18-year periods.  The chart below illustrates this point.

18-Year Cumulative Returns for period starting in 1963

Each pair of bars corresponds to an 18-year period (the time period in the Schwab chart) starting in the year shown.  The bar on the left in each pair shows the estimated cumulative 18-year return on a portfolio of 60% stocks[2] and 40% bonds[3] that is re-balanced annually.  The bar on the right shows the corresponding return on the S&P 500 during each period.  As you can see, in most recent years, the right bar (100% stocks) has a higher return than the left bar (60% stocks and 40% bonds).  In older years, the left bar tends to be higher.

How to Use this Information

If your investment goal is to maximize your return without regard to risk, a portfolio with 100% stocks will better meet that objective more than two-thirds of the time when considering 18-year periods and an even higher percentage of the time if you consider only more recent experience.  If interest rates increase substantially at some point in the future, you might look at the longer time period for deciding whether to add bonds to your portfolio, as interest rates were higher and rose in many of the years from 1962 to 1980.  But you’ll want to wait until interest rates are a fair amount higher than their current levels before those years are relevant to your decision-making.

If, however, you want to reduce volatility, adding bonds (or other asset classes) to your portfolio can help.  My post on diversification for investments provides several illustrations about how the addition of bonds to your portfolio reduces risk, but also reduces your total return.  As you consider using other asset classes to reduce volatility, you will need to consider your time horizon for your investments.  As indicated in the chart above, there have been no 18-year periods in the time covered by the analysis in which the S&P 500 had less than a 3% annualized return or 59% compounded return.

Fallacy #2: Diversification in Rank Order Matters

When I first saw this chart from Callan[4], I thought it was very impressed with how it illustrated the benefits of diversification.

Callan Periodic Table of Investment Returns

The font is small so your probably can’t read the words and numbers, but the visual impact is terrific.  Each column is a calendar year.  Each color corresponds to a different index.  The rows correspond to the order of the returns on each index in each calendar year, with the top row showing the index with the highest return; the bottom, the lowest return.

The indices by color (in the order they appear in the first column) are:

  • Rust: S&P 500 Growth
  • Olive green: S&P 500
  • Grey: MSCI (Morgan Stanley Capital International Index) World ex US
  • Dark blue: S&P 500 Value
  • Light green: Bloomberg Barclays Aggregate US Bond Index
  • Medium blue: Bloomberg Barclays High Yield Bond Index
  • Mustard: Russel 2000 Growth
  • Brown: Russell 2000
  • Light blue: Russell 2000 Value
  • Orange: MSCI Emerging Markets

Incorrect Inference about Diversification

At first glance, it appears that there is a lot of diversification among these asset classes, as the colored boxes move up and down on the chart from year to year.

The Reality

It wasn’t until I plotted the returns (using roughly the same colors) on a line chart that the true lack of diversification became apparent.

Annual returns from 1997 to 2017 for funds in Callan chart

Even though the order of the indices changes, as shown in the Callan chart, most of them actually move substantially in sync.  For example, the MSCI Emerging Markets Index moves all over the Callan chart not because it adds diversification but because its returns are much more volatile.  In 14 of the 20 years in the Callan chart, the MSCI Emerging Markets Index is either at the top or the bottom.  It moves in the same direction as most of the other indices, it just makes bigger moves.

Correlations

The goal of adding new asset classes to your portfolio is to increase diversificationAsset classes are diversifying when they have negative or even small positive correlation.  I provide a detailed explanation of correlation and diversification in this post.  The chart below shows the correlations between each pair of indices in the Callan chart.

Correlations between funds in Callan chart

High positive correlations are highlighted in red (as that means they aren’t diversifying).  Medium positive correlations are shown in yellow and small positive and negative correlations (the ones we are seeking) are in green.

It becomes quickly apparent that the only asset class that is diversifying over this time period is US bonds (Bloomberg Barclays (BB) Aggregate US Bond Index).  If you look at the line graph above, I have made the line for the Bloomberg Barclays Aggregate US Bond Index a bit thicker than the others to help you see its lack of correlation with the other investment classes.

