Seemingly Standard Funds Vary by Management Style, Fees

A client once said to me, “We’ve seen a number of financial advisers. They all sounded like they knew what they were talking about. Unfortunately, we didn’t know what they were talking about.” If you’re an experienced investor, you know the basics. But if you’re new, or feel like you missed some key points, let’s review some fundamentals.

 

What’s a Mutual Fund?

A mutual fund is a basket of investments purchased by a manager with funds contributed to by many investors. Because so many investors pool their money, they’re able to buy shares in many more investments than if they were buying individual stocks or bonds. Most of us couldn’t buy significant amounts of all 500 stocks in the S&P 500, but we can easily buy shares in mutual funds where we own a stake in all of them. Similarly, individually buying a diversified selection of individual bonds is expensive, but easy with bond mutual funds.
 
Most investors purchase either open-ended mutual funds or their newer cousin, exchange-traded funds (ETFs). Open ended funds can be bought or sold on any trading day. Share price is determined after the markets close, based on the value of all investments included in the fund (individual stocks, bonds or other mutual funds) divided by number of shares outstanding. This gives a net asset value (NAV). So, if the NAV is $20, and you invested $5,000 that day, you own 250 shares of that mutual fund.

ETFs are slightly different in that they do have a NAV, but the actual share price can vary throughout the trading day. Depending on investor sentiment on a given day, the share price may be higher or lower than the actual value of the underlying company shares. Prudent investors choose ETFs whose share price and NAV have historically been very close.

The advantage of an ETF is that you know exactly how much you’re paying and how many shares you’ll get at the precise moment you purchase or sell, rather than at the end of the day. Because ETFs trade like stocks, there is no minimum amount you may purchase. Since many ETFs are alternate versions of a mutual fund, you won’t have to meet a minimum purchase. You could theoretically purchase $100 of the ETF version.
 

Where to Buy Them?

The easiest and most familiar way is to choose from the selection offered by your workplace retirement plan. You’ll probably be limited to the offerings from the plan provider. Unless the plan offers a “brokerage window” you won’t be able to buy ETFs.

Next, you could open an account with an investment company that offers mutual funds. Most big fund companies, e.g., Vanguard, Fidelity, T. Rowe Price, Dodge & Cox, etc., will be more than happy to have your money invested in their in-house funds, and will usually offer free trades if you want to move money between their funds.

Usually they’ll allow you to purchase funds from other companies, e.g., purchase Fidelity funds at Vanguard, but you’ll likely incur higher trading costs. Every company would like to encourage you to choose their in-house fund, and in the case of strictly index funds, it may not matter all that much.

Finally, you can house your account at a general low-cost brokerage, such as Charles Schwab, or an advice-giving brokerage or bank, like Chase or Edward Jones. Costs can be higher at these houses, and if you look to them for advice, the recommendations may be all their own proprietary funds. Be sure to find out whether the person giving you advice is a fiduciary (legally obligated to act in your best interest). Many are not and tend to recommend mutual funds which pay the best commissions for them.

If you choose an independent brokerage, some funds may not be available to you. A mutual fund company may restrict some of their most popular funds only to investors who have an account with them. These funds will be “closed” to new investors from outside.
 

What’s an Index?

An index is a list of investments intended to reflect a specific segment of the market. Some indexes are the S&P 500; the Russell 2000 (small caps); the MSCI Emerging Markets; the Barclays Aggregate Bond, and more — approximately 5,000 in all.

Many large funds choose to match their investment portfolio to a specific, well-understood index. But managers have been known to select an index which will more favorably reflect on their performance and may choose to measure themselves against that.

As you move into more esoteric investments or smaller sectors, an index may be whatever the indexer says it is: smaller and somewhat obscure. This is not necessarily a problem. By carving out a smaller chunk, you’re hoping to do better than a broad market of all stocks or bonds. You should, however, keep your eye on how your investment measures up against broader indexes.

 
Why Specialize if It Means You Do Worse?

Passive Versus Active Management

A passive management-style manager selects and maintains a portfolio that corresponds as closely as possible to the chosen index. There are no management decisions involved. If a company drops off the index (as sometimes happens with the S&P 500), management sells the com­pany from the portfolio.

While replicating an index is not usually a problem for large mut­ual funds, funds that focus on small segments of the market may limit or close to new investors. Underlying companies may simply be too small to sustain large influxes without actually moving the market.

Passively managed funds should have very low internal costs because most of the selection is done by a computer.

