Fund structures
This post is part of the Financial Freedom Guide series
OK, you want to invest in a particular asset class - say US stocks, for example. How do you actually do that?
Active vs passive management
One option is to open a brokerage account, pick a small number of US stocks, and buy them. Sounds simple, right? It's just... which of the thousands of US stocks out there should you buy? Because either (a) you are extremely confident in your pick(s) - like legendary investor confident, or (b) you aren't diversifying enough. So really you should buy at least 30 (and preferably more) US stocks. Which only expands the question - how do you know which stocks are going to do well?
The whole nature of the stock market is that investors attempt to buy stocks at a price less than their “fair value” and to sell them when they trade at a price more than their fair value. "Fair value" here means the value justified by the stock’s expected intrinsic cash flows.
The net effect is that - on average, over the long-term - the market's valuation of any given stock should be "efficient" (or accurate), meaning stock prices already reflect all expected future growth or decline in intrinsic cash flows.
On the up side, this means if you play monkey and throw darts at a board, your random 30+ stock picks on the board should roughly return the same as the market average. On the down side, it means it is incredibly hard to consistently outperform the market. Because for any investor who outperforms the market average, there must be - by definition - another investor who underperforms the market average. Else it wouldn't be the market average.
Despite this, plenty of people believe they are smarter than everyone else and that they can pick those stocks that are surefire to outperform the market average - it’s much like the old trope that >80% of US drivers believe themselves to be above average drivers. The attempt to pick the best stocks is called “active” management. Proponents of this approach include those professional money managers who run “active” or “smart money” funds and get paid handsomely to believe in their skill - or at least make you believe in it.
Thank them! Active investors are essential to "price discovery" - or figuring out what each stock should be worth to you and me. They take big risks and spend lots of time, brains, and crazy amounts of money figuring out what the right prices should be - all while ending up - on average, over the long term - performing exactly average (well, minus those costs and life years in stress they incurred). They deserve a big thank you from those monkeys throwing darts at boards like us!
So wouldn't it be great if we could just shortcut all that, save ourselves the heartburn and cost, and just get the average market return like everyone else without incurring the cost? Ha, well, yes you can! Welcome to passive management, also known as index investing.
As their name suggests, index funds invest your money according to an index. An index is effectively a list of different assets with a weighting percentage attached to each. Say, for example, invest 50% of your money in stock A, 30% in stock B, and 20% in stock C. An index fund takes the index “shopping list” and goes and buys it.
A particularly well-known example of an index is the S&P 500. This index is managed by S&P Global and is meant to (roughly) include the ~500 highest market capitalization stocks traded in the US. These stocks are then weighted by their relative market capitalization (price per share * number of shares outstanding). So if one company makes up 1% of the total market capitalization (or value) of the companies included in the index, it will get a 1% weight in the index. The benefit of this is that there is no need to buy or sell shares as companies gain or lose in value - the index automatically reflects changes in the market capitalizations of its component stocks.
There are countless other indices issued by companies such as S&P Global, Dow Jones, MSCI, FTSE Russell, as well as by many global stock exchanges. These cover anything from each stock exchange's few dozen or hundreds biggest stocks (like the S&P 500) to particular industry sectors (say all US REITs) to total market indices covering entire markets - e.g., all US stocks, all developed country stocks, all emerging markets stocks, or even all globally investable stocks. It is these total market indices ones you want for your asset allocation.
Wonder why I'm not recommending investing in the S&P 500? Check out my post on Total US stock market vs S&P 500 index funds (coming soon - subscribe to encourage us to hurry up).
Mutual funds vs ETFs
Indices are cool - but how do I actually get someone to buy and manage those investment shopping lists for me? And will they do it reliably, cheaply, accurately (called a low index "tracking error"), and with good liquidity if you need to withdraw your funds?
That's were mutual funds come in. Mutual funds are pretty simple. You give them your money and they invest it as agreed, minus a fee - typically charged as a percentage of your "assets under management" or AUM each year, also known as an expense ratio.
