Investing based on return is like buying cattle because you like their brown eyes. — Ian Lohr, author
So, what are the helpers trying to sell you?
Mutual funds invest shareholder assets (your money) in stocks, bonds, options, futures, currency, cash and a raft of other investment vehicles. You do not own the securities the fund buys — you own a fractional interest of the fund. The value of the fund (its NAV) changes daily at the end of trading based upon a weighted average of the securities it owns. There are more than 7,000 mutual funds today and they come in all sizes, shapes and costs.
Before you actually buy a mutual fund, you have to figure out what they buy. What are their investment philosophies, their investment objectives? Don’t be misled by their name. The XYZ Income and Growth Fund may not actually provide any real income, and it may not buy “growth” companies, but that’s the subject of a future column.
Salespeople are quick to point out the so-called advantages of mutual funds:
1. They provide diversification, owning as many as perhaps 100 securities. The salesperson will tell you that diversification reduces the risk of large losses in the event of a financial collapse of one particular sector (think banks and mortgage-backed securities.)
What they usually don’t tell you is that diversification limits your upside and does not protect you from loss caused by overall market freefall. Remember, diversification is a myth. It only works until you need it.
2. Mutual funds provide you with professional money management with access to extensive research and the best traders.
What they don’t tell you is whether the fund manager is a grizzled veteran of Wall Street Wars or a 28-year-old MBA who has barely started to shave.
3. Mutual funds are liquid and can be bought and sold every day.
What they don’t tell you is that the combination of sales commissions, internal operating expenses and the fund manager’s fees and trading costs can eat up as much as 2.5 percent of your money annually. (see Part 3).
4. Mutual funds offer convenience by being available for purchase by mail, in person, through brokers or other financial advisors, or on the Internet. What they don’t tell you is that many funds can be purchased directly without a helper. (see Part 3).
There are lots of different mutual funds, share classes and expenses, but let’s look at two broad categories:
1. Actively managed funds buy and sell securities daily, seeking to provide investment returns better that a target benchmark, like the S&P 500.
2. Index funds buy baskets of stocks that replicate a benchmark. A S&P 500 index fund may buy all 500 stocks in the index and hold them unless there is a change in the composition of the index.
There are fundamental problems with both categories:
1. Active managers rarely beat the market. In fact, you can’t outsmart the market because the capital markets rapidly discount all known information and any new investing techniques quickly become obsolete by overuse.
2. Index funds are by definition assured to underperform their benchmark by the amount of their expenses and fees.
So, which is better? It depends on your individual investment objectives and preferences. Index funds usually have lower costs than actively managed funds because their fees are lower and trading costs are small because they rarely trade.
But says the local at the Bozeman Crossing Restaurant, “My helper showed me a fund that was up 38 percent last year and USA Today said last week’s winner was up 6 percent in a week.” Well, that big-hitting fund and last week’s winner might be invested in Ugandan gold mines or Bolivian emerald futures. Buying a fund like that for investment is like starting out in the cattle business by buying one cow and hoping it grows to 42,000 pounds so you can make a killing.
Yet, mutual funds are the investment vehicle of choice in America and will likely remain so for years to come.
Today, more than 50 million consumer households own mutual funds, and mutual fund assets under management are more than $9 trillion, with more than half of that in stock funds. There are some other mutual fund issues to be aware of.
1. Taxes. Mutual funds are required to distribute their capital gains every year to all investors as of a certain date, regardless of when they bought in. That means you could lose money in a fund and still have to pay taxes on what they distributed to you. Seriously. Remember, timing matters.
2. While regulated by the Securities and Exchange Commission, funds have no guarantees. Even if the fund invests in U.S. government securities, its value will still fluctuate.
Exchange Traded Funds (ETFs) are another investment vehicle your helper may try to sell you. Looking a little like index funds, ETFs try to track an index and can be bought and sold throughout the trading day. Unlike mutual funds, they can be sold short and there are options and arbitrage schemes.
An S&P 500 ETF may not own the entire 500, but a representative “sampling” of the index. They are low cost, but they have trading expenses attached to them. You can’t buy them from a broker for free. Capital gains are relatively insignificant unless you sell them.
However, not all ETFs are created equal. There are thousands, and no two S&P 500 ETFs produce identical results. So, buyer beware. If a helper offers to actively “manage” an ETF portfolio for you, ask yourself, “What is the skill level of this helper, and is the cost effectiveness of ETFs mauled by the helper’s management fees?” Do not pay 1 percent for any “service” like this.
I would be remiss if I didn’t make a quick comment about annuities as investments. Annuities are not investments, they’re bets you make against the giants. Can you say Vegas odds?
Stay tuned.