Continued from yesterday’s stage one post.
Stage Two – Mutual Fund and ETF Investors
After saving up some money to invest, the next decision is where to put it to make more money than a CD or savings account can make. For many, the first stop is mutual funds. They have the best marketing and continually tell us how great they are. Eventually it’s hard not to succumb to their stories of success and we turn over our money for their “expertise” even with knowing that past results are no indication of future returns.
In the movie “The Waterboy” Kathy Bates’ character, Mama, might have said “Mutual Funds are the Devil” if she was asked. Then again everything was “the Devil” to her. Still, this is how I feel about mutual funds. They have a certain evil element to them. As you can read in just about any financial magazine report, mutual funds do not beat the indexes on average. Obviously some do, but not the majority. Many of them charge high fees to help pay the highly compensated fund managers and their staffs and of course for the marketing of the funds to new investors.
Along with not beating the major market indexes and additional fees, mutual funds have another downside when used in a taxable account. Any capital gains distributions are passed on to the investors on record when an equity is sold. On the surface that can sound harmless – you’ve made the money and now you have to pay taxes. What if you bought into the fund after the gains were made? What if you actually took a loss on the fund? I’ll give an example to make my point a little stronger. Around the time of the dot com bust, I jumped in on a mutual fund devoted to science and technology. They had enjoyed a great long run and I decided it was time to get my share of it. I bought, the fund came down before I got out and I took a loss only to find out that during the time I was holding the fund they sold some of their biggest gainers. I was taxed on those capital gains distributions even though I had taken a loss on my stint with the fund.
These high fees, sub-par returns and tax challenges led to the growth of index funds. Index funds reduce these negatives. They aim to return same gains and losses as the market averages. Their goal is mediocrity which is obviously better than the sub-par returns their mutual fund siblings are bringing home. They have small turnover of holdings so trading fees are reduced and drastic capital gains distributions are reduced. When mutual fund investors start seeing how they could have had better after-tax, after-fee returns returns with index funds they tend to move their money in this direction. Not to confuse the situation, but index funds are still mutual funds, just with different stripes.
Eventually investors discover the simplicity of Exchange Traded Funds (ETFs). ETFs come in nearly every variety now. You can buy into any sector or index using an ETF while keeping the low turn-over rate found in index funds. Fees are even lower in ETFs than index funds too. One of the other added benefits of an ETF is that they trade like stocks. Investors don’t have to wait until the end of a trading day to enter or exit a position. If good news is announced an investor can be a part of the rally in just a few clicks of the keyboard. The same is true for exiting a position. ETFs can be used to hedge other investments too, but that’s more stage three and four activity.
ETFs are like a gateway drug to investing directly in stocks. Investors still have the false sense of safety by diversification while having the ability to get in and out of positions whenever they want. While I certainly have little respect for mutual funds, ETFs can be a reasonable alternative for those who want to leave their money somewhere and not be bothered with it aside from a yearly rebalancing of holdings. Even for an investor who wants to be more active, ETFs offer so many niche plays that one could jump between sectors as the tides change.
Spending some time in mutual funds (ugh) or ETFs still has its merits. This period offers investors who still need to learn the basics of investing time to study without losing big as much money due to their inexperience. Certainly someone could spend time studying the market with no money invested, but having money at risk gives more incentive to study harder and learn how your emotions react to the ebbs and flows of the markets’ rhythms. With my sincere distaste for mutual funds, I think a better starting move for a beginner is to aim for building up a diverse collection of ETFs. Vanguard offers VB, VO, VV and VWO, among others, which cover small-caps, mid-caps, large-caps and emerging markets respectfully.
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