Category: Personal Investing

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 IIC

Mutual Funds/ETFs: Index Funds vs. Actively Managed Funds

You’ll hear actively managed funds or index funds in relation to usually only mutual funds, but in reality, it can be true for ETFs as well.

An actively managed fund is one in which a “fund manager” or an entire management team makes decisions about how to invest the fund’s money—stocks, bonds, how much, which ones, and when to buy/when to sell.

An index fund, by contrast, is passively managed and follows a market index. It does not have a manager or management team making any investment decisions. Whatever index it follows (e.g., Dow Jones, S&P 500, NASDAQ, etc.), it will mimic those exact same stocks in the exact same proportions exactly (I know, I know; redundant and repetitive) and precisely nothing else. (If you want to know about stock indexes/exchanges, slow your roll, as the kids say,…creepers…that’s the very next post…no peeking!).

Actively managed funds carry far more expense with it than index funds because the manager needs to be paid (a murky number, but the average when last checked out is just over $436,000/year with some over $20 million/year based on performance bonuses, but, hey, you know all about the Krebs cycle, so you’ve got that going for you), research staff/analysts, data analytic software which require updates, etc., etc.

For that reason, how much index funds charge you (the expense ratio, remember? Come on people. This is only going to get harder as we go and impossible if you can’t remember the simple stuff. You can do this. You went to med school and forced yourself way less important stuff than this. Other than the really important things in your life and your professional career, this is the most important thing you need to know and understand) is usually way less than an actively managed fund.
Actively managed funds often carry an expense ratio of 1% or greater whereas index funds are often less than 0.5%, even below 0.1%. When dealing with such small percentages, it may seem like there’s not much difference, but when dealing with many thousands of dollars over many years as you undoubtedly will in the future eventually, it makes a massive difference which will only be overcome by your actively managed fund doing much better than an index fund every year year after year. (Much more on this in a later post.)

Actively managed funds make it possible to beat the market especially in down years. As soon as the conversation on actively managed funds vs. index funds comes up, the actively managed fund groupies always invoke the name: Peter Lynch.

Ah, yes.

Peter.

Lynch.

The sainted Peter Lynch, the fund manager of all managers, ran Fidelity’s Magellan Fund, the world’s most famous actively managed fund (mostly because of Lynch), from 1977-1990. Under his management, the Magellan Fund outperformed the S&P 500 in 11 out of 13 years and had the best performance record of any mutual fund in the world over that time.

Not bad, huh?

At a time where the S&P 500 was at an absolutely sizzling 14.43% per year, the Magellan Fund from 1977-1990 averaged just over 29%/year.

In other words, if you do the math using the Rule of 72 and the Rule of 144, in those heady days of the 1980’s, you doubled your money in just five years by broadly investing in the S&P 500.

Pretty awesome!

But, if you had your money parked with Peter Lynch and the Fidelity Magellan Fund, you quadrupled your money just under five years.

Even more awesomer!!

Fidelity couldn’t have been more thrilled because when Lynch took over the Magellan Fund in 1977, the mutual fund had $18 million in total assets under management and by 1990, assets in the fund had increased 1,286 times to over $14 Billion!

(To be fair, Lynch didn’t post the best returns ever or not in the history of the Magellan Fund even. The best return for the Magellan Fund for one year was 116.08% (!) in 1965, and the best three year record was 68.32% annualized between 1965 and 1967.)

Lynch retired at the top of the financial world in 1990 at age 46 and never re-entered with a net worth reportedly hovering around $350 million in this past decade.

Also, not bad.

SR: “OK, Lynch did great for himself. Fidelity crushed it. What about the average guy like me who invested in the Magellan Fund?”
Physician, Wealth Thyself AKA PWT: If you invested only $10,000 in the Magellan Fund the day Peter Lynch took over and then sold the day he retired and not even more dime the whole time, you made $280,000 before taxes.
SR: Oh. Well, yeah, but who’s that lucky to go in and out with only Lynch?
PWT: 1.) It’s not Lynch’s fault what you do or don’t do. You asked about him; I gave you what you asked for. ***Never ask a question unless you want the answer.*** 2.) When you notice your exceptional fund manager that has beaten the market for over a decade is exiting the place, you should walk out too. It’s like defying gravity. Sooner or later, you have to start dropping. Get out while you can.
If you don’t know who your fund manager is and when they leave, then you’re
doing actively managed fund investing wrong.
WHETHER YOU REALIZE IT OR NOT, ONCE YOU INVEST IN AN
ACTIVELY MANAGED FUND, YOU HAVE DECIDED TO BECOME
AN ACTIVE, INVOLVED INVESTOR. SO DEAL WITH IT.
3.) Even if you fell completely asleep and were under a rock for the decade after
Lynch retired, you did well if you stayed in the Magellan Fund.

