5

USING MUTUAL FUNDS AND ETFS TO ACHIEVE YOUR FINANCIAL GOALS

“If you have the stomach for stocks, but neither the time nor the inclination to do the homework, invest in equity mutual funds.”

—Peter Lynch, American investor, mutual fund manager, and philanthropist.

Nearly 100 million individual investors own mutual fund shares, either directly or indirectly through their retirement plan account. Over half of the Generation Xers (born between 1965 and 1980) and nearly 40% of the adult Millennials (born between 1981 and 2004) own mutual funds. Why? The answer is simple: mutual funds are the best way for a novice investor to start investing. Through mutual funds, you can invest in the stock market or bond market or both, even with a small initial investment stake. You can easily diversify that small initial investment and subsequent contributions to reduce risk. This level of diversification is impossible when buying individual stocks. If you choose a fund or funds wisely, you may never have to pick another fund again. So, if you want to join those savvy investors and use the wealth-building power of the stock and bond markets but don’t want to spend your time following the economic prospects of dozens of companies, then mutual funds are for you.

You may already be exposed to mutual funds through your employer. Mutual funds are especially prevalent in retirement planning. Indeed, most people buy their first mutual fund through an employer-sponsored retirement plan, and many others own mutual funds in an individual retirement account. Chapter 6 provides a discussion of retirement accounts. You may also have seen a mutual fund distributor at your bank or credit union, which often operates under the appearance of a financial advisor. If you’re unsure how mutual funds operate and what they can do for you, read this chapter!

The term “mutual fund” actually encompasses many similar types of pooled investment vehicles (PIVs) including open-end mutual funds (OEFs), closed-end mutual funds (CEFs), exchange-traded funds (ETFs), and unit investment trusts (UITs). However, most people generally associate mutual funds with OEFs. The characteristics of these types of funds are described here. After reading about them, you’ll be able to utilize their investing power in your life to build wealth.

5.1. WHAT IS A MUTUAL FUND?

A mutual fund is a popular investment vehicle that enables you to invest even small amounts of money into targeted or diversified investment strategies. Organizationally, an investment company pools money from investors like you to buy stocks, bonds, and other financial assets aligned with its stated objectives. Fund objectives are formulated similar to “capital appreciation from large capitalization company stocks,” or “income from government bonds.” A fund’s objectives are specified in its prospectus, which is a legal document required by the Securities and Exchange Commission, that provides details about an investment offering for sale to the public. The fund’s professional investment managers select the securities in its portfolio. The most popular type of mutual fund is known as an “open-end” fund. Another less common mutual fund structure is referred to as a “closed-end” fund.

“Many financial innovations such as increased availability of low-cost mutual funds have improved opportunities for households to participate in asset markets and diversify their holdings.”

Janet Yellen

“Mutual funds were created to make investing easy, so consumers wouldn’t have to be burdened with picking individual stocks.”

Scott Cook

5.2. WHAT ARE THE ADVANTAGES OF OWNING MUTUAL FUNDS?

Mutual funds are a popular investment choice because they offer many advantages. Savvy investors appreciate that funds offer a wide variety of investment strategies, provide diversification, are convenient, can be cost-effective, and use professional managers. In some situations, like your employer’s retirement plan, mutual funds may be the only choice available. Specifically, fund attributes provide:

“The ‘know-nothing’ investor should practice diversification, but it is crazy if you are an expert.”

Charlie Munger

5.3. WHAT ARE THE COSTS OF MUTUAL FUNDS?

A main disadvantage of owning mutual funds involves the various fees that they charge. Remember, savvy investors evaluate performance after costs. Fund fees add up over time and reduce investment return. Below are some statistics from the Investment Company Institute 2019 Fact Book.

“To make the most of your money, I recommend sticking with mutual funds that don’t charge a commission when you buy or sell.”

Suze Orman

“Even a 1% difference in expense ratio can make all the difference between a comfortable retirement and financial distress.”

Robert Rolih

5.4. WHAT ARE OTHER DISADVANTAGES OF MUTUAL FUNDS?

Although fees and costs are the primary disadvantage of mutual funds, they also have some other disadvantages.

“Another huge toll has been taken by taxes. Passively managed index funds are tax-efficient, given the low turnover implicit in the structure of the Standard & Poor’s 500 Index.”

John C. Bogle

5.5. WHAT ARE THE DIFFERENT MUTUAL FUND CATEGORIES?

Worldwide, tens of thousands of mutual funds are available. In 2018, the United States alone had 9,599 mutual funds. Two ways to categorize these funds is by their asset type and by their investment strategy. The next question examines investment strategy. Here, the focus is on the primary groups of funds. The following list is ordered by the fund’s general level of risk with the lowest risk shown first. Note that risk and expected return are positively related. Thus, they’re also ordered by their relative expected return with the lowest expected return presented first. Note that Figure 5.1 illustrates the basic fund type and its associated risk and expected return.

