We left off in Part 4 with a question: With literally tens of thousands of options out there for individual stocks and bonds, how does anyone know which ones to pick for their portfolio? And doesn’t building a well-diversified portfolio of both stocks and bonds get very complicated, very quickly? (Okay, okay…that was two questions.) The answer is, fortunately, there is a much better option: funds. Funds come in two main forms—mutual funds and exchange-traded funds (ETFs)—that make it much easier to build a well-diversified and simple portfolio, and one that gives up nothing in potential returns. Let’s look at what these investments are.
Mutual Funds and ETFs
A mutual fund is a type of investment created by a brokerage firm that, in simplest terms, is a collection of stocks, bonds, or other assets. Stock mutual funds are the most common, so most of the time we will be referring to these in our discussion. The composition of these funds can be almost anything; for example, you could have a mutual fund made up of technology stocks, or stocks only from large companies, or a mutual fund made up of government-grade short-term bonds, or even containing stocks only from companies that begin with the letter “A” (though I can’t imagine the strategy to this one…). Mutual funds are sold in units called shares.
As investors buy shares of the mutual fund, they are essentially buying shares of all the stocks that the fund holds. This allows for instant diversification; an investor, by purchasing so much as one share in a mutual fund, can be invested in all the stocks within that fund—and some mutual funds contain hundreds, if not thousands, of stocks. This alone can simplify the process of investing for many people. Mutual funds are also professionally managed. A fund manager in charge of the fund is responsible for overseeing it, and for picking the assets that comprise it. It’s important to note that this is not always a benefit; fund managers are often not as skilled as we would like to believe, and the costs associated with their services and buy/sell decisions can significantly erode an investor’s bottom line. More on this later.
Mutual funds allow for instant diversification; an investor, by purchasing so much as one share in a mutual fund, can be invested in all the stocks within that fund.
Exchange-traded funds (ETFs) are very similar to mutual funds, in that they are also funds comprised of other assets. The key difference is that ETFs are traded on exchanges, much the same way that stocks are. This leads to some differences in the way ETFs operate that are important to understand. For now, though, this is all you need to know; we are going to get a lot more in-depth regarding the differences between mutual funds and ETFs later on (in Part 8).
Index investing is a strategy that involves investing your money in a type of mutual fund (or ETF) called an index fund. Now that we have a basic understanding of what mutual funds and ETFs are, we need to understand what makes a fund an index fund. Here’s the basic idea: Index funds are constructed to mirror the makeup and performance of any of several market indexes, or even of the entire stock market.
A market index is, in simplest terms, a model used to measure the performance of the stock market, or a part of the market. There are many market indexes used today, and you have probably heard of some of them: the Dow Jones Industrial Average, the Nasdaq, the S&P 500, and the Wilshire 5000 are all examples of market indexes. All track the market in different ways. As an example, the S&P 500 is a popular index that tracks around 500 of the top companies in the United States. The companies in the S&P 500 are so large and influential that the index represents (by weight) approximately 82% of the entire U.S. stock market. As such, it is sometimes used as a proxy for tracking the entire stock market; this will become important later when we talk about fund selection.
Active and Passive Investing
Before we move on from our discussion of funds, there is one more important thing to understand: there are two competing philosophies when it comes to how a fund is managed—and this, perhaps more than anything else, will determine the kind of experience you will have with a given fund. These competing philosophies are known as active investing and passive investing.
Active investors aim to beat the market (earn a higher rate of return than the market). They do this largely by trying to predict movements within the market and profit from them. This can take many forms, such as attempting to predict the next big growth stock, trying to capture the short-term price jumps of certain stocks (this is known as swing trading, or day trading), or anticipating overall market gains/losses (and buying/selling appropriately). This game is the game of speculation, and this approach involves a level of time, effort, and risk that is not commensurate with the reward. Most active investors, even professionals, have been shown to underperform the market significantly over the long term (we’ll look at a couple of studies on this in Part 6). The reasons for this mainly have to do with the sheer unpredictability of the market (as an example, consider the wild fluctuations in the market recently caused by the COVID-19 pandemic), and the significant costs associated with this type of investing. Fees and expenses have a corrosive effect on an investor’s rate of return, especially when compounded over time.
Most active investors, even professionals, have been shown to underperform the market significantly over the long term.
Passive investors, on the other hand, aim simply to match the return of the market (or a benchmark index within the market). This approach does not involve speculation. Instead, it picks a market index—or even the entire market itself—and selects investments with the aim of matching the return of its chosen target. If done correctly, this approach will not significantly exceed, nor significantly drop below, the performance of its target. (The ability of a passive investment to mirror the performance of its target is called index tracking). Unlike active investing, passive investing does not react to specific market conditions; it simply accepts the volatility of the market as a given condition that will always be present, and relies on the construction of a solid portfolio to weather whatever storms may come. While this investing approach might sound at first like it has less potential, when the costs of active investing are figured in, passive investing pulls ahead nearly every time. Costs matter.
All funds are governed by one of these two management philosophies, and as such, there are (broadly speaking) two main types of funds: actively managed funds and passively managed funds. Let’s look at both of them.
Passive investing simply accepts the volatility of the market as a given condition that will always be present, and relies on the construction of a solid portfolio to weather whatever storms may come.
Actively managed funds have a fund manager who aims to beat the market (or benchmark index). This manager buys and sells stocks within the fund (often frequently) to achieve this, and the fund’s success or failure is largely determined by its performance against the market or index it competes with. As we will see in Part 6, net of costs, very few do better than the index over time. As I said earlier, the costs associated with this approach can be significant: transaction/commission fees are charged for most buy/sell orders for stocks within the fund; in addition, the manager typically charges a significant fee for management services; and so on.
Passively managed funds, on the other hand, still have a fund manager, but this person is relatively hands-off. This is largely a “set it and forget it” style fund. Passively managed funds aim to mirror a selected market index, or even the market itself. The role of the manager in these types of funds is solely to pick the stocks that mirror the chosen index, in the same proportions as the index, and let it run; stocks are only added or taken away as the index changes, which is relatively infrequent. This is an important distinction, because as noted above, there are typically costs associated with every buy and sell order, and these are ultimately passed on to investors in the form of higher fund expenses.
As you might have guessed (I wager the name gave it away), index funds are simply passively managed funds that aim to match the performance of their given market index. So, an S&P 500 index fund is comprised of largely the same stocks as the S&P 500 index, and due to this, achieves almost identical performance. A U.S. total stock market index fund—which chooses the entire stock market as its index—might have literally thousands of individual stocks, with the intention of “owning” the entire U.S. stock market. Stocks within these funds are weighted so that they match the respective market capitalization of the stocks within the actual index (or the market itself). All of this means that they are designed to—and realistically do—mirror the index with a high degree of accuracy. And, because they are passive funds, fund costs are kept rock-bottom. This is key.
In our discussion of index funds, we have already covered one of the major benefits they have over other kinds of funds: lower costs. There are many others: simplicity, diversification, higher than average rate of return, no “human factor” risk, low maintenance, tax efficiency, and more. In Part 6, we will cover each of these in more depth and show you that the case for index funds is truly compelling.
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