What the Heck is an ETF? More on Understanding Funds

When I first started this blog several months ago, I added a snappy little glossary definition of ETF's, figuring that I would not be able to get many of you excited about them as a topic. But the other night I got a question from a reader about these increasingly popular investment vehicles, so I have decided it's time to give you the fully story (or at least the slightly-longer-but-not-too-tedious story)—

Let's start with my original glossary definition:

An investment fund that tracks a list of stocks, bonds, commodities or other investments. Investors own shares of the fund, rather than directly owning the investments within it. Unlike mutual funds, ETF's trade like a stock such that the price changes throughout the day.

The best known ETF's are index funds and are popular for their low costs.

If you really want to wrap your head around ETF's, you need to understand how funds in general work. A fund is a like a shared pot for which the fund manager buys a selection of investments. Those investments are usually stocks or bonds, but there are other investments they can choose from as well. Once the fund manager has created that "pot", she will buy and sell investments according to whatever strategy she has laid out at the beginning—think of that strategy as the fund's "recipe." The recipe can be pretty precise: "I'll only buy stock from companies that make things out of timber." It can be broader: "I'll look for the most undervalued stocks in the U.S. market." Or it can be blended: "I'll always keep 70% U.S. stocks and 30% U.S. bonds."

Regardless of the fund manager's strategy, all of the money for these purchases comes from people like you who buy shares in the fund. And this raises the question of how you buy "into" the fund...and how you get your money out. This is where the type of fund you buy—ETF or mutual fund—makes a difference. If you want to purchase or sell one share of a mutual fund, you will always find the price of a share from the fund's Net Asset Value (NAV for short). That number is a simple calculation of how much the fund's current investments are worth, and it's only calculated once a day—at the end of the trading day. Simple!

An Exchange Traded Fund (or ETF) doesn't make things so easy. Just as stock prices slide up and down over the course of a trading day as people bid and sell them, an ETF price slides around constantly depending on how much traders in the market are willing to pay for a share in it at that moment. If everyone is betting that the fund manager is doing well, the price of a share in the ETF will go up (and vice versa).

Should you buy ETF's?

As you can see from my glossary entry, ETF's have been a particularly popular form of "pot" for a fund manager wanting to create an index fund, where the "recipe" is to have a little bit of everything on a given list (say, all companies on the S&P 500, or all U.S. oil companies). With index funds, a computer does most of the work calculating buys and sells, and the fund manager generally can charge you, the fund owner, a little less as a result. Lower fund management fees is always a good thing.

And there is one other thing you should know about ETF's vs. Mutual Funds—the taxes are different. If you own a share of a mutual fund, you and the rest of the fund's owners will share the fund's tax bill at the end of the year. These are called contribution taxes, and they come from the capital gains taxes created when the manager sells an investment in the fund for more than she paid for it. As with any investment, you will also pay a capital gains tax on your shares when and if you sell them for more than you originally paid.

On the hand, the IRS treats ETF's like a big, funny looking stock. As with the mutual fund (and other investments) you pay capital gains taxes when you sell your shares. But the IRS ignores the fact that the ETF has all of that other buying and selling going on inside it, which means no contribution taxes for you. A lot of investors and fund managers choose ETF's over mutual funds for this tax efficiency.

Have more questions about ETF's or other investments? Post something to me in the comments box below!

Asset Allocation 101

Capital Growth

In my opinion, asset allocation has had more impact on average investors over past the two years than any other topic in investing. Why? The whole idea of asset classes used to be foreign to anyone but the professionals, even though they serve as the foundation of what we do. Fortunately, even low-cost stock trading platforms and 401k's started adding new online tools a few years ago to help investors choose a standard asset allocation model.

If you don't have access to one of these tools, you want to customize your existing account, or you just want to understand how asset allocation work, this article is for you.

Let's start with the what and why of asset allocation.

Stocks and Bonds

To create an asset allocation model, always start by splitting your model between stocks and bonds. The value of bonds generally doesn't fluctuate as much over time, and they usually produce income (interest payments). This makes them a great investment base, but you aren't going to be bragging about how much your investments are up with an account full of bonds.

