Charles Rotblut recently spoke at the 2017 AAII Investor Conference. For information on how to subscribe to recordings of the presentations, go to www.aaii.com/conferenceaudio for more details.
Applying portfolio concepts to the actual selection of investments requires not only understanding the characteristics of each asset class, but also the vehicles that comprise the actual investment. In this month’s column, I discuss the characteristics of five types of investment vehicles you may consider using: individual securities, mutual funds, exchange-traded funds, closed-end funds and annuities.
To be clear, an asset class and an investment vehicle are not the same thing. An asset class is a broad category of investments and securities with similar characteristics. An investment vehicle is a means for investing in a particular asset class. For example, an ETF can enable you to invest in bonds.
The most direct way to invest in a company is to buy a security issued by it. This can be a common stock, preferred stock or a bond. Purchasing individual securities provides the most control over what is held in your portfolio. (Common stock also provides the most direct exposure to any upside, and downside, experienced by a particular company.)
Securities are most commonly purchased through a broker, who facilitates a trade through an exchange, such as the New York and NASDAQ Stock Exchanges. Expenses, including brokerage commissions, are incurred when ownership changes.
Comprehensive analysis of the underlying company is required before and after a security is purchased. Any decline in the security’s value will directly impact your wealth. Prudence must also be used to ensure that the security provides diversification within the portfolio. Taxes are realized at the time dividends or interest payments are received and when the security is sold—if the investment is held in a taxable account. (No taxes are incurred if the security is held in a tax-deferred account, such as an IRA.)
A mutual fund is a pooled set of investment dollars. This means every shareholder owns a proportionate part of the mutual fund’s assets. The advantage of pooling assets is that it allows individual investors access to professional money management for a comparatively small minimum investment. Since most mutual funds hold many securities, they provide more diversification and are less likely to be impacted by the volatility of a single company.
Mutual funds are purchased from a mutual fund company. (A brokerage firm can facilitate this transaction if you do not want to set up a separate account with a mutual fund company.) Since a mutual fund is comprised of pooled investment dollars, a new investment increases the size of the fund’s assets and a withdrawal decreases it. Though most daily transactions have a nominal impact on the fund’s total assets, large inflows or outflows of cash can alter the fund’s investment strategy.
Although a mutual fund offers access to professional money management, many actively managed mutual funds underperform their benchmarks (e.g., the S&P 500 index). However, some mutual funds are designed to mimic the performance of an index, rather than beat it. Diversification differs by fund, with some specializing in a specific industry or country. Other funds may target stocks of a certain market capitalization (e.g., large-cap), invest in bonds (including municipal, corporate or international), or seek to achieve a return opposite of a major index (“inverse funds”). Holdings between funds can overlap significantly, meaning the diversification benefits of owning several mutual funds may not be as great as they seem. Thus, it is important to read a fund’s prospectus before buying shares and to regularly read the annual reports after purchase.
Mutual funds charge an annual fee to cover the cost of management and other expenses, such as marketing. A fee may also be charged at the time of purchase (a front-end load) or the time of withdrawal (a back-end load or redemption fee). Taxes can be incurred if the mutual fund distributes a dividend or realizes a gain on assets that it sells.
An exchange-traded fundis a portfolio of securities that is traded on a stock exchange. Unlike a mutual fund, an investor does not make a direct investment into a portfolio of pooled assets. Rather, an ETF issues a block of shares that is then traded on an exchange. Shares are bought and sold between investors as opposed to through the fund itself.
This difference impacts both expenses and taxes. Since there are few inflows and withdrawals, an ETF has lower overhead expenses than a mutual fund and charges lower annual management fees. Furthermore, the unique structure of ETFs means that capital gains are not passed through to shareholders when a security is sold at a profit from the underlying portfolio. However, dividends are passed through to shareholders and are taxable. Additionally, an ETF may trade at prices above or below the value of its underlying investments, especially if the number of shares traded on a given day is not very high.
ETFs have traditionally been designed to track an index—typically stock indexes, though some ETFs track bond or commodity indexes. Though this results in fewer buy and sell transactions by the fund, the performance is only as good as the manager’s ability to track the index and the construction of the index itself. Many indexes have been custom-designed to follow a specific asset class, industry or country. There are some actively managed ETFs that rely on the security-selection abilities of a fund manager, but these currently account for only a small fraction of all ETFs.
As is the case with mutual funds, it is important for investors to read the ETF’s prospectus and annual report. Diversification is also an issue, especially when using sector or industry-specific ETFs. Since holdings are frequently updated—typically daily—it is much easier to determine whether the holdings of one ETF overlap those of another.
Closed-end funds are professionally managed portfolios whose shares trade on a stock exchange. They typically hold several securities. They can target a broad asset class such as stocks or bonds, or a specific sector, industry or country.
Unlike mutual funds or ETFs, closed-end funds have a fixed amount of outstanding shares. This means there are no new inflows or outflows of capital from investors. (Some closed-end funds are allowed to temporarily open up to new investment dollars, but such occurrences are rare and infrequent.) Since there are a fixed number of shares, closed-end funds can trade at prices above or below the value of their underlying assets. These premiums and discounts are influenced by both how actively traded the closed-end fund is and by the sentiment toward the fund’s investment strategy.
Fees are charged for managing the fund. Transaction costs are encountered at the time the closed-end fund is bought or sold, and include brokerage commissions and bid-ask spreads. In addition, any capital gain realized on the sale of an underlying security is passed through the shareholders, just as with mutual funds.
Investors should read the prospectus and annual report. In addition, compare the holdings against other investments to ensure there is no overlap.
An annuity is a contract between an investor and an insurance company to provide a stream of payments at a specified date. This is a key difference from other investment vehicles—annuities are designed to provide a stream of cash flow, as opposed to an investable portfolio that may or may not provide a stream of cash flows in the future via withdrawals made by the investor or the distribution of income (e.g., interest payments from the bond portion of the portfolio).
The rate of return can be tied to an agreed upon minimum level (fixed annuity), the performance of various investment portfolios (variable annuity), or the performance of a stock index (equity-indexed annuity). The last option provides a minimum level of return and also a capped level of maximum return. In other words, the rate of return for an equity-indexed annuity can significantly trail that of stocks during a bull market period.
Annuities can provide tax-deferred growth, but they have higher fees relative to other investment vehicles. Read the contract thoroughly and consider the credit rating of the issuing firm. Costs are an issue, especially since fees can be high for exiting an annuity before the specified contract date. Finally, an annuity should be considered in the context of a broad portfolio to ensure proper diversification is maintained.
The determination of what investment vehicles to use is based on a variety of factors including wealth, investment goals, and how involved you want to be in analyzing individual securities. Keep in mind that each investment vehicle is not mutually exclusive. Rather, many investors use a combination of the aforementioned investment vehicles. The key is to ensure that each investment is unique and adds to your overall diversification.