You may have one or both – do you know the difference?
By Steven Lewis
When I got into the business of financial consulting nearly 22 years ago, I had no idea how complicated the industry was and how quickly it could evolve. I have often wondered if that is/was intentional. I started my career in 2009, as an investment advisor representative (IAR) of a large firm based out of Illinois. To my dismay, what I quickly learned was that I did not need to have much knowledge of anything. After attending my first meeting in Chicago in 2009 with nearly 200 other investment advisors, I was shocked how little I, or anyone else, was expected to know regarding investment vehicles (i.e. stocks and mutual funds predominantly).
So, what was the purpose of these meetings? It became very clear that the agenda and purpose was to learn how to direct individuals into one of several investments (i.e. models) that consisted primarily of mutual funds or exchanged trade funds (ETFs). The purpose of these conventions, that I quickly learned was lacking, was the goal of becoming a student of the business regarding how each of the investment vehicles worked and behaved. Professionally, I did not want to just direct clients into investments, but I wanted to tell them how and why. Unfortunately, many financial advisors lack this depth of knowledge. Because of this perceived deficiency, it was not too long before I broke out on my own. It has been eye opening, and I can confidently say today that I will never go back.
Mutual funds can be a complicated investment. If I were to briefly describe what a mutual fund is, I would describe it as a “pooled investment,” meaning, investors put their money in a series of investments into one bowl, if you will. This concept has its origins going back to the 18th century and was labeled as an investment trust. This “pooled” investment was managed by one or more professional managers which are compensated by fees inherent in the fund.
Let’s jump ahead nearly 250 years to today when the current investment community calls these “pooled” investment(s) mutual funds. With that being said, I am going to avoid going into the weeds of the global expansion of, the evolution of, the technological advancements of, and the regulation and growth of these types of funds that most people invest in. I will just describe the basic elements contained therein.
How many mutual funds are there today? Simply put, hundreds and thousands with hundreds of companies selling them. The largest mutual fund is said to be a mutual fund represented by Vanguard (symbol VTSAX) holding assets that exceed $1.5 trillion. That’s a whole lot of money.
Expenses are a big part of mutual funds. There are shareholder fees, management fees, advisor fees, and sales load fees. Mutual fund fees, as necessary as they are, represent a reduction in the net return on investment in a fund. For example, let’s assume you invest $10,000 for 30 years, with an average annual rate of return of 7%. Over 30 years, your $10,000 will grow to $57,435. Now, let’s suppose you make the same investment except you choose a fund with average annual fees of 0.50%. That will lower your effective annual rate of return as well, but only to 6.5%. Over 30 years, your $10,000 will grow to $66,144. The difference over 30 years is $8,709. This difference in return is all because of the fees assessed.
Exchange traded funds (ETFs) are a completely different breed of fund. Our thanks can go to State Street Advisors (SPDR) who created the first ETF in 1993. This ETF was designed to track the performance of the Standard & Poor 500 (S&P 500). Soon, due to the popularity of ETFs, the industry took off. What would an investor hope to achieve investing in ETFs? For starters, an investor can literally isolate a specific sector within the S&P 500; symbol SPY (in which there are 11 along with its 88 industries). The same goes for the NASDAQ 100. Secondly, ETFs are quite “cheap” to own with the average fee under .25%. That’s it! There are no front or rear load sales fees, no management fees, nor any advisor fees. That’s quite a deal. What also makes them attractive to me (as a portfolio manager) is that ETFs trade just like a stock and can be traded before market (extended AM), after market (extended PM). One cannot accomplish this with mutual funds. In other words, ETFs are extremely flexible. One could say that an investor can trade an ETF for virtually anything: commodities, bonds, master limited partnerships (MLPs), unit investment trusts (UITs) and more. This can all be done with very low fees.
There is so much more that can be said about mutual funds and ETFs. Both are effective, however mutual funds are clearly not as flexible as ETFs. ETFs win that battle. So as an investment professional who has managed portfolios for over 14 years, ETFs are my professional preference. As a client you need to understand that with many investment brokers, commissions will drive a sale. In the case with ETFs vs. mutual funds, investment brokers will favor mutual funds because of the commissions. Commissions paid to brokers range between 1-3% (I have seen higher), plus brokers will also obtain what is called a “trailing” commission. So be educated. Investment advisors, who are not commissioned driven, will normally utilize ETFs. However, I am seeing more mutual funds creeping into these portfolios as more and more investment advisors either hire or are directly under the authority of their firm’s money managers.
So, what can you take from this brief article?
Be educated. Ask about the expenses contained in your overall portfolio. Don’t be shy about it. Expenses weigh down a portfolio regardless of size.
Follow the sectors of the markets. As mentioned above, there are 11 sectors and 88 industries contained in the sectors. Diversify. Follow trends.
Ask the tough questions. Does your financial professional do the trades or are they “farmed out” to some else? If so, why? Understand this, if the trading duties are being performed by someone else (whom you’ll never meet), challenge him/her on their fees. What are they doing to earn those fees? Negotiate if necessary. There will be push back. But remember, it’s your money and your relationship with your financial consultant MUST be transparent.
There’s no advisor autonomy if investment models are used. If you utilize one or more “models” constructed by either a broker or an investment advisor’s money manager, understand that “they” cannot (in most cases) override the money manager who actually “pulls the triggers” in your portfolio(s).
Remain flexible. Understand that the market sectors are moving constantly. If you’re in a “diversified portfolio,” what does that mean? If there are five or more sectors represented in your portfolio that are not moving well, get rid of them.
Not only should a financial advisor be able to answer the above questions transparently, but they should also put your financial interests and goals first. And lastly, they should welcome, as well as teach, financial self-advocacy and knowledge of what, and how, your portfolio is being managed.
Sources: Vanguard, Bloomberg, Time.com, IBF
