Tuesday, 24 April 2012

Understanding different types of funds

Hello again, I hope you’ve had a good week. I’m going to get slightly technical this week – but hopefully not so technical that it’s difficult to follow. If you do find it a bit hard-going, skip to the last couple of paragraphs…

Anyway, I was actually posed some questions from a regular reader about the similarities and differences between Exchange Traded Funds (ETF’s), Mutual Funds, and Index Funds – and as all are increasingly common forms of investment, I thought it may be of interest to other readers too.

Firstly, what are they?

Any grouping of shares on a stock market is referred to as an Index - but not the market itself. So for example, the London Stock Exchange is not an Index – but the FTSE 100 is (the top 100 companies listed on the London Stock Exchange, based on their value, which in turn is based on their share price). So is the FTSE 250, and the DJIA, and so on.

An Index Fund is a type of investment which aims to track a particular Index, rather than outperform it – thereby giving investors the option of investing in a passive way. (No decisions are made by anybody in terms of what to invest in, or when to buy/sell – it just follows the crowd). An Index Fund can be either a Mutual Fund (most common) or an Exchange Traded Fund (ETF).

A Mutual Fund is known by several other names – “Mutual Fund” tends to be the term used in the USA, but is the same thing as what people in the UK would normally call a “Unit Trust” or an “OEIC” (Open Ended Investment Company), and Europeans would refer to it as a “SICAV” which depending on the language used roughly translates as “Investment Company with Variable Capital” – they helpfully change what the acronym stands for as you cross borders, to enable all Continental European countries to use the same term.

Whatever you call it, it’s essentially a collective investment fund where separate individual investors can pool their money together and benefit from the much better economies of scale and diversification which can be attained through this process.

An ETF is set up to trade as a stock, on a stock market. You can get all sorts of ETF’s, much like you can get all sorts of different companies which trade on stock exchanges.

But for the purpose of explaining the differences between Mutual Funds and ETF, let’s compare one of each (which both operate as Index Funds).

Ultimately both of them are trying to achieve the same thing – exposure to the performance of a particular Index, such as the S&P 500 - but go about it in a slightly different way.

The first thing to mention is that ETF’s are traded just like ordinary shares, so their value can (and does) rise and fall throughout the day in line with supply and demand. This is different than a Mutual Fund, which has its Net Asset Value (NAV) calculated at the end of each trading day, and is therefore a constant price throughout the day.

So from a trading flexibility point of view, ETF’s can be better because you’re buying/selling at the current market price for that ETF, rather than “flying blind” by placing your trade before you know the price, which you do with a Mutual Fund (any trades placed for Mutual Funds are carried out at the end of the trading day, when the NAV has been calculated based on the market closing prices).

For the same reason, there is more flexibility with the type of trade you can execute with an ETF, in that you can “go short” if you like, and buy as little as one share.

So which one is the cheapest?

In relation to operating cost, each has advantages and disadvantages when compared to the other.

The two main costs to consider are in relation to Index Tracking (the costs involved with making sure that the funds’ performance stays in line with the Index that it’s tracking) and the costs of owning and trading.

For tracking costs, ETF’s are much cheaper, as they are able to use a process called “creation/redemption in-kind”, which basically means that the ETF can issue or buy-back shares in itself in order to swap with other similar securities, which eliminates the normal trading costs which would be incurred by Mutual Funds when they rebalance (in respect of any net purchases/sales of the fund) on a daily basis.

For the same reason, Mutual Funds have to retain a cash balance to deal with any potential net redemptions, which means that a portion (albeit a very small portion) of your investment in a Mutual Fund is sitting in cash, therefore not being invested.

Mutual Funds fare much better when it comes to dividends though, because any dividends received can be reinvested immediately; ETF’s can only distribute dividend income at the end of each trading quarter, therefore missing out on up to 3 months’ worth of potential gains each time.

For the general operating costs of investing in each type of fund, first you have management costs, which are almost always lower for ETF’s because with them, they are not responsible for the fund accounting on a daily basis (because it trades just like a normal share, not like a Mutual Fund).

Trading costs however, are much cheaper for Mutual Funds (usually no cost at all with ones that just track an Index), because ETF’s traded as normal shares will incur both a brokerage fee and a bid/offer spread – neither of which are usually applicable to an Index-tracking Mutual Fund.

The transaction cost is usually the biggest factor in determining which fund option is best for an individual investor, and it generally comes down to (a) How much they are planning to invest, and (b) How long they are planning to hold it for.

So in terms of assessing the total operating cost, as a general rule, if you were planning to hold the fund for a long time (several years), with a relatively large amount of money ($100,000+), you’d be better off with an ETF; with a relatively small amount for a short duration you’d be better off with a Mutual Fund.

For the very same reason, because the amount & term of your investment will have an effect on which has the cheapest operating cost, it will also have an impact on which would give you the highest return – although you can expect them to be VERY similar, unless it’s an extremely long or short duration, and/or an extremely large/small amount invested.

It’s worth mentioning that both all Index-tracking Mutual Funds and ETF’s, as “passively managed” funds, generally outperform the average return from an “actively managed” mutual fund confined to just one Index (there are more fund managers who underperform than those who outperform their benchmark).

BUT the average “actively managed” portfolios drawn from many Indexes and asset types generally outperform the average return of any one Index, so depending on what you’re aiming for financially (and where you are now), you are usually much better off following that as a strategy – no-one has ever passed a financial exam by suggesting that their clients all track indexes for the rest of their lives.

If you’ve read all of that and followed it, well done - I’ve just read it back and it is a little complicated in places. If you didn’t understand it, or indeed if you got bored and skipped to the end, I’ve just got one piece of advice – don’t manage your savings and investments yourself. While this may seem incredibly technical, this is actually quite basic stuff compared to all the other things which need to be taken into account when sorting out your finances.

As always, if you’d like to discuss your personal situation with me, or if you’ve got financial questions you’d like me to answer, please just send an email – I’m always happy to help J

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