So what are some of your options for investing in index funds? There are two broad classes of funds available to investors today. These are traditional Index Mutual Funds and Exchange Traded Funds or ETFs.
Mutual Funds hire investment professionals to do fundamental company research and then hire portfolio managers or fund managers to assemble a group of good companies together. Index Mutual Funds in contrast buy the shares in the index and try to match the index performance. Index Mutual Funds tend to be lower cost than actively managed funds. Index Mutual Funds were invented or at least popularized by John Bogle who founded the Vanguard Group.
ETFs are similar to Index Mutual Funds. One of the most common ETF structures is as follows. A trust is set up. The trust buys all of the stocks in an index in the same proportion as the index. The trust issues Depository Trust Receipts (DTR’s), which are like shares. These DTR’s are usually issued for a fraction of the index value like one tenth.
The Depository Trust Receipts are traded on a stock exchange like the American Stock Exchange. The price of the DTR goes up and down exactly in step with the index. Unlike Mutual Funds, the price of ETF’s are set with every trade instead of the end-of-day Net Asset Value. So ETF’s are more liquid than Mutual Funds. Also, when an investor wants to buy or sell an ETF, the does so with another investor through the exchange. The transaction does not affect the securities in the trust. This improves the tax efficiency of ETF’s even compared to index Mutual Funds.
Let me explain. When you sell your shares of a mutual fund, the fund manager has to sell some of the stocks in the fund to get the money to pay you. This triggers a capital gain or loss for the fund. Investors who did not sell, have to pay taxes on the gain at year end, even though they did nothing to create a tax liability. So they end up with an unexpected and undesired tax. With an ETF, because you are not trading with the Trust, but with another investor, the trustee does not have to sell stocks from the trust to create enough liquidity to pay you. So there are fewer year end surprises. The only buys and sells in the trust are for companies that enter or leave the index the trust is replicating. There are other ETF structures, but they all have similar advantages.
Re: Mutual Funds
Of the many things to consider when investing in mutual funds, here are a few of them:
(1) Load vs. No-Load
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The method in which shares are purchased. Load charges typically range between 3% to 8.5% at the time of purchase. No-loads do not have an up-front purchase fee, but occasionally will have a small back-end load of 1% to 2% commission of the value of shares redeemed. Watch out for the "redemption fees" and hidden annual distribution fees which some brokers tack on to load funds. READ THE PROSPECTUS CAREFULLY!!!
(2) Past performance history
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How did it perform in both bad economic times as well as good? October 1987 ring a bell?
(3) Fund manager
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How long has he/she been there? What is his/her track record?
(4) Turnover
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Be careful with any fun that has a high turnover rate. If the fund manager has a higher than 150% turnover in the funds portfolio, this might indicate that he/she is either "churning" or scrambling to find something that works.
Janus Fund, Twentieth Century Select, and Dreyfus Fund are three examples of top, sensible, no-load, no-hidden-fee mutual funds tht have weathered the big ones (including October '87), and came out shining.
"Money Magazine" publishes a section on a monthly basis called FundWatch. Stick to something with no load, and if you hold it for long enough, it'll catch up with other "load" funds that outshone it in the beginning.
DON'T LET A STOCK BROKRE SQUEEZE YOU INTO A MUTUAL FUND WITH AN 8% COMMISSION. It is the closest we get to stealing outright in the financial industry.
I've only scratched the surface here. You should do your homework before you make any kind of investment. Buy books, ask questions, and don't be greedy. Good luck!
Posted by: Bob Hansell | February 14, 2006 11:12 AM | Permalink to Comment