Here at the Alder Financial Group, we use a wide array of financial instruments in client portfolios. Two of the most common are mutual funds and exchange traded funds, or ETFs. While they share many similarities, there are also a few very important distinctions between them. We think it’s important to make sure our clients understand the securities that we are buying for them and some of the reasoning behind them.
Mutual funds and ETFs are both “pooled investments”. These pools contain several different stocks, bonds or other securities depending on the goal of the fund. By owning a mutual fund or ETF, investors have the ability to create diversified portfolios essentially made up of hundreds of securities without the hassle, risk or expense of owning the securities individually.
Mutual Funds
The very first mutual fund was founded in 1926. They really began to take their modern form in 1940, with the passage of the Investment Company Act of 1940. In the 1960s, the idea of these funds blossomed. By the end of that decade there were about 270 mutual funds in existence with $48 billion in assets. The first modern index mutual fund was created in 1976 and is now known as the Vanguard 500 Index Fund. Today, it has over $100 billion in assets all by itself. As of October 2007, there were over 8,000 mutual funds in the United States with combined asses over $12 trillion.
Most mutual funds don’t charge commission for buying and selling, so investors have used them as a place to put small amounts of money, and money they plan on moving somewhere else soon. Their lack of commissions also makes them good for the technique known as “dollar cost averaging” since there is no penalty for purchasing often.
Some mutual funds have minimum investment amounts as high as $50,000. This can be a big obstacle for small investors who don’t have that sort of money to spend. The mutual funds we use here at Alder, in most cases, have a minimum investment of $1 so everyone is eligible for them. It is also possible to own a fraction of a share of a mutual fund, so they are ideal for “filling in the holes” in an account. For example, you may need $100 of small cap stocks. The small cap ETF may cost $75 per share and the small cap mutual fund may cost $15 per share. We will buy one share of the ETF and $25 worth of a small cap mutual fund to finish filling the allocation. In this case we will buy 1.667 shares of the mutual fund.
Most mutual funds are “managed”. This means that they have a team of analysts and fund managers whose goal is to outperform a certain benchmark. This mandate is very difficult to do, and most mutual funds underperform their benchmark. Actively managed mutual funds also carry higher expense ratios, which directly impact the performance the funds. Paying the fund managers, analysts and marketing the fund are all included in these expense ratios. Most of the mutual funds we use here fall into the “index” category. Their purpose is to mimic a benchmark like the Dow Jones Industrial Average, or the S&P 500 Index. These funds are managed by computers, so their expenses are very low and they usually perform exactly the same (within a percentage or so) as their target benchmark.
Mutual funds are structured differently from ETFs. When investors buy a mutual fund, the managing company takes that money and buys shares of the stocks that will make up the underlying assets in the fund. Alternatively, when an investor sells a mutual fund, the fund company has to sell shares of the underlying stocks to raise cash to give to them. This causes two problems for mutual funds. Eventually, as a mutual fund becomes more successful and popular, they will run out of good investment choices. As the good investment choices run out, the fund managers are forced to make worse and worse decisions and the performance of the entire fund suffers. This is one of the factors that contribute to the poor performance of some mutual funds. The same is true when fund owners sell their shares. The managers of the fund must select which securities they are going to sell, which affect the performance of the rest of the fund.
The structure of mutual funds also has an important tax impact. Since the fund managers must sell stocks in the fund when investors sell back their mutual fund shares, the fund incurs taxable capital gains on the securities that they have sold for a profit. These capital gains are passed on to the rest of the owners of the mutual fund. It is possible to still have a big tax bill on a mutual fund, even in a year that the fund itself has gone down in value.
Mutual funds came be very helpful if they are used properly. Investors are best served by using index mutual funds as a portion of their allocation in certain asset classes. By using the strengths of mutual funds (their lack of commissions, and flexible position size), investors can get the most out of their portfolios.
Exhange Traded Funds
The first exchange traded fund was established in 1989. It was only sold for a short period of time before a lawsuit halted its trading in the U.S. The first major, successful ETF in the US was the Standard and Poors Depository Receipts (ticker SPY). It was released in January of 1993. SPY became very popular and in 1995, its sibling MidCap SPDRs was released (ticker MDY). ETFs have continued to become very popular. As of May 2008, there were over 680 ETFs with combined assets of over $610 billion.
Exchange traded funds function similarly to normal stocks. They can be bought or sold at anytime during the day when the stock market is open. They share several other attractive advantages with stocks. Just as with common stock, an investor is allowed to short an ETF, betting on its price going down. Most ETFs are also eligible for options trading. This allows investors to use the myriad of options strategies available to stocks on the diverse sectors and indexes that ETFs follow.
ETFs are structured in a special way. Fund companies buy huge “pools” of the stocks they wish to hold in an ETF. Then, they issue shares of the pool, the ETF itself. These shares in the pool are bought and sold in stock exchanges like normal stocks. Investors buying and selling ETFs have no impact on the pool of underlying assets. For every sale of a share of an ETF, there is a corresponding buyer. Since this transaction is separate and distinct from the underlying assets of the ETF, investors don’t have to worry about getting a tax bill for capital gains passed on to them from the fund company (in most cases).
Unlike some mutual funds, there is no minimum investment in ETFs; it is possible to purchase one single share if you want. However, you are limited to purchasing whole shares of ETFs (unlike mutual funds, where partial shares are allowed). This can lead to positions that are either slightly smaller or slightly larger than you would like due to the price of the shares. Also, while it is possible to purchase a very small number of shares of an ETF, the commission you will be charged for them may make this approach disadvantageous. This may soon be irrelevant because brokerage houses are starting to offer tiny or even free commissions for trading the most popular ETFs.
Another consideration with ETFs is that they distribute their dividends in cash. This creates the need for a good investment plan, so you know where to invest the cash that you accumulate in your accounts over time.
ETFs and mutual funds both have important roles in your portfolio. ETFs are extremely valuable for their liquidity, tax efficiency and versatility. Mutual funds are also very useful because they are free to buy and sell in small amounts. If you are one of our clients, the next time you are looking at your statement or quarterly report from us, you can easily pick out the mutual funds because most of the ones we currently own have 5 letter symbols that end in “x”. The ETFs have 3 letter security symbols. If you would like to learn more about these securities feel free to contact me any time.
