This episode describes mutual funds, index funds, and ETFs. It then takes it further by describing the background behind each one and how to tell if they are worth your money. The episode then describes fee structures and how certain fees may be deceptive. The podcast concludes with cost analysis and tells you which ones may save you the most amount of money and increase the returns of your portfolio. This is a perfect starter episode to somebody who wants to get their feet wet with investing, or wants to get a deeper understanding of the basics.
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You can find the script of this podcast at the bottom of the E-mail.
Here is the script that was used in today’s episode.
Note: I don’t follow scripts word-for-word as they can sound unnatural, but the episodes do closely follow them.
The basics amped up – More than just stocks, bonds, mutual Funds, ETFs, index funds, and what we can expect
This is episode 2 in the series of how to create a better investment and retire,emt portfolio. In this episode, we’re going to talk the basics of mutual funds, index funds, and ETFs then amp them up. We’re going to talk about not only what they are, but also what we can expect from them and how they work. If you don’t know what any of them are, that’s fine because we’re going to go through with them one-by-one.
Let’s jump right into it:
Most of us have heard of mutual funds, index funds, and ETFs, especially from financial advisors or articles we read. When we tell a friend we’re going to start investing or trading, they tell us tons of stock tips. But very rarely do they tell us their “favorite mutual fund.” It’s just not as sexy to say “OMGosh you gotta invest in the Fidelity Low Price Stock Fund It’s soooooo good. ”
But they can be sexy and we’ll get into that now.
So in the past episode we mentioned stocks and bonds. Well a mutual fund, index fund, and ETF is when we decide to give our money to another company and they buy stocks and/or bonds for us. Many other people do this too, so we as a group of individuals, we pool money together and give it to a company. This is the core essence of what Mutual funds, index funds, and ETFs all have in common. We, as individuals, pool our money together, and give it a company so they can buy stocks and bonds on our behalf.
Investing together with other people has advantages for example, remember how I said bonds require a lot of money to buy or sell? Well individually we may not have enough money, but when we pool it together with others, suddenly we can own a ton of bonds – or an entire portfolio of just bonds.
The question you may be wondering is, well then what makes a mutual fund, index fund, and ETF different from each other? And the answer is, what makes them different, is what they decide to do with our money once we give it to them
Let’s discuss what a mutual fund does after we give them our money:
The company we give money too then hires people called “Portfolio Managers” who decide what to buy and sell for us. This allows us to make a more laid back approach to investing.
A benefit should be that since we all pool our money together, we can pay to hire somebody who is very very talented. In this case the company we give money to evaluates Portfolio Managers and hires them. Notice how I said this should be the case, that the portfolio managers we hire should be very talented… many people consider this line of thinking very optimistic and a lot of data agrees with them. But we’ll get to that in a few moments.
Because nothing is free, the Mutual fund company asks for a fee for managing our money and providing this service. The fee structure for mutual funds can be a bit complicated here so let’s break it down:
When you’re looking up a mutual fund, you may see a page related to expenses. A good site for this is Morningstar.com. You will see something called an expense ratio or net expense ratio. This is the total all inclusive fee that the management company takes out of your investment. Now when they take out this money, they don’t charge you directly. Instead, they collect the fee divided up for every day of year on daily basis. For example if the fee is 1%, they approximately divide 1% by 365 and apply that throughout the year.
So that is the net expense ratio, but what is it made of? Well it includes the management fee – paying the portfolio managers, the administrative fee for running the business, and a marketing fee. You may be wondering why you’re paying for a company to market, and this depends on your view of the company. Yes it’s true, some mutual fund companies may try to take advantage, but in order for the company to exist and be able to provide you this service, they do have to market.
Before we move on to the next type of fee, let’s talk about the management fee that’s included in the expense ratio, because this is pretty important. So a mutual fund manager typically gets paid between .20% to 1% – more or less. On a small mutual fund, like $100 million, the manager can take home $1 million dollars in pay. On $500 million, it may be $5 million. You may think this is outrageous, but if the fund manager can return you 5% more than you could, and you give up 1% to pay him, isn’t it worth it as you come away 4% richer? Now a lot of people argue that the fund manager isn’t worth their fees, that they don’t make up for the 1% that they charge…which means that they actually perform worse, but we’ll come to that in a moment.
Okay, so now I want to talk about sales fees. This is something that really bothers me because I’ve seen it happen to a number of friends. When somebody pushes mutual funds on you, or they are financial advisor and they are pushing only their own company’s products on you, chances are there may be a large fee involved. This is called a load. Funds that do not charge a sales fee are called no-load funds. Those that do are load funds. And the fee is called a load fee. There are a few types of load fees. The front-load fee is charged at the onset of a fund. So if you buy a mutual fund, they take away something like 5% immediately from the money you invested. A mutual fund isn’t allowed to charge a front-load fee of greater than 8.5%.