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Figure 5.1. Figure 5.1. Mutual Fund Categories and Their Risk and Expected Return

“Mutual funds have historically offered safety and diversification. And they spare you the responsibility of picking individual stocks.”

Ron Chernow

5.6. WHAT ARE THE DIFFERENT INVESTMENT STRATEGIES OF MUTUAL FUNDS?

Funds within each mutual fund category can invest for different investment goals. For example, one large-cap stock fund could seek capital appreciation by trying to buy stocks that increase in price, while another fund could seek income by owning high-dividend paying companies. Thus, the two funds’ portfolios would have little overlap even though they’re both large-cap funds.

Other common investment strategies are those associated with the growth/value dimension. Companies are often delineated by their growth versus value prospects. Growth stocks are expected to grow at a faster than average rate. In contrast, value stocks are shares of a company with strong fundamentals that are priced below those of their peers. Value stocks provide a lower relative price. Common measures of growth and value are the stock’s price-to-earnings (P/E) ratio and book-to-market (B/M) ratio, respectively. A lower stock price compared to earnings per share indicates a value stock. A higher P/E ratio is associated with a growth stock. Similarly, a higher book value (B) per share compared to the stock price (M) indicates a value stock. Growth stock mutual funds own many high P/E ratio and low B/M firms. Value funds own low P/E ratio and high B/M firms.

5.7. WHAT IS AN INDEXED OR PASSIVELY MANAGED FUND?

The old saying, “if you can’t beat them, join them,” has worked well in the mutual fund industry. Traditionally, all mutual funds shared a common goal of beating the stock market or their respective benchmark. Then, in 1976, John “Jack” Bogle, the founder and chief executive of The Vanguard Group, had a different idea – just try to match the market. Some derided this idea as only trying to be average and labeled it Bogle’s Folly. However, because of the high fees funds charged in those days, most funds didn’t beat the market. In fact, they underperformed. If a fund could match the market, it would rank much better than average. The idea was to form a portfolio that mimicked the S&P 500 Index with very low fees. Since the investment company didn’t need to hire expensive portfolio managers, it could charge an extremely low management fee to fund investors. Also, since the stocks in an index rarely change, the fund would have little turnover and experience lower associated trading costs. With the start of the Vanguard 500 Index mutual fund (VFINX), the indexed fund was born. Formally, a passively managed fund, also called an index fund, invests using a strategy to match the performance of a stock index. An actively managed fund has a manager or team choosing investments with the objective of outperforming the fund’s benchmark or market index. The mutual fund industry now differentiates between actively managed and passively managed funds. Today, index funds hold more than one-fifth of the total mutual fund AUM. Clearly, Bogle’s idea was not folly but quite savvy! The competition from the growth of index funds has caused actively managed funds to lower their fees. Now, the average expense ratio for actively managed stock mutual funds is around 0.76%. The largest stock index funds’ expense ratio averages only 0.08%. In 2018, Fidelity Investments announced two zero-cost index mutual funds – the Total Market Index Fund and the International Index Fund. The cost of trying to mimic an index has become negligible and thus should be an important part of a savvy investor’s portfolio.

5.8. WHAT DO ACTIVELY MANAGED MUTUAL FUNDS TRY TO ACCOMPLISH?

Actively managed funds don’t try to mimic the return of a particular index. Instead, they try to beat it. If you owned all of the same stocks in an index and owned them in the right proportions, you’d earn exactly the index return. To beat that index return, you need to do something different. You could invest in a subset of the index’s stocks, own different proportions of each stock than represented in the index, or both. Active portfolio managers use their research, experience, and intuition to select stocks to buy and sell. If the fund holds the better performing stocks but not the underperforming ones, it will beat the market. Because stocks are risky, their prices fluctuate. If fund managers can time the market fluctuations to buy stocks at low cycle prices and sell at cycle highs, they’ll beat the market. Sound easy? It isn’t. Because mutual funds and other institutional investors hold most of the stocks and do most of the trading, they can’t all beat the market. If some funds hold the outperforming stocks, then other funds likely hold the underperforming ones. When one fund buys a stock, another fund is likely selling it. You might, therefore, think that for every fund beating the market, another is underperforming. That is, half the funds beat the market and half don’t. Unfortunately, that’s not true because of the fees that mutual funds charge. Active funds charge higher fees than index funds. So, in the end, abundant research evidence shows that most actively managed funds underperform the market net of fees and expenses. Because of that, index funds tend to outperform most actively managed funds over time.

