Stock Mutual Funds and ETFs

What stocks are and how they work may seem like a grand mystery.  Most folks that grew up outside of the world of high finance have never been exposed to stocks.  Never fear; we will delve deeper into what stocks are and how they can make you rich in a later section of this book.  For now, we want to look at stock mutual funds and how they work.  Stock funds invest primarily in stocks, which are also known as equities.  For now, we will just answer one simple question:  Why invest in stocks?  The answer, according to Jim Cramer is this:  “Because every academic study shows that in any twenty-year period in history, no asset—not gold, not real estate, not bonds, not cash—outperforms high-quality equities that can pay good dividends.”

This stuff isn’t as exciting as making a ton of cash on a great company as it grows from obscurity into a titan of business, but mutual funds are the way that you will build the most wealth over your lifetime.  This is because 401(k) (and similar programs) retirement plans usually only let you invest in mutual funds—there is no option to invest in individual stocks.  For most plans, there isn’t even the option to invest in particular sectors of the market.  Also, if you are self-employed and save for retirement through an IRA that you have a high level of control over, you still want the bulk of your savings in a mutual fund.  Note that many investors consider certain Exchange Traded Funds to be equivalent or superior to traditional mutual funds.

Think of a mutual fund as a company that buys stocks in lots of companies.  When you buy shares of a mutual fund, you are buying a tiny piece of all the stocks that the mutual fund owns.  The reason that these funds are the most crucial retirement investment vehicle in America today is that they are diversified.  Even the grandmaster of stock picking, Jim Cramer, says that you should put your retirement savings into mutual funds to achieve this level of diversification.

Diversification is all about risk reduction.  If your mutual fund holds 500 companies, then a few of them can go completely bust, and you will not even notice it because roughly an equal number will do exceptionally well and make up the difference.  You need to invest the bulk of your retirement savings in a diversified mutual fund because, when you are older, you cannot afford to lose value in your portfolio, and you cannot afford to take the risk that your portfolio will not be worth enough to retire on when you are young.

Although a stock fund’s value can rise and fall quickly (and dramatically) over the short term, historically, stocks have performed better over the long term than other types of investments—including corporate bonds, government bonds, and treasury securities.  Stock funds can be subject to various investment risks, including Market Risk, which poses the most significant potential danger for investors in stock funds.  Stock prices can fluctuate for a broad range of reasons—such as the overall strength of the economy or demand for particular products or services.

Balanced funds invest in stocks and bonds and sometimes money market instruments in an attempt to reduce risk but still provide capital appreciation and income.  They are also known as asset allocation funds and typically hold a relatively fixed allocation of the categories of portfolio instruments.  However, the distribution will differ from balanced fund to balanced fund.  These funds are designed to reduce risk by diversifying among investment categories, but they still share the same risks that are associated with the underlying types of instruments.

Target Date Funds (also called target date retirement funds or lifecycle funds) are funds that invest in stocks, bonds, and other investments similar to the other funds discussed above.  Target date funds are designed to be long-term investments for individuals with particular retirement dates in mind.  The name of the fund often refers to its target retirement date or target date.  For example, there are funds with titles such as “Portfolio 2050,” “Retirement Fund 2050,” or “Target 2050” that are designed for individuals who intend to retire in or near the year 2050.

Most target date funds are designed so that the fund’s allocation of investments will automatically change over time in a way that is intended to become more conservative as the target date approaches.  That means that funds typically shift over time from a mix with many stock investments in the beginning to a blend weighted more toward bonds.  Even if they share the same target date, target date funds may have very different investment strategies and risks, and the timing of their allocation changes may be different.

They also may have different investment results and may charge various fees.  Often a target date fund invests in other funds, and fees may be charged by both the target date fund and the additional funds.  Also, target date funds do not guarantee that an investor will have sufficient retirement income at the target date, and investors can lose money.  Target date funds are generally associated with the same risks as the underlying investments.

There are no rules for how these things are constructed, and you may think the asset allocation of a particular fund is stupid.  I suggest that you avoid target date funds altogether.  There is just no point in paying someone to do something you can do yourself in less than an hour per year.  If you do consider one, download the prospectus and see what the allocation looks like.  You may be surprised to find much higher exposure to a particular asset class that you expected.  Some of these funds are good, and if you know that you will not rebalance regularly for whatever reason, it may be a good option for the late stages of your career.

Alternative funds are funds that invest in alternative investments such as non-traditional asset classes (e.g., global real estate or currencies) and illiquid assets (e.g., private debt) and/or employ non-traditional trading strategies (e.g., selling short).  They are sometimes called “hedge funds for the masses” because they are a way to get hedge fund-like exposure in a registered fund.  These funds generally seek to produce positive returns that are not closely correlated to traditional investments or benchmarks.

Many investors may see alternative funds as a way to diversify their portfolios while retaining liquidity.  The risks associated with these investments vary depending on the assets and trading strategies employed.  These funds can use complicated investment strategies, and their fees and expenses are commonly higher than traditionally managed funds.  Also, these types of funds generally have limited performance histories, and it is unclear how they will perform in periods of market stress.

Smart-Beta Funds are index funds (discussed below) with a twist.  They compose their index by ranking stock using preset factors relating to risk and return, such as growth or value, and not merely by market capitalization as most traditional index funds do.  They aim to achieve better returns than conventional index funds, but at a lower cost than active funds.  These funds can be more complicated and have higher expenses than traditional index funds, and the factors are sometimes based on hypothetical, backward-looking returns.

Also, these types of funds generally have limited performance histories, and it is unclear how they will perform in periods of market stress.  The funds that I would recommend without hesitation tend to have million dollar minimum investments, so I’m skipping those in this book.  If you consider these, be very careful and think about what macroeconomic factors may wreak havoc with the strategy.

Hedge Funds

A hedge fund is a general, non-legal term used to describe private, unregistered investment pools that traditionally have been limited to sophisticated, wealthy investors.  Hedge funds are not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual funds for the protection of investors.  This includes rules requiring that mutual fund shares be redeemable at any time, rules protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of leverage, and more.

Money Market Funds are a type of mutual fund that has relatively low risks compared to other mutual funds and ETFs (and most other investments).  By law, they can invest in only certain high quality, short-term investments issued by the U.S. Government, U.S. corporations, and state and local governments.  Government and retail money market funds try to keep their NAV at a stable $1.00 per share, but the NAV may fall below $1.00 if the fund’s investments perform poorly.  Investor losses have been rare, but they are possible.

Think of a money market fund as being equivalent to a savings account at your local bank.  Because that account is housed in your investment portfolio, it is a great way to “stash cash.”  All money market funds pay dividends that generally reflect short-term interest rates, and historically the returns for money market funds have been lower than for either bond or stock funds.  A risk commonly associated with money market funds is Inflation Risk, which is the risk that inflation will outpace and erode investment returns over time.

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