A back-end load means you pay the fee when you exit the mutual fund. There is often a variation of this which means you pay the load fee throughout the 5 or 6 years.
Now some people argue that if you buy a no-load fee, the fee is still there but put in the expense ratio. In my experiences, the funds that charge load fees are the ones that are pushed by individuals belonging to a “financial advisor” companies. On top of this, the “load” fee tends to be absurdly high. Because often the “load” is designed to get you to pay more. This is a deceptive tactic I have seen in the industry and it really upsets me. You will notice on this show, I always try to give a balanced perspective and take a neutral stand in the current events I discuss here. But on this topic I will express my opinion loud and clear. I’There are thousands of very reputable funds that offer no-load funds. In fact, I would argue the most reputable and top mutual funds do not charge a load fee
OKAY! So let’s move on from this frustrating load fee topic before I have to practice soothing meditative breathing.
Alright I’m back. So you’re probably thinking, “AHHH RISHI SO MANY FEES! What do they all mean??”
In essence the fees mean this: since you are giving your hard earned money, you better make sure it’s worth it! So with that, let’s talk about how we can make sure the investment was worth it.
Okay, so far we have discussed what a mutual fund is, how they work, and what their fees are. And now let’s talk about how we can measure if they are useful. Afterall, since we’re paying fees we need to make sure that we’re getting our moneys worth. But before we can talk about if we’re getting our money’s worth, we need to discuss index funds.
So what are Index Funds and why do we need to discuss them?
So let’s just do a recap, we pool our money together with other investors and give it to companies so they can buy stocks and bonds on our behalf. This is what mutual funds, index funds, and ETFs have in common. And because these companies charge fees for this convenience, we want to make sure we’re getting what we paid for: and that’s stellar amazing performance. After all, if the manager is going to be paid millions of dollars, we want to walk away knowing we’re better off too.
And how do we measure that? How do we know we’re better off? Well if we buy a mutual fund that’s supposed to pick the best large companies, what is a fair way to measure the portfolio manager? We could say, well the fund we invested in made 10% this year, so they must be awesome! But wait, what if the S&P 500, a stock index that tracks big companies, was up 30%? So the stock market was up 30%, but we are up 10%? That doesn’t feel so good does it?
And so the way we track the performance of mutual funds, is by comparing them to a stock index. So if we invest in a mutual fund that says “I will only invest in large companies and I’m going to be awesome at it” we compare the mutual fund’s performance to an index measuring big companies…which would be the S&P 500. If we invest in a mutual fund that says “I will be the best stock picker of smaller companies” we may compare them to the Russell 2000, a stock index that represents small and medium sized companies.
Now what if I told you, study after study after study, has shown that mutual fund managers perform worse than the stock index. Studies show that anywhere from 70-90% of mutual fund managers perform WORSE than the stock index once you take into account their fees.
And so you may be thinking, “well Rishi, I bet if we find one mutual fund manager who does really well, they will continue to do well.” Well other studies show that if you took 3,000 mutual funds, and invested in the top 25% of them….only 2 or 3 would stay in the top 25%.
This is why mutual funds get so much flak. As we discussed, it’s okay if a mutual fund collects high fees, as long as you’re better off more than you could be without the fund. But studies show this is very much not the case.
Now the truth is, there are some stellar stellar mutual funds out there. There are some people who are so brilliant and put so much work into it, that their process is very good. The issue isn’t that they don’t exist, the issue is that they are very hard to predict and find. There are people out there whose sole job is to find the top mutual funds and invest in them. And then there are others who invest in a very concentrated portfolio of stocks. Instead of holding 100-200 stocks, they may hold 20-30. The argument that people make against mutual funds isn’t that there aren’t any good ones out there…the argument is that they are incredibly hard to find and it may not be worth your time. The vast majority of the time you’re better off holding the stock index.
Even Warren Buffett, whom many consider the best stock and company picker of all time, has said to put your money in index funds.
Here is a quote from one of his letters:
My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.
Before I want to continue, I want to urge individuals not to immediately put 90% of their money in stocks. We will discuss why in the next episode. There are specific reasons Warren Buffett advocates this, which if you follow his advice without knowing the context of it, can be very dangerous.
Okay, now that we’ve set the stage for index funds, let’s talk about what they are:
Throughout all of this you may have thought, well it’s all good and well to compare a mutual fund manager to an index…but what difference does it make? A stock index is just a statistical measurement. We can’t invest in a statistical measurement.
