The Simple Intricacy of Passively Investing In ETF’s For Wealth
Before I was a broker, I worked in commercial real estate and made the acquaintance of an accountant who was truly a savant. Yes he had his MBA, his CPA, and a true gift for math, but that is not what made him exceptional. He was exceptional because he did not get lost in the minutia. Cyclically adjusted price-to-earnings ratios, price to book ratios, debt to equity ratios, he couldn’t have truly cared less. The only thing that mattered to him was money in, money out; and by holding true to those same principles, we too can accomplish the same.
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There is a difference between being a trader and being an investor, similar to how there is a difference between being healthy and being fit. I can eat healthy and not be fit enough to do three pull-ups, just as I can be fit enough to squat 450 lbs yet not healthy enough to prevent a heart attack after years of eating poorly.
An investor invests for the long term, almost never sells out of his investments, and does not hesitate to buy when the market is down. Traders can move in and out of the market several times per day, will hold both long and short positions, and rarely carry their trades into the weekend. You need to define your objective, and my objective is to invest.
Everyone’s An Expert When It’s Time To Buy, But How Many Ever Recommend What They Actually Hold
In terms of minimizing your out of pocket costs, the best mutual funds to invest in are those that are passivley managed. They generally do not carry any front end or back end loads, their management fees can be as low as 4 basis points, and you pay no bid/ask spread no matter how small or how frequently you contribute to the fund. This is especially beneficial if you invest regularly, as the fees from brokerage charges and paying bid/ask spreads on the secondary market add up rather quickly.
Passively managed ETF’s are similar to passively managed mutual funds in that they track an index; however, that is roughly where their similarities end. ETF’s trade intraday, so you will immediately know your price per share when your order is filled. With a mutual fund, your price per share is determined after the close of market. With ETF’s, you also pay the bid/ask, so a portion of your investment will go towards that spread, which in the long term can be price prohibitive if you invest frequently.
It is also more difficult to invest smaller amounts in ETF’s, as you can never purchase less than a whole share off of the secondary market. If one share costs $93, you will have to pay $93 for that share. With a mutual fund however, you can invest incredibly small amounts (i.e., $5), even if that amount were to only net you a portion of a share.
I Have Fallen Behind Investing, So I Prefer Extreme Measures To Get Rich Quick
So That Means Larger Is Better?
While there are certainly plenty high of risk, high reward options out there, spending more, and risking more are not always the most practical options over a long time horizon. Let’s take a look at the far end of the spectrum at spending more, because more expensive is always indicative of a better return right?
We are all familiar with the behemoth that is Berkshire Hathaway, but just how familiar are you with their returns? As of today (3/21/2018) Berkshire Hathaway Class A shares closed at a value of $307,600.00 per share. While the stock price is certainly impressive, so too would any other stocks on the S&P 500 had these companies never split their shares either.
Furthermore, the average return for Berkshire Hathaway in 2017 was 21.9%, nearly identical to the 21.8% return of the S&P 500 throughout the same time period. As such, investors tracking the S&P 500 via mutual or exchange traded funds (ETF’s) would have seen nearly identical returns to owning Berkshire Hathaway with never having owned the conglomerate themselves. Factor into the equation the risk of putting $307,600.00 of your retirement into a single share of Berkshire Class A, and the proposition is not nearly as attractive as it once might have been.
Mutual funds charge you no bid/ask spread, let you make purchases less than a single share at a time, have no commissions, and often mirror or even surpass the returns of much larger companies at a fraction of the cost. Warren Buffett himself would not even disagree. [insert link]
So That Means Riskier Is Better?
On the other end of the spectrum, we have risk. Few things in the stock market are as risky as assets that utilize options and/or margin in order to magnify their returns. In theory, if you purchase a 2X, 3X, or 4X fund, you would expect to see that level of return given the movement of the baseline index, but how does this work for investors who prefer to hold long term?
Direxion’s Miners Index Bull 3X Shares is a perfect example of risk. Direxion uses gold futures contracts that are leveraged in order to magnify returns, but that leverage comes at a cost. Where as passive mutual funds and ETF’s often have a cost as low as 4 basis points, triple leveraged funds such often begin at 100 basis points or higher. Direxion’s Miners Index Bull 3X Shares charges 1.15% less any commissions. Funds such as these also require volatility to produce a return. A bull fund such as this would require the market to move up. If gold were to trade flat, you would lose money the longer you stayed in the position not only due to the exorbitant costs, but due to the underlying erosion the futures time value with within the fund. If the market were to go down, you would see your loss magnified by 3X due to the futures in the fund. A truly losing proposition for any long term investor.
Passively managed mutual funds and ETF’s can offer you the returns of much larger companies such as Berkshire Hathaway, the diversification of owning hundreds of stocks in a single fund to mitigate volatility, and the savings of not relying on options or futures to magnify your returns in short term.
How Do I Invest In Mutual Funds And ETF’s That Work Together
To understand how we can best leverage mutual funds and ETF’s within our portfolio to minimize costs and further our returns, we need to start dealing with specifics. As a point of reference, these are going to be the three Vanguard ETF and mutual funds that I reference throughout this section: (VOO), (VFIAX), and (VFINX).
By Cutting Costs
Not all index funds are the same, as here we have three different funds with two different expense ratios that all track the same index, the S&P 500. The Admiral Share class (VFIAX) has the lowest expense ratio of 0.04%, or $40 per $100,000 invested per year. The requirement to get into the fund however, is that you have to invest a minimum of $10,000. Otherwise, you have to invest in the investor share class (VFINX), which has a minimum initial investment of $3000. At an expense ratio of 0.14%, this comes out to a total of $140 per $100,000 invested per year.
This however, is one of the areas where Vanguard is truly unique. If you want to capture the expense ratio of the Admiral Share class (0.04%) but do not have the capital to do so, you can simply purchase the ETF share class (VOO), and capture the Admiral Share expense ratio without having to invest $10,000. In fact, you can capture that expense ratio with as little as a single share of the VOO ETF.
By UtilzingTax Efficient Conversions
Certain mutual fund companies such as Vanguard also have the unique ability to do a one-way conversion into an ETF. The not so well known benefit of this action is that if you have current holdings in Vanguard mutual funds that also offer an ETF share class, you can do a conversion, and the act will not be counted as a taxable event.
So why would you want to do this? ETF’s are generally more tax efficient than mutual funds, which needs to be a large consideration when you have holdings outside of your IRA and 401(k). ETF’s are generally more tax efficient because of the way they are structured. When you redeem a share of a mutual fund investment, the fund manager must sell the underlying shares if there is not enough cash on hand, this generally creates a taxable event within the fund, which is passed on to every shareholder at the end of the year. With an ETF however, there is generally less selling within the underlying fund, since the majority of shares are bought and sold on the secondary market, and not redeemed through the fund manager.
Now It Is Time To Take Action
Mutual funds and ETF’s should absolutely be utilized in harmony together in order to mitigate costs and increase your returns. Ultimately, the only thing that we can control in the market is our costs, and by investing wisely we never have to surrender that control. It is only when you do not clearly define your objectives that you may find your wandering between trading and investing in your portfolio. When you begin to understand the benefits of passively investing for wealth, you may never find yourself trading in your portfolio ever again.