3. MUTUAL FUNDS AND EXCHANGE TRADED FUNDS (ETF'S)
Mutual Funds and ETF’s (Exchange Traded Funds) are great for new, young investors who don’t quite understand all the financial and technical jargon of the stock market quite yet. They both have their pros and cons, but both allow you to spread your money over hundreds of stocks or bonds in tons of different industries. You also don’t need to dish out large amounts of money to purchase them either.
3.0 Some Basic Terms First
Even though we're not at the Stocks section yet, we have to discuss the Stock Market since it applies to ETF's and Mutual Funds too!
- Stock Market Index
You know when you’re watching the 6 o’clock news and they say, “Well Jim looks like the TSX is up 1.5% today and the Dow Jones is down 2%,” what are they talking about??
A stock index or stock market index is a method of measuring the value of a specific section of the entire stock market. For example you could have an index that follows the average performance of the 50 biggest Telecommunications companies in Canada or the 100 biggest Oil and Gas companies in Brazil. There can be an index for anything!
In Canada you are most likely to use the Standard and Poor’s TSX Composite Index (S&P TSX). It is computed by averaging the performance of the largest Canadian stocks on the Toronto Stock Exchange (TSX or TSE) together into one index value. Indices like these are extremely useful tools that allow us to track changes in the index's value over time and use it as a benchmark to compare a specific company to the index it belongs to.
Let’s suppose that a Canadian Oil and Gas index has gone up significantly over the last two years but the value of Petro Canada has gone down. This would suggest Petro Canada is “Under Performing” in the Oil and Gas market. But if Petro Canada has increased more than the index, the company would be “Outperforming” the market.
Here are three other indices that you’d be most likely to run into:
- NYSE Composite Index- tracks the price movements of all common stocks listed on the New York Stock Exchange.
- Dow Jones Industrial Average (DJIA) - an index of 30 "blue chip" stocks of U.S. industrial companies. (Blue Chip: huge multi-national companies like Coca-Cola or Chevron)
- Nasdaq-100 Index - follows the 100 largest and most actively traded companies on The Nasdaq Stock Market.
- Dividends
When a company earns a profit, they can either put that cash back into their company (i.e. new office chairs, inspirational posters in office hallways) or they can distribute the profit to their loyal investors as a cash dividend. It's normally given either monthly, quarter-annually or annually. We’ll talk about dividends in some serious detail later in the Stocks section.
3.1 Mutual Funds
Minimum investment required: Usually ~$250 minimum investment
Cost to buy: Mutual Fund brokers normally charge $5 to $30 to buy funds, and a 0.5% to 4% fee to manage the fund for you
Current return: Wide range ~0.5% to ~10% depending on riskiness of fund
Risk (out of 10): 4 to 6/10
Liquidity: Can take a few business days to sell and receive your cash
Where to buy: Major banks, some online brokerage firms
Income: Two ways: Increase in value of fund over time, and/or periodic dividends paid out to fund holder
Here’s the basic principle behind a Mutual Fund: you, along with a bunch of other investors give your money to a professional investment manager and he/she invests that money over a wide range of stocks or bonds. In doing so, you reduce the risk of losing all your cash on one bad bet. This is known as diversifying.
Sounds great hey? The downside is these investment managers expect to get paid for their services. Therefore they charge an annual fee known as an M.E.R. (Management Expense Ratio), which generally ranges from 0.5% to 3% of your money. That’s going to bring down your overall return, but it’s worth the cost to those who want to benefit from professional guidance and extensive diversification. There's over 7500 Mutual Funds out there, granting you instant investing access to every industry, stock exchange and country that you can possibly think of. You can buy Mutual funds at pretty much any large bank, but make sure you do some research about which bank first!
Some Mutual Fund brokers require as little as $250 to start, and you can set up automatic savings plans to automatically buy mutual funds from your savings account at regular intervals. This allows you to take advantage of something called Dollar Cost Averaging.
Dollar cost averaging works like this: by buying a set dollar amount of stocks on a regular basis, say $50 each month, this will ensure you buy less number of funds when they are pricier, and more funds when they’re cheap. Using this method you don’t have to worry about timing the market, you’re just always buying. Dollar Cost Averaging can also be used for buying stocks, bonds, and most other investments in fact.
Here are a few different types of Mutual Funds to think about:
- Low- Cost Index funds
Index Funds are very straightforward: they simply invest in companies in a given market index. So an S&P 500 Index Mutual Fund will just buy up stocks in all 500 companies listed in the S&P 500. And since they are passively managed (the manager doesn't buy and sell the stocks day-to-day, he/she just buys them one day and lets them do their thing) they charge a low M.E.R., hence the name ‘low-cost.’
In addition to this attractively low M.E.R, there’s also a whole lot of data out there that suggests passively managed funds like index funds actually do better than actively managed ones. The theory is that no one can predict the market, just like no one can predict the future (as far as I know? Maybe that Tarot Card lady), so you might as well just follow the market. In fact, something like 95% or more of passive index funds outperformed actively managed funds last year.
