Investors are usually faced with a wide variety of options when deciding where to put their money. Each has its own pros and cons. In addition to bonds, derivatives, foreign currencies, and commodities, the investor can choose from among the following options.
Individual stocks are a good option if you are willing to take on higher risk for a higher potential return. They offer you two ways to make gains: by receiving dividends on each share and by an increase in the value of the stock (capital gain).
To make a decision about buying a stock, investors should look into promising companies in promising sectors. Sectors with a high level of anticipated growth represent better investment choices. However, the investor should also choose highly competitive companies within those sectors since the performance of different companies can vary.
There are many considerations that should be taken into account when building a portfolio.
- The investor should begin with determined financial objectives. The main objective is usually the return on investment.
- The investor should choose investments that are suitable for his or her tolerable level of risk. This is extremely important.
- The investor should consider how the composition of stocks in his portfolio will affect his tax payments.
- The investor should choose an appropriate strategy for managing his portfolio.
The strategy can fall somewhere in between extreme diversification and extreme concentration. The most prudent choice will be somewhere in between. Extreme diversification will limit gains whereas excessive concentration will increase risk.
Mutual funds are pools of investments. Investors gather their funds and provide the capital for the fund. The capital is then managed by investment professionals. The fund invests in either stocks or bonds or both. The fund makes a profit in two ways, the appreciation in the value of the stocks it holds (in case it sells them at a higher price), and from the dividends on stocks and interest on bonds it holds. Usually, earnings are distributed on an annual basis.
- Professionals manage the fund
- Economies of scale which allow for higher returns
- Reduced risk due to diversification
- The fees of professional management
- The reduced returns due to diversification
- The need for large amounts of cash to be liquid, which would reduce invested capital
The history of mutual funds goes back to 1700 in Europe when a Dutch merchant invited investors to share their capitals in one pool to be able to achieve their financial goals with more success. In England, the practice appeared under the name of “investment pooling” in 1800, and it moved to the US from there.
The mutual funds industry is quite large — at the end of 2012, there were 7,238 mutual funds. The value of assets managed by funds (all types of funds) reached $74 trillion in 2015.
There are mainly two ways of managing a mutual fund.
Active Mutual Funds
The first approach is the active approach, where the managers of the fund try to achieve a performance that is higher than the market’s benchmark index such as the S&P 500. The managers usually conduct rigorous analysis in order to choose the best stocks and manage the portfolio actively.
Index Mutual Funds or Index Funds
First, let’s define an index. An index is an aggregate measure of a group of securities. For example, the S&P500 index is an measure of 500 large American companies listed on New York Securities Exchange or Nasdaq exchange.
An index such as the S&P 500 cannot actually be bought. It is rather used as a performance benchmark. If investors want to achieve the same performance of an index, they can buy the index’s ETF, since the ETF itself tracks the performance of the index, as clarified in the ETF section below.
The second approach of managing a mutual fund is the passive approach, where the mutual funds simply track an index and achieve a performance that is similar to that of the market. These type of mutual funds are knows as index funds.
This is done by purchasing all of the assets in the tracked index so that the performance is the same for the fund and the index. The two approaches are not mutually exclusive, however, since the portfolio of a fund can include individual independent assets as well as tracked indexes.
The two approached, however, differ in their costs, since usually, the management fees of an actively managed mutual fund are higher than those of index funds. Furthermore, there is no evidence that actively managed funds always perform better than the market’s benchmark.
For this reason, famous investor Warren Buffet advises investors to invest in index funds — he even recently won a bet of $1 million to prove his point.
There are many types of costs when dealing with a mutual fund, and the vary based on the fund.
Loads are fees paid to brokers who invest on your behalf in the fund. If you invest directly in the fund you do not need to pay those fees.
Transaction fees are charged when you conduct transactions such as buying or selling a share. These fees are paid to the fund itself and not to the broker. Usually, they are called purchase fees and redemption fees.
Mutual funds are like companies, and they have operating expenses. Those expenses are usually expressed in what is called the expense ratio, or the management expense ratio. These operating expenses typically constitute of hiring costs, distribution and service fees, account fees, and other expenses. Those expenses can range from 0.25% to 2%.
Demo and Real Mutual Fund Expenses
A demo account is an unreal account that an investor can open with virtual money deposited. The investors uses this virtual money to trade in real market conditions to test his performance.
A real account is a live account with real money deposited and with real profit or loss realized.
The expenses of acquiring a share in a mutual fund are not always transparent. They also can vary from the demo account and the real account with the mutual fund. For this reason, investors need to consult with the fund on the expenses charged beforehand and to use a calculator provided by some mutual funds to calculate the expenses and avoid lowering their return.
Exchange traded funds (ETFs) are funds whose securities can be bought and sold on a stock exchange. They track the performance of another asset or assets such as an index, or a basket of assets such as foreign currencies for example. This tracking feature is similar to index funds.
The assets they hold depends on the type of the ETF. If it is a commodity ETF, then the ETF’s performance is similar to that of the commodity.
The price of the share of the ETF usually fluctuates based on the fluctuations in the index it tracks, although the movements may not be exactly precise.
The fund usually purchases many diversified assets and then divides the ownership of those assets into shares. This way, the ETF works like a publicly listed company who has many assets and where investors hold shares. The only difference is that in the ETFs the investors have no direct claim on those assets, although they may receive a residual value in case the fund is liquidated. Also, the holders of the ETF shares are entitled to a proportion of the earnings in terms of dividends and interest (if applicable).
An example of a successful ETF is Vanguard 500 ETF, and its total return in 2017 was 20.2%. It tracks the performance of the S&P 500 Index. This ETF is considered among the cheapest ETF options and it is also among the largest.
ETFs are versatile in nature and investors have many options to choose from depending on their strategy. They can choose from among the following types of ETFs:
- Foreign market index ETFs: those invest purchase assets in foreign markets such as emerging markets.
- Foreign currency ETFs which track a currency or a basket of currencies, since they hold a foreign currency or a basket of foreign currencies
- Sector and Industry ETFs: they hold assets in specific sectors such as Information technology or renewable energies or others.
- Commodity ETFs: they hold commodities such as gold or silver, or others.
- Derivative ETFs: they hold derivative instruments such as future contracts or others.
- Style ETFs: they hold assets based on market capitalization such as large-cap, medium-cap, or small cap.
- Bond ETFs: they hold debt instruments
- Inverse ETFs which are good when the market is falling: those ETFs usually invest selling stocks that are declining or expected to decline.
- Leveraged ETFs: these ETFs track an asset or a basket of assets but they magnify their tracking by using debt instruments.
- Dividend ETFs: they invest in stocks with high dividends
- Innovative ETFs: they hold shares of innovative companies
Exchange traded funds are similar to mutual funds in that they pool investments together and invest the money in a single portfolio. The investors who hold the fund’s shares receive earnings in terms of dividends, interest payments, and capital gains if applicable.
The difference between mutual funds and ETFs is that the shares of the ETF are traded on exchanges where they can be bought or sold. Thus, ETF’s have higher daily liquidity and lower fees than mutual funds.
The style box is a tool developed by Morningstar company, and it helps investors understand quickly the investment style of the ETF they are considering. The two considerations are the size and the types of investments. The box is shown below with nine categories of ETFs appear as in the below boxes. This box is for equities. A similar box can be provided for bonds where instead of the style, the credit rating is considered.