Wednesday, November 18, 2009

Mutual Funds are Different than ETFs

The argument is never clear. When we compare mutual funds to ETFs, we often miss the differences between the two in large part because we are discussing two different types of investments, how they should be used and what they are. Folks on the ETF side of the disagreement point out a variety of plus while conveniently leaving the minuses out of the conversation. People who argue for mutual funds are looking for something other than a simple index fund.

The Pluses of ETFs (with the minuses)
The tax benefits that are often touted by the ETF camp rely on the buy-and-hold strategy that index funds offer. It should be noted that when comparing these two investments, one should drop the vast majority of mutual funds from the argument and concentrate only on the index mutual fund.

With any investment, capital gains are a consideration. The only way these two can be compared on a tax basis is when there is a sale. While funds held outside of a 401(k) or other retirement account distribute capital gains on a regular basis, ETFs do so only when sold. An actively managed mutual fund (which is what numerous ETF supporters believe is a fair comparison) can generate a capital gains even if the fund losses money. Actively managed mutual funds shift the holdings in the fund during the course of the year and this does present the possibility that you will need to pay taxes on those transactions. But like index funds, ETFs only shift holdings when the index fund it tracks shifts holdings.

So in this argument, ETFs and index funds are similar in tax efficiency. But when ETFs are compared to actively managed funds, ETFs seem the better choice.

Are ETFs a more simple investment?
While you buy an ETF at a set price (which can also be done with index funds, the main difference is the when the price is fixed - in mutual funds it is at the four o'clock close; ETFs reprice throughout the day depending on how well the underlying portfolio has done) that price can gyrate wildly throughout the day. In fact, much of the last minute swings in the overall market are due to ETF positioning and may offer you a false picture of the underlying worth of the ETF.

Those for ETFs suggest that this one price, one trade principle makes these investments better. But the cost of that one trade can be much higher than the purchase of a mutual fund (actively managed or indexed) and that trade, which is whatever your brokerage account charges, is also a factor in the sale. If you add those two transaction to the cost and the fact that many mutual funds do not charge for the purchase of their shares, the argument about simplicity falls flat.

So in this argument, on the surface, ETFS seem less expensive but only as long as you buy and hold which is not what professionals do with this investment.

Perhaps ETFs are more cost-effective
Once again, ETFs cost you dollars to trade. While this is a fixed cost that can be calculated, mutual funds charge expenses against portfolio balances. This makes any mutual fund purchase, even index fund investments, subject to fee considerations. The lower the fee, the greater the cost-effectiveness. With ETFs, you do pay an underlying fee which when compared to index funds is often higher and you pay commissions on the purchase and sale.

One percent is one percent no matter who charges it but if you can buy one for nothing compared to the cost of a brokerage fee both in and out, the ETF argument runs into problems.

The ETF option
While there are numerous types of ETFs available there are also numerous types of mutual funds tracking essentially the same markets. Mutual funds offer sector investments just as ETFs do. Here ETFs are probably better. The simple reason is the ability to allow you to get in and out of a hot sector without any pain other than the cost of the trade. But for the vast majority of investors, their style is passive. They really want to do the research, make the decision and then let the money and the investment ride.

ETF investors crave action even if they do it under the guise of flexibility. They are essentially chasing the next hot corner of the market while mutual fund investors leave the pursuit up to the professional manager they hired.

So in this argument, ETFs play nicely to the investor who wants to move quickly in and out of a hot sector.

Are ETFs easier to transfer
Of course they are easier to transfer. Held in your brokerage account, the shares are yours to take wherever you want. Transferring assets in a mutual fund (index or actively managed) does require a bit of work and there may be a slight charge for the effort but this argument also falls flat. When moving a fund, those shares must be sold and there is a cost in doing so. But most mutual fund investors spend a great deal of time researching their investments (manager tenure, fees, performance and underlying holdings/investment style) and if they desire to move, it is because something has gone wrong with the fund. In this instance, moving a fund is worth the cost incurred. ETF investors move based on price value alone. And they move to another ETF.

So in this argument, the better research you do the more likely you are to buy an index fund and hold it or buy an actively managed fund and monitor it. Owning an ETF is always a temporary investment and the investor is always looking for another ETF to suit their needs.

Wednesday, November 11, 2009

Investing in Mutual Funds: The Mean Reversion

I'll admit as should everyone who writes about investing, there is no silver bullet, no perfect scenario, no predictable table you can follow when it comes to investing. Some suggest that the only way to come close to a comfortable retirement is to invest in stocks. But they have a limited historic return, somewhere in the vicinity of about 6.3%.