Year*   MFR**   S&P 500 Return
1990    (4.51%)          (3.10%)
1991     41.03%            30.47%
1992     7.01%               7.62%
1993   24.66%          10.08%
1994   (1.81%)             1.32%
1995   36.82%          37.58%
1996   11.69%          22.96%
1997   26.59%          33.36%
1998   33.63%          28.58%
1999   24.05%          21.04%

*Duh
**Magellan Fund Return
Any returns in parentheses are negative. (Don’t ask me why. It’s an accounting thing.)
(Keep that in mind when you peruse your statements.)

As far as Lynch retiring in his 40’s with many millions and being celebrated worldwide… not bad work if you can perform for that level for that long…which no one else ever has thus why Lynch is a legend and bringing us to the problem of actively managed funds.

Statistically speaking, the vast majority of actively managed funds tend to “underperform,” or in other words, do worse than the market index.
The Magellan Fund (the example cited above) is bandied about so often because it’s the exception to the rule, not the rule…not even close actually.

Plus precisely no one guessed that the Magellan Fund would have done so well when Peter Lynch began as its manager. (Quite frankly, the Magellan Fund was an obscure fund that only became main stream a few years after it took off year after year.) We only know how well it did looking back.
Realize that every single time an actively managed fund sells a stock, the fund is hit with taxes and fees, which diminish the fund’s performance. Therefore, the more buying and selling (i.e., turnover) in an actively managed fund, the worse it will do unless the performance of the stocks it remains in outdoes the taxes and fees it has accumulated in the process…a chancy proposition.

Remember this also: You’ll pay a flat fee every year regardless of whether your fund does well or does poorly. (That’s true for index funds too though.) If the index offers a 7.25 percent return, and your index fund charges you 0.25%, then you’re at a 7% gain for the year. If your actively managed fund gives you an 8 percent return (Yay!) instead, but charges a 1.5 percent fee, then your gain that year is 6.5% (Booo).

Owning an actively managed fund means you’re dreaming of beating the market consistently or, at least, often enough and high enough that, net of fees (i.e., once you’ve subtracted out how much you’re paying each year as a privilege of owning the fund—you’ll see this phrase used a lot in articles, books, etc., so memorize what this means), you’re coming out ahead of an index fund.

Realize one more thing: If you own an index fund, you can just check in on your index (e.g., S&P 500, NSADAQ, Dow Jones) for the day, week, month, or even year and know exactly how well you did in that fund (minus a small expense ratio).
If you own an actively managed fund, how the market or a certain index or a certain stock or even a group of stocks performs tells you absolutely nothing about how your actively managed fund has done. In fact, believe it or not, the market or index could be up and your actively managed fund could actually be down because your genius fund manager (who only got the job because he’s the fund family’s CEO’s idiot nephew—bitter much, PWT?) is heavy into the only stocks that are actually down in an up market.
The only way to check on how your actively managed fund is doing is to check on the actual fund itself.

I think we’ve all had enough for one post.

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.

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 IIB

Mutual Funds vs. ETF’s: The Final Showdown*

Think of your investment portfolio as a wardrobe.
It’s many different pieces (shirts, pants, socks, shoes, etc.) that cover all of you. Stocks, mutual funds, ETF’s, bonds, commodities, and many other items (all known as financial instruments) comprise your “financial wardrobe” so to speak.
Funds can be like that great piece of wardrobe that has many functions/pieces just as a fund may have many stocks or bonds or both in any combination.
But they can be structured very differently.

Open End Funds vs. Closed End Funds

Open End Funds=Mutual Funds

There. That’s it.

You’re welcome.

*Crickets*

*Puzzled faces*

OK. Fine. Let’s talk some more (eye roll so severely hard that you can hear it through the Interwebs).

Open end funds (which are typical/normal mutual funds) have no limit or end to the number of shares that it can issue. When someone buys shares of an open end fund (which you are buying from the fund itself), more shares are created (really out of thin air). When someone sells their shares of an open end fund, these shares are “retired” or taken out of circulation.
When a massive load of shares are sold within a short period of time (often within a day), the fund may actually sell/have to sell some part of its investments to pay for the amount of money owed to the seller(s). This is known as a redemption.
Though they’re usually composed of stocks, open end funds don’t trade/fluctuate like them. Open end funds reprice at the end of each weekday based on how many shares are bought or sold. (Simplistically thinking, massive buying of shares ups the price of an open end fund whereas massive selling of shares deflates the price.)
The price of the shares of an open end fund at the end of the day is determined by the total value of the fund based on the buying/selling of the shares throughout the day. This total value of the fund is known as the net asset value (NAV).

NAV=Total assets-Total liabilities/Outstanding shares

Total assets (i.e., all the stocks, bonds, etc. the fund owns)

Total liabilities (i.e., all the debt, borrowed money, etc. it owes)

Outstanding shares (remember this? What do you mean, no? Jerks! It’s all the shares of the [in this case] fund floating out there in the world for anyone to buy)

Realize that not only some stocks will produce dividends quarterly (or much more rarely monthly) which will be taxed, but mutual funds as well. (More on all of this in a later post.)