“Santa Claus and the Easter Bunny should take a few pointers from the mutual-fund industry. All three are trying to pull off elaborate hoaxes. But while Santa and the bunny suffer the derision of eight year olds everywhere, actively-managed stock funds still have an ardent following among otherwise clear-thinking adults.”

Jonathan Clements

5.9. CAN YOU JUST SELECT THE ACTIVELY MANAGED FUNDS THAT OUTPERFORM THE MARKET AFTER FEES?

“The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently.”

John C. Bogle

That turns out to be difficult to do for several reasons. First, the stocks that outperform one quarter are often not the same stocks that outperform in the following quarters. Thus, active managers need to rotate their holdings to try to keep picking the winners, which involves trading costs. Second, funds that do well for several quarters attract much more money to invest because investors chase these winner funds with their investment stake. This phenomenon is called herding. The larger the portfolio becomes, the more difficult it is for fund managers to invest in the subset of stocks they think will outperform. Finally, discerning manager talent from luck can be difficult, especially in the short run. What if it’s just luck that causes the subset of the stocks in the index a manager selects to outperform? After all, a broken clock is right twice a day.

Say that you find 64 actively managed mutual funds with a small-cap growth objective. Like flipping a coin, half of them, 32, will outperform one quarter. Half of those, 16, will outperform two quarters in a row, and 8 will do so for three quarters. Only about four will outperform in all four quarters of the year. So, when you see a fund has outperformed in every quarter of the year, was this performance based on investment skill or just luck? Because differentiating between manager luck and skill for short time periods like a few years is so difficult, savvy investors have moved to passively managed, low-cost index funds.

5.10. WHAT FUND CHARACTERISTICS SHOULD YOU EXAMINE?

You should pick a mutual fund based on specific characteristics that suit your situation. The main factors that are likely to drive a fund’s suitability for you revolve around strategy, cost, and performance. Performance evaluation is discussed in the next question. Ultimately, a fund’s return depends on the performance of the underlying securities in the portfolio. Thus, the type of assets and the strategy for selecting them is paramount. Besides performance, you should consider the following factors.

5.11. HOW CAN YOU EVALUATE THE PERFORMANCE OF A MUTUAL FUND?

The answer to this question may seem like it should simply be “historical return.” However, evaluating a fund’s performance is more complicated. A basic principle in finance is the risk–return trade-off. That is, a positive relation exists between risk and expected return. Over time, if you take more investment risk, you should earn a higher return. Therefore, when you see that one stock mutual fund earned a higher return than another, it could simply be that it took more risk, which doesn’t make it a better fund, just a riskier one. Additionally, a stock fund’s performance over time depends on how the market performs in general. Therefore, you should consider both risk and the contemporaneous market return when evaluating a fund’s performance. Popular strategies for evaluation include computing a risk-adjusted performance, comparing performance to indices or other funds with similar risk, or both.

Three major types of risk-adjusting performance methods are prevalent in the industry. To adjust for risk, you first need a measure of risk. Two common risk measures are the standard deviation of historical returns and beta. A high standard deviation indicates high total risk because it means that the return varies considerably and is unstable. Beta is a measure of market risk, also called systematic risk, that indicates the relation between a fund’s return and the return on a market index, such as the S&P 500 Index. A higher beta indicates a stock or portfolio has more market risk. That is, the stock or portfolio is more sensitive to market movements than the overall market, which has a beta of 1.0. For example, a stock with a beta of 2.0 would return twice the market return in a given period. Thus, if the market as measured by the S&P 500 increases 3%, the stock would be expected to increase 6%.

Three common risk-adjusted measures are:

Where can you find Sharpe ratios, Treynor ratios, and alphas for the funds you’re researching? One common source is Morningstar.com. You can get information like the performance of Fidelity Growth Strategies, which is in the mid-cap growth category of funds. For the past three years (ending September 2019), the fund’s alpha was –0.78%, which is negative but still better than the category average of –1.09%. The fund’s Sharpe ratio of 0.85 beat the category average of 0.80. Although the fund beat the average performance of its category, it underperformed its benchmark index, the Russell Mid-Cap Growth Index. The Index alpha was –0.04% and its Sharpe ratio was 0.91. Underperforming a benchmark index is common because funds charge fees, have trading costs, and need to hold some cash to facilitate redemptions. In contrast, indexes have none of these limitations.

A comparison with the fund’s category and benchmark is a common way to assess its performance. Two popular mutual fund information services conduct this analysis using category rankings and performance indicators.

“The best-known stars are, of course, those funds awarded top five-star billing by Morningstar Mutual Funds.”

