Never forget these two axioms:
Money frees us, but its pursuit may enslave us.
It’s not about how much you have at the end; it’s how much you could have made.
Asset Classes, Part IIA
Mutual Funds/ETF’s
Mutual funds and ETFs (exchange traded funds) are simple to understand in principle, but complicated to follow in practice. Simply put, they are just a collection (or “basket”) of stocks or bonds or a combination of both that collectively will determine if the mutual fund or ETF will increase or decrease in value. Inevitably, some of these stocks will go down as others will go up.
Whichever direction the majority goes is the direction the mutual fund/ETF goes…possibly. The “possibly” part comes in that no fund (for the sake of convenience, I’ll just say fund from now on in reference to both mutual funds and ETF’s) is obligated to buy each stock in the exact same proportion as each other stock already held.
For example, Fund X (sounds cool and futuristic—who wouldn’t want to get a piece of this???) may hold/own/have (all meaning the same thing, but used by different people thus adding to people’s confusion potentially) 200 stocks in it, but ten of those stocks may comprise 50% of the fund [and not even 5% each necessarily, but in any combination adding up to 50%] whereas the other 190 remaining stocks make up the other 50% of the fund.
If 200 stocks in one fund sounds excessive, it’s not.
Sapp and Yan in their splendid paper in Financial Review in 2008 showed that the average mutual fund owned a portfolio of 91 stocks and that the top 20% of most diversified mutual funds hold (on average) 229 stocks. Not much has changed since then.
The choices are dizzying.
The number of mutual funds in the US alone as of 2016 was 9,511.
The number of ETFs in the US as of 2016 was 1,707.
(To be fair, the two largest stock exchanges—NYSE and NASDAQ—have 3,812 companies listed for anyone to buy their stock. There are over 15,000 more companies offering their stock for sale in lesser exchanges. Thus, the US alone has nearly 20,000 companies you can be a shareholder in. Much more on stock exchanges in a later post.)
The expenses associated with stocks are the following three:
1.) when you buy them (obviously)
2.) taxes on any dividends
3.) capital gains taxes when you sell them for higher than when you bought them (hopefully)
Funds however have four potential associated expenses as detailed below.
1.) when you buy them (obviously)
2.) taxes on any dividends
3.) capital gains taxes when you sell them for higher than when you bought them (hopefully)
4.) expense ratio
Dr. Unwise: Uh…wait…what’s this expense ratio you speak of? What’s that all about?
Dr. Know It All: Pffft. You don’t know that?!? God, how stupid are you? Everybody knows that.
Dr. Unwise: So…you know?
Dr. Know It All: Of course I do!
Dr. Unwise: So tell me.
Dr. Know It All: It’s very complicated. I doubt you would understand.
Dr. Unwise: Well, tell me. I’m pretty smart. I am a doctor after all.
Dr. Know It All: Let this blogger guy tell you. He seems weirdly passionate about all this investing stuff.
PWT: Sure, super duper smart guy, I’ll let you hide behind your bluster…again.
The expense ratio (or ER) is the annual fee that all funds charge their shareholders. This does not include any charges related to the purchase of the fund itself. Stocks do not have such an expense.
So, unlike stocks, you are charged a fee every year no matter what as long as you hold the fund just for the privilege of owning this fund. How much you’re charged, why that much, etc. is variable between funds.
This fee is what pays all the people at that fund to help run it, manage it, sell stocks (hopefully) that they believe will perform poorly, and (hopefully) buy stocks that they believe will perform well. (Much much more on expenses, taxes, and their breakdown with all basic investments in a later post.)
So why not then just buy stocks instead of funds?
It’s that dreaded two word phrase no doctor ever wants to even hear about, let alone deal with: risk management.
A fund has many stocks which will protect against the downside in any one company or even sector of the economy (such as oil/gas/energy) undergoing a downturn whereas owning one stock which may get crushed by some new technology destroying its way of business (e.g., music stores were wiped out by MP3 players, downloads, and streaming music services) or your company is destroyed by a civil war in a country you’ve never even heard of where the critical supply of a mineral you’ve never heard of is from and without said mineral the process needed to make their final product which you also never heard of is impossible.(If the latter happens to one of the companies where your money is, you didn’t do your homework. Sorry. This blog holds hard truths. If you want someone to make you feel better, call your mom. Seriously. Call her. She’s probably awesome and loves you unconditionally. So call her and tell her the same. And don’t text her. Call her. And Dad too. You are where you are because of them. Don’t be a jerk.)
Funds can be (let me emphasize the words “can be” here and further emphasize the word “are” was not used) a simple way of still getting upside in your investment as/if the economy hums along with decreasing the potential downside as mentioned above.
Perfect investment, right?
Dr. Know It All: Obviously. Everyone knows that.
PWT: Eh…not necessarily.
Mutual funds over a five year period of time generally do not beat the S&P 500 and never beat the S&P 500 over a longer time period (10-20 years) and that’s before accounting for the expense ratio (ER) costing you money.
If you’re invested in only funds and nothing else, you’re banking on the gains minus the ER being close to how the S&P 500 performs while ensuring a few under performing stocks don’t sink you.
Whew!
A lot of assumptions are baked into that line of thinking.
As an advocate of the “funds only” approach, you’re assuming that as a stock only holder, you’d have the worst performing stocks thus making your funds only approach look brilliant.
But what if you just held only four stocks in equal 25% proportion each, the so called FANG stocks (Facebook, Amazon, Netflix, and Google [now Alphabet])?
Your returns would be 27.1% as opposed to 7.21% for the S&P 500 by late 2017.
Yes, it’s only one year, but look at those FANG stocks again. You’d have to think the next five years will be very kind to them.
No way, your mutual fund is going up 27.1% (unless the entire market is) even if the FANG stocks are a core holding of your mutual fund because the fund will have dozens (or hundreds) more stocks crowding out the FANG stocks thus dragging down the overall return of the fund. Then subtract out the ER. Then if you have any dividends from your mutual fund, those will be taxed.
So…
Not so easy, this investing thing huh?
I think we have done enough for one day.
Coming up next…the difference between different types of mutual funds and ETFs
I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.
Talk to you soon.