For us Canadians, a good place to start if low-cost index funds interest you is ING Direct Streetwise Mutual Funds (low 1% M.E.R) and TD e-funds with TD Canada Trust (0.2% M.E.R). For reference, most fully managed Mutual funds charge 2% to 4%. That can really hurt the bottom line.
- Sector funds
Just as the name suggests, these specialty funds concentrate their assets in a particular sector like health care or utilities. It’s not a bad strategy as long as you remember that a popular sector one year can crash the next year. Anyone remember the dot-com bubble?
- Others Funds
As I said earlier, there are thousands of Mutual Funds to choose from. Other types include international funds (invest in foreign stock markets like China and Europe), small-cap companies (companies worth less than $1 billion), and emerging market funds (countries like Brazil and India that are experiencing rapid growth and industrialization). So many choices! And finally as we discussed before, there are Bond Funds which invest in bonds of various levels of risk and maturity time.
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Where can I buy Mutual Funds?
You can buy Mutual funds at any major bank or with online brokers. Check out Bank of Montreal - BMO Mutual Funds: http://www.bmo.com/home/personal/banking/investments/mutual-funds/funds Or Questrade.com, a discount brokerage that will sell Mutual Funds www.questrade.com |
3.2 Exchange Traded Funds (ETF's)
Minimum investment required: N/A
Cost to buy: Trades just like normal stocks, so the cost to buy is broker transaction fee ($5 to $30 to buy/sell)
Current return: I find the typical dividend is ~3%, Growth varies
Risk (out of 10): 4/10 to 6/10
Liquidity: Time required to sell stock and withdraw from trading account
Length of term: N/A
Where to buy: Stock Broker or Online Brokerage
Income: ETF value can go up, and some ETF’s pay dividends
ETF’s are very similar to Mutual Funds except for one key difference: you buy them just like you’d buy a stock. Companies like iShares or Vanguard are in the sole business of creating ETF’s. And just like Mutual Funds there is an endless buffet of ETF’s to choose from. Fortunately the iShares and Vanguard websites have a ton of information about their products on their websites. You can also try the website MorningStar.ca which gives 5-star ratings to many of the ETF’s and Mutual Funds. You can choose the ETF that’s just right for you based on your risk tolerance and interests.
The other bonus of most ETF’s, just like the low-cost index funds, is that they don’t charge crazy management fees. They seem to hover around only 0.2% to 1%. So if you get a 5% gain in the value of your ETF in one year, you’re actually getting about 4%, which is still something to be happy about. Compare this to a fully managed Mutual Fund with a 3.5% MER, bringing you down to a measly 1.5% gain. That’s why exchange traded funds are highly recommended in the Couch Potato Portfolio, an awesome portfolio for those getting started with investing. Read all about it on my blog post, or here: http://canadiancouchpotato.com/model-portfolios/
Cost to buy: Trades just like normal stocks, so the cost to buy is broker transaction fee ($5 to $30 to buy/sell)
Current return: I find the typical dividend is ~3%, Growth varies
Risk (out of 10): 4/10 to 6/10
Liquidity: Time required to sell stock and withdraw from trading account
Length of term: N/A
Where to buy: Stock Broker or Online Brokerage
Income: ETF value can go up, and some ETF’s pay dividends
ETF’s are very similar to Mutual Funds except for one key difference: you buy them just like you’d buy a stock. Companies like iShares or Vanguard are in the sole business of creating ETF’s. And just like Mutual Funds there is an endless buffet of ETF’s to choose from. Fortunately the iShares and Vanguard websites have a ton of information about their products on their websites. You can also try the website MorningStar.ca which gives 5-star ratings to many of the ETF’s and Mutual Funds. You can choose the ETF that’s just right for you based on your risk tolerance and interests.
The other bonus of most ETF’s, just like the low-cost index funds, is that they don’t charge crazy management fees. They seem to hover around only 0.2% to 1%. So if you get a 5% gain in the value of your ETF in one year, you’re actually getting about 4%, which is still something to be happy about. Compare this to a fully managed Mutual Fund with a 3.5% MER, bringing you down to a measly 1.5% gain. That’s why exchange traded funds are highly recommended in the Couch Potato Portfolio, an awesome portfolio for those getting started with investing. Read all about it on my blog post, or here: http://canadiancouchpotato.com/model-portfolios/
3.3 Comparing Mutual Funds and ETF's
Which is better for you? Both are very useful and who’s to say you can’t have money in both? The deciding factor is mainly how often you plan on contributing to your fund. If you are planning to take advantage of Dollar Cost Averaging and you intend to make frequent contributions (ex. bi-weekly or monthly), a Mutual Fund is a better option- this is because Mutual funds require no purchase fee like ETF’s do. Every time you buy an ETF it’s just like buying a stock and therefore your broker is going to charge you anywhere from $5 to $30 to buy it. You don’t want to do that every month! ETF’s are great only if purchasing once a year or so.
3.4 More Info on Mutual Funds and ETF's
Check out CNN Money Basics for more information on Mutual Funds and ETF’s:
http://money.cnn.com/magazines/moneymag/money101/lesson4/index.htm
Head on over to the Stock Market to talk about the most talked-about investing tool: stocks. -------->