Well turns out this is where index funds came into play! Let’s start with the story: John Bogle was one of the first individuals to study mutual funds and realized they were no better than index funds. In 1974 Bogle started the Vanguard group and in 1975 formed the first index fund. An index fund works by buying the stocks that make up an index in their right proportions. For example, an S&P 500 index fund would buy all 500 stocks in equal proportion. They may use other instruments too, but that’s a more advanced topic for later. Just know, an index fund tracks the index, like the S&P, very very closely by replicating the index. Anyway, back to our story about Bogle. People thought he was crazy and was nuts for creating a product that would returne “just average returns.” Well Bogle turned out to be one of the smartest individuals out there. A pretty good motivational story given that Warren Buffett in the above quote recommended Vanguard and The Vanguard Group now manages $3 trillion dollars.
So what makes an index fund and index fund, besides it tracks the performance of a stock index?
An index fund should have no load, or no sales fee. On top of that is expense ratio is very very low. For example, according to vanguard the industry average expense ratio is around 1.1%. The average index fund offered by Vanguard has an expense ratio of 0.2%. The reason index funds are so much cheaper is that their management fee is much much smaller. They may also eliminate marketing fees and keep their administrative fees very very low. By not having to pay for quote “very talented managers” and searching for them, they stick to the index. By going to an index fund, you save an extra .90% on average. Over time that can add up to quite a bit.
Just to put things into perspective. If you invested 10,000 into a mutual fund with a fee of 1.10% and also another $10,000 in an index fund with an expense ratio of .20%…after 10 years you would save $1,500 with the index fund. That’s a 15% savings on your initial $10,000.
This is why people advocate index funds so much.
So far we’ve discussed mutual funds, index funds, and compared their performance. Now let’s talk about ETFs.
ETFs are an abbreviation for an Exchange-traded-fund
You can think of an ETF between a hybrid of a mutual fund, index fund, and stock all in one. Before we get into the ETF structure, let’s talk about buying a mutual fund or index fund. Let’s say you’ve now figured out which mutual fund or index fund you’re going to buy. When you place an order, it is executed the same day or the next, but it is not executed immediately. When you buy or sell a stock, you see the price on the screen and as soon as you buy or sell the stock you get that price or very close to it immediately. This is not the case with a mutual fund or index fund. With a mutual fund or index fund, you don’t know what price you get until the end of the day or the next day. This is because the value, or Net Asset Value, abbreviated NAV, is calculated at the end of the day. The cash value of stocks being held to replicate an S&P 500 index fund is called the Net Asset Value. Remember, an S&P 500 index fund buys the underlying stocks to replicate it (sort of). And those stocks are worth something – the NAV.
This sounds so complicated! Wouldn’t it be awesome if buying a mutual fund or index fund was like buying a stock? Well that’s where ETFs come in. An ETF is a vehicle that mixes a stock structure with the concept of a mutual fund or index fund. SO you are pooling your money together with other investors when you buy an ETF, but the ETF trades on an exchange like a stock. I know this is a bit weird, but think of it this way: instead of getting a price at the end of the day, like when you buy a mutual fund or index fund, the price of the ETF is continually changing throughout the day – just like a stock.
Now here is the thing with ETF index funds. Their fees are cheap. Very cheap. Not only are there many thousands of different ETFs out there, allowing you to easily diversify, they are also very easy to trade. It’s like trading a stock. AND on top of that, they are so much cheaper. Take for example Vanguard. And no I’m not being paid by them, it’s just they are the pioneers and one of the most popular.
The Vanguard S&P 500 index fund has an expense ratio of 0.17%. What about the equivalent ETF? 0.05%. Now here’s the thing with Vanguard and it will illustrate a point. If you have $10,000 to invest, you can qualify for their lower fee index fund, which charges .05%, the same as their ETF. In this case it make sense to go with the index fund instead of the ETF. The reason is, is that ETFs trade like stocks, and when you trade stocks, you have to pay a commission. Now a broke rmay charge you a commission on a mutual fund too. So sometimes things can get dicey, but often it is cheaper, from an expense ratio standpoint to hold an ETF than an index fund.
Wow we’ve covered a lot of the basics here on the amped up basics. We’ve focused mainly on large company mutual funds, index funds, and etfs. The truth is that there are many many different categories of mutual funds, index funds, and etfs. For example, there are some funds that only focus on the U.S. market while others that only focus on the international market, including specific countries. But we will get into that in the next episode when we discuss how to put this all together in a basic investment or retirement portfolio. Not bad for learning all of this in little over an hour!
I hope you all have enjoyed listening to the amped up basics just as much as I have had creating it.
If you have any feedback please E-mail me at Rishi@tiingo.com. In the next episode, we’re going to talk about commodities, mutual funds, index funds, etcs and so on.