Stock funds do worse according to available statistics. The comparisons here get a bit sketchy. In almost every instance, a stock fund, no matter what it invests in, how well it has done, is compared to the Wilshire 5000, an index that represents the whole of the stock market universe.

But in truth, it doesn't even come close. Any sort of index fund that attempts to mimic that index is unable to buy all of the stocks and some buy less than a fourth of what is available. The reason is easy to see and generally accepted: some stocks are simply to small to buy and any investment of any size by any index fund would drive the price of those stocks up. There simply aren't enough shares available (liquidity) to buy.

This comparison suggests that the real rate of return in stock funds is about 3.9% in part, as some suggest, because of fees. And that is if you are fortunate to have the iron-will to stay invested through thick and thin, ups and downs. Sadly, most of us don't.

Our Investment Expectations
We expect everything that is up to stay up and everything that is down to stay down. This leads us to believe that selling a stock fund as it begins to lose share value in favor of a stock fund that is on the top ten lists for the previous quarter or year. Oddly enough, and this is why economist refer to it as the mean reversion, selling on the way down eliminates the opportunity to buy additional shares and a reduced price because we do not expect the fund to recover.

The real trouble is buying a fund at the top with the expectations that there is still additional upside potential. the knee jerk reaction to such a dilemma is to simply buy an index fund and let it ride. The Bogleheads will love this idea. For those of you who are unfamiliar with this emphatic group, they swear by the index fund. It was not a some might think, created by John Bogle of Vanguard but when the age of computers advanced far enough, he became its leading disciple.

Mutual funds present an interesting opportunity even as they seem to offer you more volatility. Even index funds, left alone from the date of your initial purchase, will suffer fits and starts as it lumbers across a thirty or forty year investment career.

Some of us writing about finance will offer you the realistic possibility that a Treasury Inflation Protected Security (TIPS) could do as well as any investor who bought stocks or stock mutual funds. Fine if you are good with 2.6% over a working career.

Because folks usually purchase stocks and stock funds in the hope they will provide some additional growth and risk that will help fund their retirement, pursuing that path might leave you struggling.

The Best Investment Option
The best option remains the hardest one to execute. Ignore the markets in the short-term and invest across a wide variety of investments. begin with actively managed funds. As your wage increases, add more money in the form of index funds that drill into various sectors deeper than a total market index fund might. As you continue to age, add a bond fund or two, domestic and international.

The key is to find low fee funds as compared to their peer group - not to an index. Find a manager who has navigated rough water in the past and emerged with better than average returns. You will have to go back a few years for that. Keep in mind, you are not looking for an average that is comparable when the fund may have lower lows that the funds in its group and an occasional brush with the top ten performers.

In the case of mutual funds, average is good. It avoids the mean reversion problem that many investors have and keeps your risk level at a much higher rate than fixed income. According to Simon Johnson and James Kwak, writing in the Washington Post recently, the goal is to have enough money to buy an annuity upon retirement, in large part because the gamble of outliving your money is simply too great.

Tuesday, November 3, 2009

When to Buy a Mutual Fund: Tax Advantaged Mutual Fund Investing

Most of us who write about retirement planning and investing all focus on getting in as soon as possible and staying invested as long as you can.

And to do this, we use mutual funds. Now we all know that mutual funds have their faults. Some drift in style exposing us to the possibility that we will hold too much of the same underlying investment. Some simply charge too much compared to their peer group. And others simply cannot find the right investments to boost their performance and keep the investors they already have, interested in staying for the long-term.

Attracting new investors and keeping legacy shareholders happy is the real key to the success of the mutual fund. You do not have to be represented by a large mutual fund company to be a very good mutual fund. Not only does the availability of invest-able funds grow, making growth opportunities increase, but the potential for the worst possible problem for a fund, redemptions, stay at a minimum.

Redemptions cause two things to happen. First, the fund manager is forced to sell some of the fund's underlying holdings to satisfy your fellow shareholder's exit. A lot of these types of transactions makes the fund vulnerable and adds to the grief experienced by fund shareholder who believe that the fund is a good one, even if the markets as a whole are suffering.

The second thing it does is force a taxable event. Whether you defer the taxes in your 401(k) or hold the mutual fund outside in a taxable account, this is perhaps one of the worst things that can happen to a future or current shareholder.

Mutual Funds and Taxes
Taxable events are unavoidable in any investment. In fact, it acts as a confirmation that you have made money - in most instances. But in a mutual fund, the tax event might come as a surprise even if the fund will or has posted a loss.

Read the full article here.