ABCs of Investing

One question that often comes up when deciding on how to invest is the choice of investment vehicles.  If you want to buy low cost investments then index funds and exchange traded funds (ETFs) are the best choices.

Most investors are better off with index funds for a number of reasons - however it really depends on the individual situation.  Let’s take a look at some of the differences between these two investment types first.

Exchange Traded Funds - ETFs

• Lower ongoing management costs (MER).
• Higher trading fees.
• Manual orders (ie you have to sign in and order each purchase).

Index funds

• Higher MERs.
• No trading fees.
• Orders can be automated.

Since most investors tend to make purchases on a regular basis, the trading fees on an etf will quickly eliminate any advantage of the lower MER.  This means that index funds are often a cheaper alternative.

Another factor is the size of portfolio - if the portfolio is large enough then ETFs might make more sense.  The MER savings on a larger portfolio might outweigh the higher trading costs.

Keep in mind that not all ETFs are cheaper than index funds and trading and annual account fees can vary quite a bit between institutions.

Best solution

Most smaller investors (less than $100k) are likely better off with index funds because of the lower trading fees.

Larger investors have more choice - they can keep going with index funds, or switch to ETFs or perhaps own both.

Once you have a large enough portfolio, you can consider having the bulk of your portfolio in ETFs and then make regular contributions into index funds.  This way you get the low MERs of ETFs and have cheap trades with index funds.

Thanks to Green Panda Treehouse (a personal finance blog) for this post suggestion.

If you own a mutual fund, index fund or exchange traded fund (ETF) then you pay a fee called the management expense ratio (MER) or “expense ratio”.  This money goes to pay for the cost of running the fund.  It’s important to note that this fee is not directly charged to the investor but rather to the fund itself.  It will never appear on any transaction order form or account statement.

Why do I care about the MER?

The fees charged to the funds you own will reduce the return you get.  For example if you have a mutual fund that got 7% last year and then charged a 1% fee, then the return you will see is 6% - a 1% difference makes a huge difference over a number of years.  Generally speaking, the lower the fees are, the better off the investors are since they get to keep more of their own money.

Know your fees

It is the responsibility of the investor to know what kind of fees they are being charged.  If you have an advisor you can ask them or you can just look it up yourself.  Make sure you do this!

You should be able to go to the website of whatever company’s funds you own to look up the MER or you can go to a site like Morningstar.com which contains this information for all mutual funds.

Index funds typically have lower MERs than managed mutual funds because they don’t have to pay the portfolio managers as much.  ETFs can be cheaper than index funds.  Vanguard charges MERs that are among the cheapest in the industry.

Some examples

Here are some ETFs and funds and their MERs (the trading symbols are in brackets):

• Vanguard Total Stock Market Index (VTSMX) - MER = 0.15%
• Vanguard Total Stock Market ETF (VTI) - MER = 0.07%
• Aim Large Cap Growth Inv (LCGIX) - MER = 1.24%

An important part of investing is to occasionally rebalance your investment portfolio.  In a previous post we talked about portfolio asset allocation.  Your portfolio will be made up of different asset classes such as stocks, bonds, cash etc and the amount of each is your asset allocation.

Portfolio rebalancing is accomplished by occasionally resetting the proportions of each asset class back to their original percentage.

Let’s look at an example

Susan has just won $50,000 in a lottery.  After doing some reading she decided that her portfolio asset allocation will be 60% stocks and 40% bonds.  To create her portfolio, Susan bought $30,000 (60% of $50k) of a stock index fund and $20,000 (40% of $50k) of a bond index fund.

One year later, Susan checks out the value of her portfolio - the bonds have gone up 4% and the stock fund has gone down 9%.  The portfolio is now worth $48,100.

Susan notices that now the stocks make up 57% of the portfolio instead of the original 60% she wanted.  The bonds are now 43% of the portfolio instead of the original 40%.  Susan decides to rebalance her portfolio so the asset allocation is the same as when she started.

To accomplish this she must sell some of the bonds and use the money to buy some stock fund.  To calculate how much bonds she has to sell, she takes the new portfolio value ($48,100) multiplied by the bond allocation (40%) = $19,420 which is how much she should have in bonds.  Since she now has $20,800 of bonds she has to sell ($20,800 - $19,420 = $1560) of bonds and buy $1560 of the stock fund.  Then she will then have 60% stocks and 40% bonds.

What is the purpose of rebalancing?

• Potentially increase returns - By selling asset classes that have risen in value and buying other asset classes that have dropped you are selling high and buying low.
• Maintain risk profile - Susan decided that she wanted a 60/40 allocation - if she never rebalanced then it is possible that her allocation (and investment risk) could change from her intended levels.

Photo credit Mandj98