There are active and passive mutual funds. You want the latter, also known as index mutual funds. Index mutual funds pay a small amount of money to license an index from an index issuer and then invest your money to track that index. As discussed above, this is a lot cheaper than hiring a bunch of smart, overconfident guys to pick stocks, so index mutual funds tend to have much lower expense ratios than active mutual funds. While active mutual funds typically charge around 0.5% to 2.5% of your invested funds every year, good index mutual funds charge less than 0.2% and in some cases less than 0.05% in management fees. And that's before all kinds of other fees that active mutual funds tend to charge, such as purchase and redemption “load” fees.
Think of the difference in fees between active and index funds as guaranteed return for yourself. If you invest $1M for 10 years and save, say, 2% in annual management fees by choosing an index fund - all while, for all the reasons discussed above, earning the same 7-8% average real stock market return - you will end up with a whopping $350,000+ more than if you had chosen an active fund. The active mutual fund would have to outperform the market by at least that $350,000+ (which we know is incredibly difficult) just to break even. It gets worse if you let this hypothetical scenario run for 40 years. The difference would compound to around $10M! And this difference of course would have gone to those smart, overconfident guys and their suits and fancy cars.
When you are ready to withdraw your money, mutual funds sell some of the assets they are holding and hand you the cash. All of your transactions are directly with the mutual fund manager (called "primary market" transactions).
Which gets us to an innovation in mutual funds that has been taking the financial world by storm over the last couple decades: exchange-traded funds or ETFs.
ETFs work similarly to mutual funds and there are both index ETFs and actively managed ETFs out there. The key difference is that you don't buy and redeem ETF shares directly with the fund manager. Rather, you buy and sell shares of the ETF on the "secondary market", i.e., on an exchange, in the same way you would purchase stocks.
This has two advantages:
The fund manager doesn't have to deal with thousands of small fish investors wanting to buy or sell tiny $100 amounts of their fund. That saves a lot of administrative costs, which in turn leads to lower expense ratios.
When you sell your ETF shares, you aren't actually redeeming shares. You are simply selling your shares to another investor in exchange for cash. This means the fund manager doesn't have to sell any stocks to free up cash, which in turn means there is no taxable event and no capital gains tax due for the remaining shareholders in the fund. This makes holding ETFs a lot more "tax efficient" than traditional mutual funds.
Fun fact: Vanguard has a patent on a technique that uses multiple share classes of the same fund and so-called “heartbeat trades” to effectively impart the tax advantages of their ETFs on their mutual fund share classes as well. Check out this Bloomberg article for some exciting financial market shenanigans. The upshot is Vanguard's mutual fund shares are just as good as their ETF shares for tax purposes. Also check out my more detailed discussion of Vanguard mutual funds vs ETFs (coming soon - subscribe to encourage us to hurry up).
So how do new funds actually get added to (or taken out of) ETFs? Well, you can actually go directly to the mutual fund manager and buy or redeem ETF shares in huge (millions of dollars worth) chunks called "creation units". But you wouldn't be exchanging cash but rather baskets of securities (e.g., stocks). So you would approach the issuer and say: Here's the precise shopping list worth of this ETFs' stock holdings, please give me the equivalent number of ETF shares - or vice versa. This is important as this arbitrage opportunity (or ability to make a profit) ensures the ETF shares will always trade reasonably close to the "net asset value" or NAV of the ETF's underlying securities, without too large of a "premium" or "discount". - And because these transactions do not involve the exchange of cash for securities, there is no taxable event and no capital gains due for shareholders.
OK, enough of the financial wizardry. What you need to know is that ETFs work incredibly well and it's no surprise that they are rapidly replacing traditional mutual funds.
Broad index ETFs should be the mainstay of your investment portfolio.
Summary
We introduced active vs passive investing and know that we are probably best off investing in index funds. Among those, we have a choice between traditional mutual funds and ETFs, with ETFs usually being the lower cost and more tax efficient option. If you are considering investing with Vanguard, check out this article (coming soon - subscribe to encourage us to hurry up) specially for you.
So who should I entrust my money to?
Go back: Asset allocation
