Long-term Investing: Mutual Funds and Index Funds
An introduction to long-term investment strategies.
Even if you are not a professional investor, you’ve probably heard people talk about Index Funds and Mutual Funds. I will introduce you to these very important and potentially profitable financial instruments that can help you build wealth. As I talk about in previous articles, I am a fan of long-term investing and these tools are the building blocks of long-term wealth creation.
When people start out trading they are confused by all of the instruments that are available to trade, even if you just stay with stocks. Just imagine, you can trade individual stocks, mutual funds, index funds, and ETFs, not including the other types of instruments like options, futures, or forwards. It’s intimidating! When people don’t know what stocks to buy or where to put their money, I like to tell them to invest in index funds. Jack Bogle, one of the most respected investors of our century, was always a fan of index funds, as shown in my favorite quote if his:
Don’t look for the needle in the haystack. Just buy the haystack!
Index Investing
When people refer to index investing, they mean investing your hard earned savings in index funds. An index fund can be a mutual fund or an exchange-traded fund (ETF). For example, I talked about Jack Bogle, who started The Vanguard Group, which offers an index fund that tracks the stocks within the S&P 500 index. This fund is called Vanguard 500 Index Fund Investor Shares ( VFINX). So if you invest in this, what do you actually invest in? This index fund tracks a specified basket of underlying investments, in this case the companies that are within the S&P 500 index, which are the 500 largest American companies. In the past 10 years, the fund returned ~14% on an average annual basis, which matches the S&P 500 index.
What’s also great about these funds is that they have a very low fee compared to, for example, a mutual fund. The VFINX has an expense ratio of 0.14%, which just means that the fund will deduct 0.14% from your assets every year. So if you have a $10,000 investment, it will cost you $14 each year, which is a minuscule fee compared to the annualized return of ~14% in the past 10 years.
Index funds are also called passive funds which mean that they are not actively managed by professional money managers. As mentioned before, index funds just simply track a given index and are only changed when there are stocks added or taken out of the index. So for example, if there are rumors that Tesla (TSLA) will be added to the S&P 500 index, then all of the index funds that track the benchmark index will most likely add Tesla to their index fund.
Rebalancing
A couple of interesting topics when it comes to both mutual funds and index funds are rebalancing and the turnover ratio. When money managers rebalance a portfolio it safeguards the investor from being overly exposed to undesirable risks. Secondly, rebalancing ensures that the portfolio exposures remain within the manager’s area of expertise. Rebalancing is the process of realigning the wight of portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk. If we have a fund that invest 60% in stocks, 20% in bonds, and 20% in foreign exchange, then based on the manager’s strategy, they will try to keep that portfolio balanced. If the manager has a calendar rebalancing strategy, then they will choose a date on which to look at the portfolio and if the weights are different from the original weights, then they will sell or buy assets so that the weights get rebalanced.
Turnover Ratio
Fund turnover typically measures the replacement of holdings in a mutual fund and is commonly presented to investors as a percentage over a 12-month period. If a fund has 100% turnover, the fund replaces all of its holdings over a 12-month period. This is an important concept as a high turnover rate means higher transaction costs and higher commission costs which will decrease overall annual returns. In general, a smaller turnover also means a higher quality fund, but it also depends on the manager’s investment style. A growth fund tends to have a higher turnover ratio as these funds invest more actively and look for opportunities nonstop, while index funds have a very low turnover ratio as the assets within an index fund only change when there is a new company added to the index. Based on data from Morningstar, in a 5-year period funds with a lower turnover ratio outperformed funds with a high turnover ratio. Naturally, there are a lot of factors that influence performance, but turnover ratio could be one of those factors.
Index funds are a big deal when it comes to investing with close to 45% of all US-based investments being held in passively managed funds.
The advantages
- Less time to create a portfolio as you just invest in one fund, rather than pick dozens of stocks yourself.
- Less risk than individual stock picking since your fund will contain dozens of different stocks from different sectors, therefore it will be diversified.
- Less expensive than actively managed funds.
The disadvantages
- If you invest in once specific index fund, such as the S&P 500, you will never beat the market as these index funds track the market, so very similar returns will be generated to the actual index.
- Since you own dozens of stocks, some stocks will be better than others, but this is the price of a diversified portfolio
What are Mutual Funds?
Mutual funds are also a great way to set up a diversified portfolio without you having to pick stocks yourself. Mutual funds are professionally managed investment funds that pool money from many investors to purchase securities. The main idea of these mutual funds are that people have the option to buy a fund that has dozens or even hundreds of shares of some of the best companies for cheap and they don’t have to hand pick these stocks themselves and spend more than $3000 on one single share.
Mutual funds are great for people who would like their money to grow without having to pick stocks themselves and be professionally managed. We have to talk about passively and actively managed funds when we talk about mutual funds. Passive funds are like index funds that track an index and is not managed by professionals. Actively managed funds are a bit different. These funds are managed by professional portfolio managers who hand pick stocks that they believe will perform well in the long run. On average, mutual funds hold around 40 shares which means that by buying a mutual fund you are able to pocket the gains (or losses) from the performance of those 40 companies.
Let’s take an example. I have a position in the Artisan Developing World Advisor Fund ( APDYX), which is a developing world fund and has 35 stocks within its holdings. So far, I believe it is a great fund as I wanted something that can track the developing world as I believed that those markets and stocks are undervalued, especially after the pandemic. It’s holdings include Visa, Alibaba, NVIDIA, etc and has returned ~24 so far this year. These returns come with a price though. The fund’s expense ratio is 1.18%, which is an average fee in my experience.
But choosing a Mutual Fund can get tricky. There are 9,599 mutual funds on the US market all offering something unique. First, you would have to decide what you are looking for. Is it wealth creation? Quick cash? Investing in a specific sector or country? Second, you will want to look at market analysis on the specific funds that are out there for your specific needs. A quick Google search will help you narrow down your process.
Additionally, US News is a great platform to find most of the funds available with ratings, descriptions, and fees. Once you have about 5–6 potentially good funds, start looking at what the market says about these funds. Look for analysis, look at the holdings, and check out the portfolio managers and their records.When you’ve found a fund that you like, you can invest in it through your broker.
VERY IMPORTANT
Investing in a mutual fund means that you will have to pay a redemption fee if you want to sell your shares in a short amount of time, usually specified by the fund. These fees can reach 36% of your investment which implies an average holding period of 35 months, which is fairly short given that equity mutual funds tend to be considered a long-term investment.
The advantages
- Less time to create a portfolio as you just invest in one fund, rather than pick dozens of stocks yourself.
- Professionally managed portfolio of stocks which are actively managed (unless you bought an index fund).
The disadvantages
- On average, mutual funds don’t beat the market, but there are some funds that do, so there is a chance.
- High expense ratio as the average is between 0.5%-1%, while index funds have an expense ratio of 0.2% on average.
- Redemption fees reach 36% on average.
Investing is super fun and exciting so learn the basics and try yourself at it. I would like to close this article with a famous quote from Benjamin Graham:
Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.
Thanks for reading and the next article will be about what long-term investing actually means and I will also share some of the mistakes I made and what you can learn from those.
Read my other articles about investing during the earnings season or about analysing market recaps.
See ya next time! 👋
Originally published at https://www.spawner.ai on August 10, 2020.