Stock prices, on the other hand, can fluctuate wildly. This can be disastrous in a recession, but it does give you the opportunity for some real gains in a good economy.

Retirement Planning

How much of your investments do you want in stocks? Most of the advice out there is focused on your age—the American Association of Independent Investors figures that "Moderate" investors fall between about 35 and 55 years of age, with more aggressive youngsters below and conservative retirees above. The truth is that this isn't really about your age—it's about your timeline and how much unpredictability your sanity can handle. If you plan on letting your money sit in the account for 30 years or more, you can afford to be aggressive, no matter how old you are. Likewise, a 20 something who might need the money out in ten years should be thinking more conservatively.

If you consider that the AAII recommends a 70%/30% split between stocks and bonds for "moderate" investors, you can see how aggressive investors will often settle for only 10% or 15% of their portfolios in bonds. The newly-retired will often have as much as 50% of their portfolios in bonds.

As you can imagine, eventually shifting your portfolio over is essential here. As you gradually get closer to the time when you'll need your money, you will want to put new deposits into bonds. If you are not adding to your account take advantage of moments when the stocks are high to sell some of those off and move them into bonds.

What Are the Asset Classes?

You now have come up with your guideline for how much goes into stocks and and how much into bonds. Some investors stop right there with their allocations—it's easy now to find a mutual fund that has a full range of stocks and a similar bond fund and call it done. Most people, though, like to break things out more precisely within those stock and bond categories.

Every investment manager has her own rule for which asset classes are necessary for a well-balanced, basic portfolio. My own basic portfolio models rely on just six asset classes (though we often make adjustments for a particular client's circumstances). The American Association of Independent Investors uses the same classes but adds in Emerging Markets as a standard class (note: we aren't opposed to emerging markets but the extra fund expenses can cancel out the extra gains you are looking for with these). Here are the six classes listed very loosely in order of risk—the classes considered most volatile are at the top and the most steady at the bottom:

• International Stocks
• Small Capitalization U.S. Stocks
• Mid-Capitalization U.S. Stocks
• Intermediate Term Bonds (7 to 10 year duration)
• Short Term Bonds (1 to 3 year duration)

I've included the AAII's three allocation models at the bottom of the post, but you can adjust these to your circumstances. So, if you have created a nice moderate split of 70% and 30% stocks to bonds, you can make you portfolio that much more aggressive or steady with some fine tuning, by say, using more Small Cap stocks to get more adventurous.

What To Expect From Your Investments

Now that you have a plan coming together for your own personal asset allocation model, it makes sense to think about how things might play out over time.

The chart below is from one of my favorite bloggers, Ben Carlson, who writes at A Wealth Of Commonsense. (Note: you can find the 2016 update from Carlson at this link http://awealthofcommonsense.com/2017/03/updating-my-favorite-performance-chart-for-2016/).

asset allocation quilt wealth of common sense

Carlson calls this his asset allocation "quilt." If you look carefully you will notice he has 10 asset classes whose performance he has tracked since 2003. Notice how the most volatile classes (REIT's, Emerging Markets, Small Cap) rise and drop wildly year by year while more steady Bond and U.S. Large Cap classes shift more modestly.

Regularly predicting what will come out on top year to year has proven impossible, even for the experts. Fortunately, asset allocation only requires that we take some of the winnings—as often as possible—over the long-term. And that is a strategy anyone can follow.

The image below shows AAII's three standard asset allocation models (note the impact of the 2008 crash on the 10-year returns at the bottom!). Click here for more details and recommendations from AAII.

AAII Asset Allocation Models | AAII: The American Association of Individual Investors

Choosing An Investment Strategy

Choosing your investment strategy is probably the toughest step you will take as an investor. Not coincidentally, it is also the one investors are most likely to skip over. Like it or not, investing is a glorified form of risk taking. Despite all of the studies, spreadsheets, evaluations and computer algorithms, we never really know what will happen next in the marketplace. Since we don't have control over  all of the things that can change the fortunes of a company or its stock, we need to have a plan for what we can control—and that's where your strategy comes in.