Closed end funds

Closed end funds, in contrast, have a fixed number of shares that do not increase or decrease depending on sales and are bought and sold among investors, not the fund itself, on an exchange
(i.e., marketplace). Like stocks, their share prices are determined according to supply and demand. They also are often at a steep discount (Yay!) or at a high premium (Whoa!) to their net asset value. (In all seriousness, realize that there is usually a reason something is really cheap [“it’s a porker”] or expensive [“you want quality, you have to pay”]. You just have to ensure that you’re getting value for the money you spend as you buy anything…anything at all.)
Just over 2/3 of closed end funds use borrowed money (known as “leverage”) to invest to bring about a bigger return to make the fund and, in turn, you money. So, anything that makes it more expensive for the fund to borrow money (e.g., higher interest rates, a fund being downgraded—more on this in a later post) will cost the fund more which will then be passed on to you one way or another thus lowering returns back to you as the investor.
Therefore, you have to watch quite a few things pretty frequently to ensure you’re in the right closed end fund and don’t need to avoid them or bail out of the one you’re already in.

Generally speaking, open end funds are safer and more predictable than closed end funds though their upside can be significantly higher than that of open end funds. Either can have dividends (though they’re more common in closed end funds), but those of the closed end funds are usually higher, but also far more likely to get cut depending on underlying conditions with that fund or the economy in general.

We will discuss investing in funds in a later post, but closed end funds are neither for the novice or faint of the heart.

Exchange-traded funds

Exchange-traded funds (ETFs) are similar to mutual funds because both group together securities (usually stocks or bonds) to offer investors diversified portfolios. Typically anywhere from 100 to 3,000 different securities can be grouped together to comprise an ETF.

SR: Uh, pal…That’s no different than a mutual fund. So what gives?

PWT: So here are the differences between mutual funds and ETFs.

SR: Finally!

ETFs are just like stocks in that they fluctuate throughout the day while, if you remember, mutual funds trade only at the end of the day at the net asset value (NAV) price.
Most (but certainly not all) ETFs track to a particular index and therefore have lower operating expenses than actively invested mutual funds. ETFs have no investment minimums (which mutual funds often do—i.e., you can’t buy any shares of a particular mutual fund unless you fork over what they demand such as $5,000 or $10,000).
Also, some mutual funds charge for the privilege of owning some shares of the fund (sales “loads” as you purchase the shares [front loaded] or as you sell the mutual fund shares [back loaded] vs. ones that don’t charge at all [no load]) whereas ETFs do not. Lastly, once you sell a stock or mutual fund, you are charged capital gains tax on it (much more on this in a later post), but that’s not the case with ETFs necessarily.
As you sell the shares in your ETF, the ETF doesn’t actually sell any shares (stay with me here), but rather creates and then offers to sellers what is known as “in-kind transactions or in-kind redemptions” which are often not taxable. Therefore, ETFs allow you to either significantly reduce or altogether avoid taxes on your way out of the ETF.

Here are the differences summed up in table fashion for all you bottom line chart/table/graphics learners out there. (Yeah, you know who you are. I went to med school too, people.)

ETFs                                                           Mutual Funds

Trade during trading day           Trade at closing NAV
Low operating expenses             Operating expenses vary
No investment minimums        Most have investment minimums
Tax-efficient                                   Less tax-efficient
No sales loads                                 May have sales load

Both open end and closed end funds have been around for decades, even a century. Closed end funds are the oldest type of fund debuting in the late 19th century.
Exchange traded funds, or ETFs, are the Johnny Come Latelys (Latelies? Who really knows how to spell these made up colloquialisms?) of the fund world being introduced just over twenty years ago.

Mutual funds are MASSIVELY popular. And why not? They allow you to invest broadly in the economy (US or global) or any part of it as you desire (e.g., technology, energy, utilities, etc.).
Currently, 7,467 open end funds exist with total net assets of $12.1 trillion (Yes, Trillion with a capital T—that’s $1,000 billion for those of you keeping track at home) as per Morningstar, the most well-known investment firm in the business.
In a relative sense (and only in a relative sense), the ETF market is small: roughly $1.7 trillion placed in 1,550 ETFs.
But closed end funds by far have the smallest amount in terms of both the number of funds and total assets: 568 funds worth about $252.6 billion (not even a measly trillion dollars; wealth just ain’t what it used to be.)

I think we’ve all had enough for one post.

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.

*My favorite Europe song of all time.** What a hair band!! Too bad they broke up in 1992…and then got back together!! And are now still touring around somewhere…somehow…

**It was actually The Final Countdown, but whatever. Still good fun. Though it was always unclear what they were counting down to as they had already launched off Earth early in the song as per the lyrics. The countdown to their oxygen running out? Maybe. But that’s probably just the Pulmonary/Critical Care guy in me coming out unnecessarily again.

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.