Different Insights

While I found the diversification message misleading in this chart, I still found value in the data itself.

Investment-Grade Bonds add Diversification

First, as discussed above, the diversification benefit of investment-grade bonds relative to all of the stock indices is quite evident.  Interestingly, high-yield bonds are highly correlated with stocks, so don’t add diversification.

Asset Classes Show Risk-Reward Balance

Second, I calculated the average annual return and the standard deviations of those returns.  As shown in the chart below, the different indices are spread widely along the spectrum that balances risk and reward.

Average and standard deviations of returns on funds in Callan chart

Specifically, the Bloomberg Barclay Aggregate US Bond Index is in the lower left corner indicating it has a lower average return than all of the other asset classes over this time period but also has the lowest risk as measured by the standard deviation of the annual returns.  By comparison, the MSCI Emerging Markets Index has both the highest annual average return and the highest risk, as it is in the upper right corner of the chart.  All of the other indices fall in the middle on both average return and risk.

Selecting Asset Classes for Your Portfolio

As you are choosing the asset classes in which you want to invest, you need to consider all three of average annual return, risk and diversification benefits.  For example, if you have a very long time horizon and can tolerate the ups and downs of the returns, the historical data indicates that investing primarily in the Emerging Markets index would maximize your return.

If you have a shorter time horizon or are less able to watch the value of your investments go up and down, you might want to invest in something with a lower return, such as one of the stock indices.  If you have even lower risk tolerance or a shorter time horizon, you might want to add something like the Aggregate US Bond Index to your portfolio.  It is important to recognize, though, that adding the less volatile asset classes to your portfolio, even if they are diversifying, will lower the expected annual return on your portfolio at the same time it is lowering your risk.

Caution about Using Past Findings in the Future

In closing, I caution you that the time period covered by the Callan charts corresponds to a time period during which interest rates were relatively low and generally decreasing.  During the time period from 1997 to 2017, the highest yield on the 10-year US Treasury on a year-ending date was 6.7% at the end of 1999.    It decreased to 1.7% at the end of 2014 and increased very slightly to 2.7% by the end of 2017.  By comparison, it hit a high of 12.7% at the end of 1981 and is currently (August 2020) below 1%.  Neither extreme is covered by this time period.

The relatively stable returns on the Bloomberg Barclay Aggregate US Bond Fund Index may be more representative of the time period included in the analysis and may understate the overall volatility of that index over a longer period of time.  Similarly, the other indices may behave differently in other interest rate environments.

I suggest using the information in this post to enhance your understanding of the returns, volatility and diversification benefit of the different asset classes.  You’ll want to supplement this information with your views on future economic environments before making any investment decisions.

[1] I am not able to include the chart directly in this post as I am not willing to accept the conditions that would be required by Schwab to get its permission.

[2] As measured by the S&P 500.

[3] As measured by the iShares 20+ Year Treasury Bond Fund ETF starting in 2002 and my approximation of those returns for prior years.  I note that the Schwab chart uses the Bloomberg Barclays U.S. Aggregate Bond Index for bonds and the FTSE Treasury Bill 3 Month Index for cash.  I don’t not have access to that information.  Because I used a government bond index that tends to provide lower returns than a corporate bond index, I used 40% weight to bonds and ignored the cash component.

[4] Used with permission.  https://www.callan.com/?s=2017+Periodic+Table.  August 8, 2020.

Mutual Funds and ETFs

Mutual Funds and Exchange-Traded Funds

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.

Securities Owned

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.

Geography

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.

Market Segment

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.

I found Investopedia to have some great information about open-end funds and closed-end funds.

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.

Income Taxes

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.

Capital Gains

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.

Interest

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

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.

Fees

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.

Front-End Loads

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.

Operating Expenses

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.

Commissions

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.

Dividend Reinvestment

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

  1. Determine what type of fund you are seeking. Are you trying to focus on a small niche or the broader market?
  2. 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

  1. 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.
  2. 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.
  3. 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.
  4. 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 Fees

  1. 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.
  2. 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

  1. 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.
  2. 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.