Hot Stocks

The riskiest strategy out there is probably the most common one among smaller investors. A simple form of stock picking, it involves placing all of your money in a short list of stocks that you think might be going somewhere.

This strategy usually results in some great conversations at cocktail stories. Chances are you've overheard someone chattering about how much she made on her Apple stock. On the other hand, you are a lot less likely to hear how much she lost in Mattel last year. Ouch. Stocks don't always rise and fall so dramatically, of course. But the kind of public chatter that often convinces someone to buy a stock is the same sort of chatter than sends herds of investors rushing—and sell—all at once. If you are going in as a stock picker, be ready for the roller coaster ride.

Diversification

To avoid those wild swings, investment advisors diversify (invest in a wider array of securities) to prevent the disastrous scenario of having all of your money in one stock when it drops. In fact, mutual funds, bond funds and more recently, exchange traded funds (ETF's) were created to make diversification cheap and easy. Your ownership of fund shares mean that you "share" in a large pot of different investments.

Asset Allocation

We investment advisors don't just add more stocks to our list, though. We also use asset allocation. In other words, we put a little bit of money into a lot of different kinds of investments. Asset Allocation strategies recognize that large company stocks, government bonds and real estate trusts all respond differently to market conditions. By investing in different kinds of securities, we hope to make money even when certain portions of the market are losing or flat. This post gives you the basics on creating your own asset allocation model.

Contrarians

Whether you are investing in a single stock or creating a diversified portfolio, you are going to run into trouble unless you have a strategy in place for deciding when to buy and sell. Everyone agrees you should "buy low and sell high." The problem is knowing when an investment actually is high or low. A "contrarian" solves this by keeping track of whatever the market seems to be doing and then doing the opposite. Is Apple soaring this week? Then it's time to sell. If a stock drops, a contrarian treats this as the time to buy.

As you can imagine, there aren't a lot of true contrarians out there. There is always a chance that the stock will go just the little bit higher or lower tomorrow, so contrarian strategies often just leave investors paralyzed in the face of a decision.

Hedging With Options: Calls & Puts

This approach deserves a post of its own, if only because most investors will find it the single most confusing aspect of of the investment world. The idea of "hedging your bets" is exactly what it says. Imagine someone placing a bet and then drawing a boundary (a hedge) around the possible outcomes. If you've placed your bet on Apple stock, hoping it will continue to go up, you might also put a little money on the possibility it goes down—just in case. You could do this by purchasing (for a price) a "put." Put are contracts that give you the right to sell your Apple stock at a certain price. If you find your Apple stock has plummeted below that contract price, you exercise your option and sell the stock at the contract price, limiting your losses.

Conversely, you might decide not to buy Apple but worry that it could be going up in value. Buying a "call" option instead of a "put" gives you the right to buy those Apple shares later at the price you've agreed on. You will exercise your "call" if the Apple stock goes above the call price, which makes the stock a bargain for you.

Most investors will never directly purchase options of any kind, but you will likely have the opportunity to buy mutual funds and even hedge funds that use this as an essential part of their investment strategies.

Index Investing

Over the past 20 years or so, a more radical approach has emerged to solve the problem of timing in the stock market. Increasingly investors are using index funds to avoid questions of when to buy or sell almost entirely. Under this strategy, you follow the markets, rather than the securities in them. An index fund has a little bit of whole lot of stocks from a particular category. The most popular of them follow well known indexes like the S&P 500 or the Dow Jones. Since your index fund has shares of just about everything on the index, you are counting on particular shares to rise—just that on average the whole index goes up. Index investing is essentially a bet that the global economy will continue the pattern of long term growth we've seen historically. An index investor just sits back to enjoy the ride.

Does index investing work? Well, so far it does. We use it at Revolution Capital, and while we still can't tell you what the markets will do tomorrow, we feel good about research that shows index investing generally wins out over even seasoned experts in the long run. If you want to read more on the research into index investing, Vanguard regularly updates their research on the subject).

So which strategy is best? You will find experts out there who swear by each of these strategies, and none of us can tell you the 'right' answer. What's important is finding the right answer for you—and then sticking with it.