Active management relies on the expertise and intuition of human managers, and you pay their salary in higher internal costs to your fund. While some managers may have spectacular performance over time, there’s research evidence that this doesn’t continue over long periods, and by the time you hear about them, their biggest wins are likely over. Active managers are often covered in a sensational way by the press because everyone likes a hero, but they shouldn’t be expected to consistently outperform an index fund.

Some actively managed funds operate in an index-like way. For example, many balanced funds have so many investors and investments that they tend to mirror the markets they’re in (stock and bond sides).

Some markets are so specialized or difficult to invest in that an index has little meaning. These would include micro-caps, non-U.S. frontier markets and small divisions of sectors. The universe of investments in some might be quite small, and a manager needs to ferret them out and make choices.

No bond fund can truly be a passively managed index because specific bonds are limited. Bond index fund managers assemble bonds that are similar in interest, term and quality rating to the established index.
 

Costs to Own

Funds can be no-load or load. Load is a charge to purchase shares in the fund. The charge compensates the broker who sold you the funds, and can be 5.75%, 4.75%, 3%, etc., of the amount you invest. If you invest $10,000 in a fund with a 5.75% load, you’ll pay $575. Deducted from your investment, you’ll only be investing $9,425. Your investment must earn that much before you’re back to even. A no-load fund has no charge. All your investment goes into the mutual fund.

All funds, no-load or load, have internal management costs or expense ratios. This is what it costs to run the fund: website costs, paperwork and regulatory compliance, rent, salaries. If there’s a star manager earning a higher salary, management costs will be higher. If the market is more difficult to invest in (international markets or some sectors), it will cost more to have people on the ground who can identify and analyze potential investments, understand regulatory environments and  manage currency fluctuations. As a rule of thumb, management costs should be below 1%, and the lower they are, the more money stays in your fund. These costs are taken out before your fund is valued, but historically funds with lower costs return better results to their shareholders.

You may incur trading costs when you buy or sell funds. Competition has driven down these to very low amounts and sometimes free. Be assured that the investment houses are making it up in some way — lower interest on cash accounts, management costs, or higher charges for those with brokerage accounts elsewhere buying the funds.
 

What Will a Share Cost?

As mentioned, ETFs trade just like stocks, with share quotes throughout the day. Mutual funds are valued at the end of the day, but you can get a pretty good idea of whether they’ll be up or down if you look up how a corresponding ETF is doing. You can place your mutual fund order for a specific number of shares, or a specific dollar amount, which will give you fractional shares.
 

How Do I Make Money?

Just like stocks, share prices increase and drop. Also, many funds pay dividends or yield. Especially in the case of bond funds the yield tends to smooth out total return. When price goes up, yield goes down and vice versa. The next time you hear “bonds (or another type of fund) aren’t making anything,” be sure to look at total return: share change + dividends paid.

If you sell shares, you may have a capital gain or loss in share price. But you may also receive short- and long-term capital gains payouts even if you continue to hold the fund. These usually occur sometime in December and are the result of activity within the fund. Managers may have had to sell shares to meet redemptions or because the composition of the index has changed. Usually share price will drop temporarily based on these payouts, so it’s something you should be aware of if you’re purchasing late in the year — just as you keep an eye on dividend dates for individual stocks. You don’t want to be liable for taxes on capital gains while you’ve “lost” money on the shares themselves.
 

Getting Money Out of a Fund

You sell shares and either have the proceeds transferred to your settlement account (a money market fund), or the proceeds sent directly to your bank by setting up an ACH (automatic clearing house) transfer.
An ACH transfer will usually arrive the next day. When you set it up, the investment house will send two small amounts to your bank account as a test. You report back the exact amounts you received to verify.

Don’t worry, they’ll withdraw it again.

Ask your investment company to issue you a checkbook. There’s often a minimum amount you can write on a check — say, $250. You can pay bills directly or write a check to your bank account.

Finally, you can have dividends and capital gains reinvested in the fund, direct them to the settlement fund so you can choose where to reinvest or have them sent to you by check when they appear. In retirement, many people collect dividends and fund the rest of their retirement needs by selling shares.
   
This article was originally published in the January / February  2021 issue of BetterInvesting Magazine.

These funds are mentioned for educational purposes only; no investment recommendations are intended. The author and some of her clients may have positions in some of the funds mentioned in this article. Danielle L. Schultz, CFP, CDFA, is a fee-only financial adviser with Haven Financial Solutions, Inc., based in Evanston, Illinois. She can be reached at www.HavenFinancialSolutions.com.

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