John C. Bogle

5.12. HOW DO YOU INVEST IN A MUTUAL FUND?

You buy and sell mutual fund shares in specific amounts. This approach differs from buying stocks where you purchase a specific number of stock shares which, along with the price, determines the amount of the purchase. For example, to buy 100 shares of a stock priced at $35 per share requires investing $3,500 plus commission costs. When buying fund shares, you choose the amount of money to invest and the NAV determines the number of shares purchased. When you invest $3,000 in a mutual fund with an NAV of $25.35, you will get 118.3432 shares. Yes, you read that correctly, you can own fractional shares of a mutual fund.

You don’t need a brokerage firm to buy mutual fund shares. You should go directly to the mutual fund family’s web page to fill out the forms. The minimum initial investment in a mutual fund usually varies between $100 and $3,000. Some funds waive the minimum when you sign up for monthly automatic investments.

5.13. WHAT IS AN ETF?

ETFs have become a popular investment tool for both individual and institutional investors. An ETF is similar to an open-end index mutual fund in several ways. An ETF is created when a financial institution forms a portfolio that is designed to mimic a specific index. Like an index mutual fund, it is a passively managed portfolio and the largest ETFs have a very low expense ratio of less than 0.20%. The main distinction is that shares of an ETF are issued like a company’s stock. To buy ETF shares, you must buy them like you’re buying shares of a company. For example, the SPDR S&P 500 ETF (with ticker symbol SPY) tracks the S&P 500 Index. It is usually one of the most traded stocks on the stock exchange and averages 70 million shares traded per day. Remember, you buy shares of a mutual fund from the fund itself, including fractional shares. Buying shares of an ETF involves a brokerage account, which may charge a commission and the purchase of whole, not fractional, shares. Compared with open-end funds, this difference involves several advantages and disadvantages.

5.14. WHAT ARE THE ADVANTAGES OF USING ETFS?

ETFs have gained popularity for several reasons.

“The reason why ETFs are a phenomenal success is that they solved a lot of problems clients faced with mutual funds, namely surrounding transparency, liquidity, costs and tax-efficiency. Remember, we have been working on developing the ETFs for 15 years before it finally caught on and became popular.”

Robert S. Kapito

5.15. WHAT ARE THE DISADVANTAGES ASSOCIATED WITH INVESTING IN ETFS?

Despite their popularity due to their flexibility and advantages, ETFs also have several disadvantages.

“The ETF industry has become like a supermarket. You can’t go in and not know what you want-you’ll end up buying all these things that you won’t ever eat.”

Matthew Reiner

5.16. FOR WHAT ASSET CLASSES AND STRATEGIES CAN INVESTORS USE ETFS?

ETFs are useful for both diversification and engaging in many different types of investment strategies. Below are some examples of the types of ETFs available in the three asset classes of stocks, bonds, and alternative investments. The alternative asset class includes commodities, real estate, currencies, and other investment opportunities. ETFs typically don’t include other alternative investments including hedge funds, private equity, and infrastructure.

“In the ETF world you can be in any sector at any point. You can now invest more like institutions. Prior to this big explosion, retail investors couldn’t invest that way.”

Nadav Baum

5.17. HOW CAN YOU USE MUTUAL FUNDS AND ETFS TO ACHIEVE YOUR INVESTMENT GOALS?

You should begin by determining your investment goals. These goals depend on your personal situation such as your risk tolerance, wealth level, age, and income. As discussed in Chapter 4, your financial goals lead to your desired portfolio allocation. Assume that you want to allocate 70% of your investment portfolio to equities, 25% to fixed income, and 5% to cash assets. Let’s look at two scenarios using this allocation scheme.

“I do love ETFs. I’m not a big stock picker, and I think, generally speaking, you do better with an index.”

Ben Stein

Many other ways are available to include funds in a portfolio. For example, someone with a high level of income and wealth might use a municipal bond OEF with a focus on her state of residence for a portion of non-retirement plan money to shelter some income from taxes. An investor who stays knowledgeable about the general economy may want to rotate some assets among different sector ETFs. Rotating between investment in the sectors of technology, health, energy, and financial is a form of market timing. Although successfully timing the market leads to higher returns, doing so is difficult and can lead to lower returns from mistiming. Because of their flexibility, you can use mutual funds and ETFs to implement almost any investment strategy. Savvy investors recognize the incredible choices and flexibility of ETF products!

5.18. WHAT ONLINE RESOURCES ARE AVAILABLE FOR MUTUAL FUNDS AND ETFS?

The following are commonly used online resources for finding mutual funds and ETFs.

5.19. TAKEAWAYS

Mutual funds are a popular and important PIV for nearly every investor. In some cases, such as an employer-sponsored retirement plan, you can’t avoid them. Savvy investors can implement nearly any investment strategy with mutual funds and ETFs. Here are some key lessons from this chapter: