Battle for the Best Fund Types
Find the Best Funds for You With This Complete Breakdown
If you are looking for a comprehensive comparison and analysis on mutual fund types and how to choose the best funds for you, this is it. This article breaks down mutual fund categories and the main types of funds for investing. Before buying mutual funds, it's wise to know which fund types are best for your personal investment objectives and tolerance for risk.
Load vs No-Load Funds
Believe it or not, there are good arguments on both sides of the load funds vs no-load funds debate. For those of you not 100% clear on loads, they are mutual fund fees charged at the time of purchase or sale of the respective fund. Loads charged upon purchase of fund shares are called front-end loads and loads charged upon the sale of a mutual fund are called back-end loads or a contingent deferred sales charge (CDSC). Funds that charge loads are generally referred to as "load funds" and funds that do not charge loads are called "no-load funds."
When to Buy Load Funds
At first, you may think that no-load funds are the best way to go for investors but this is not always the case. The primary reason for buying loaded funds is the same as the reason loads exist in the first place -- to pay the advisor or broker who did the fund research, made the recommendation, sold you the fund, and then placed the trade for the purchase.
Therefore the best reason to buy load funds is because you are using a commission-based advisor that is showing you value with advice. Although it is possible to buy load funds without a formal client-broker relationship, there is no good reason for it, especially when there are plenty of high-quality no-load funds to choose from.
When to Buy No-Load Funds
In general, any investor who is doing their own research, making their own investment decisions, and making their own purchases or sales of mutual fund shares should not buy load funds. Instead, they should buy no-load funds. Most investors can make informed decisions about buying mutual funds after spending several hours educating themselves on the basics of investing.
Actively-Managed vs Passively-Managed (Index) Funds
What do people mean when they say "active" or "passive" in relation to investing strategies? Are actively-managed mutual funds better than passively-managed funds?
Here are the definitions and differences between active and passive investing:
An active investing strategy is one that has an explicit or implicit objective of "beating the market." In simple terms, the word active means that an investor will try to pick investment securities that can outperform a broad market index, such as the S&P 500.
Portfolio managers of actively-managed mutual funds will have often have the same objective of outperforming a target benchmark. Investors buying these funds will ideally share the same goal of obtaining above-average returns.
The advantages for actively-managed funds are based on the assumption that the portfolio manager can actively pick securities that will outperform a target benchmark. Because there is no requirement to hold the same securities as the benchmark index, it is assumed that the portfolio manager will buy or hold the securities that can outperform the index and avoid or sell those expected to underperform.
The passive investing strategy can be described by the idea that "if you can't beat 'em, join 'em." Active investing is in contrast to passive investing, which will often employ the use of index funds and ETFs, to match index performance, rather than beat it. Over time, the passive strategy often outperforms the active strategy.
This is largely due to the fact that active investing requires more time, financial resources, and market risk. As a result, expenses tend to be a drag on returns over time and the added risk increases the odds of losing to the target benchmark. Therefore, by virtue of not trying to beat the market, the investor can reduce the risk of losing to it because of poor judgment or bad timing.
Because of this passive nature, index funds have low expense ratios and manager risk (poor performance due to various mistakes made by a fund manager) is removed. Therefore the primary advantage of passively-managed funds is that investors are assured that they will never underperform the market.
Index Funds vs ETFs
If you choose to go the passively-managed route, you have a choice of using index mutual funds or Exchange Traded Funds (ETFs) or you can use both.
Here are the main points to know about index funds vs ETFs:
- Both are passive investments (although some ETFs are actively managed) that mirror the performance of an underlying index, such as the S&P 500; they both have extremely low expense ratios compared to actively-managed funds; and they both can be prudent investment types for diversification and portfolio construction.
- ETFs typically have lower expense ratios than index funds. This can in theory provide a slight edge in returns over index funds for the investor. However ETFs can have higher trading costs. For example, let's say you have a brokerage account at Vanguard Investments. If you want to trade an ETF, you will pay a trading fee of around $7.00, whereas a Vanguard index fund tracking the same index can have no transaction fee or commission. Therefore, if you are making frequent trades or if you are making periodic contributions, such as monthly deposits into your investment account, the trading costs of ETFs will drag on total portfolio returns over time.
- Index funds are mutual funds and ETFs are traded like stocks. What does this mean? For example, let's say you want to buy or sell a mutual fund. The price at which you buy or sell isn't really a price; it's the Net Asset Value (NAV) of the underlying securities, and you will trade at the fund's NAV at end of the trading day. Therefore, if stock prices rise or fall during the day, you have no control over the timing of execution of the trade. For better or worse, you get what you get at the end of the day. In contrast, ETFs trade intra-day. This can be an advantage if you are able to take advantage of price movements that occur during the day. The key word here is IF. For example, if you believe the market is moving higher during the day and you want to take advantage of that trend, you can buy an ETF early in the trading day and capture its positive movement. On some days the market can move higher or lower by as much as 1.00% or more. This presents both risk and opportunity, depending upon your accuracy in predicting the trend.
- The ETF "spread:" this is the difference between the bid and ask price of a security. However, to put it simply, the biggest risk here is with ETFs that are not widely traded, where spreads can be wider and not favorable for individual investors. Therefore look for broadly traded index ETFs, such as iShares Core S&P 500 Index (IVV) and beware of niche areas such as narrowly traded sector funds and country funds.
A final distinction ETFs have in relation to their stock-like trading aspect is the ability to place stock orders, which can help overcome some of the behavioral and pricing risks of day trading. For example, with a limit order, the investor can choose a price at which a trade is executed. With a stop order, the investor can choose a price below the current price and prevent a loss below that chosen price. Investors do not have this type of flexible control with mutual funds.
Total Stock Market Index vs S&P 500 Index
When choosing a diversified stock index funds, most investors use either a total stock index fund or an S&P 500 index fund. What's the difference? Let's start with total stock funds.
Where investors can get confused and/or make mistakes, is that many total stock market index funds use the Wilshire 5000 Index or the Russell 3000 Index as the benchmark.The descriptor, "total stock market index," can be misleading. Both the Wilshire 5000 Index and the Russell 3000 Index cover a broad range of stocks but both are either mostly or completely comprised of large capitalization stocks, which makes them have a high correlation (R-squared) to the S&P 500 Index. This is because total stock funds are "cap-weighted," which means they are more heavily concentrated in large-cap stocks.
In simpler terms, a total stock market fund does not really invest in the "total stock market" in a literal sense. A better descriptor would be "broad large-cap stock index." Many investors make the mistake of buying a total stock market fund thinking that they have a diversified mix of large-cap stocks, mid-cap stocks and small-cap stocks in one fund. This is not true.
As the name implies, S&P 500 Index funds hold the same stocks (roughly 500 holdings) that are in the S&P 500 Index. These are the 500 largest stocks by market capitalization.
Which is best? Total stock market funds, in theory, can have slightly higher returns over time than S&P 500 Index funds because the mid-cap stocks and small-cap stocks in the total stock index are expected to average higher returns in the long term than large-cap stocks. However, the potential extra return is not likely to be significant. Therefore either of these index fund types can make an excellent choice as a core stock holding.
Value Funds vs Growth Funds
Value stock funds perform better than growth stock funds in certain markets and economic environments and growth stock funds perform better than value in others.
However, there is no question that followers of both camps--value and growth objectives--strive to achieve the same result--the best total return for the investor. Much like the divides between political ideologies, both sides want the same result but they just disagree about the way to accomplish that result (and they often argue their sides just as passionately as politicians)!
Here's what to know about value vs growth investing:
- Value stock mutual funds primarily invest in value stocks, which are stocks that an investor believes are selling at a price that is low in relation to earnings or other fundamental value measures.Value investors believe the best path to higher returns, among other things, is to find stocks selling at a discount; they want low P/E Ratios and high dividend yields.
- Growth stock mutual funds primarily invest in growth stocks, which are stocks of companies that are expected to grow at a rate faster in relation to the overall stock market. Growth investors believe the best path to higher returns, among other things, is to find stocks with strong relative momentum; they want high earnings growth rates and little to no dividends.
It is important to note that the total return of value stocks includes both the capital gain in stock price and the dividends, whereas growth stock investors must rely solely on the capital gain (price appreciation) because growth stocks do not often produce dividends. In different words, value investors enjoy a certain degree of "dependable" appreciation because dividends are fairly reliable, whereas growth investors typically endure more volatility (more pronounced ups and downs) of price.
Furthermore, an investor must note that, by nature, financial stocks, such as banks and insurance companies, represent a larger portion of the average value mutual fund than the average growth mutual fund. This oversize exposure can carry more market risk than growth stocks during recessions. For example, during The Great Depression, and more recently The Great Recession of 2007 and 2008, financial stocks experienced much larger losses in price than any other sector.
The bottom line is that it is difficult to time the market by increasing exposure to either value or growth when one is outperforming the other. A better idea for most investors is to simply use an index fund, such as one of the best S&P 500 Index funds, which will combine both value and growth.
US Stock Funds vs Europe Stock Funds
The United States is no doubt the strongest economy in the world and European countries combine to form what can be considered the oldest economy in the world. But what is there to know about US stock funds vs Europe stock funds?
Europe Stock is a subcategory of International Stock that generally refers to portfolios that invest in the European region's larger and more developed markets, such as Great Britain, Germany, France, Switzerland, and the Netherlands.
Today, global economies, especially the developed markets, are interrelated and stock prices in major market indices around the world are generally correlated. For example, it is not common in the modern global environment for the US or Europe to have a significant market correction or sustained decline while the other is enjoying a bull market.
US stocks have historically averaged higher annualized returns and they typically have lower average expenses than Europe stocks. Europe stocks have the highest best return but the lowest worst return, which indicates greater volatility (and higher implied market risk).
Bottom Line: If the future is similar to the recent past, Europe stocks will produce inferior returns to US stocks and at a higher level of risk. Therefore the reward does not justify the risk and an investor may be better off using US stocks and diversifying with other investment types, such as bond funds or sector funds with low correlation to the S&P 500.
Bonds vs Bond Funds
Now that the basic stock and stock fund types have been covered, let's finish with differences between bonds and bond mutual funds.
Bonds are typically held by the bond investor until maturity. The investor receives interest (fixed income) for a specified period of time, such as 3 months, 1 year, 5 years, 10 years or 20 years or more. The price of the bond may fluctuate while the investor holds the bond but the investor can receive 100% of his or her initial investment (the principal) at the time of maturity.
Therefore there is no "loss" of principal as long as the investor holds the bond until maturity (and assuming the issuing entity does not default because of extreme circumstances, such as bankruptcy).
Bond mutual funds are mutual funds that invest in bonds. Like other mutual funds, bond mutual funds are like baskets that hold dozens or hundreds of individual securities (in this case, bonds). A bond fund manager or team of managers will research the fixed income markets for the best bonds based upon the overall objective of the bond mutual fund. The manager(s) will then purchase and sell bonds based upon economic and market activity. Managers also have to sell funds to meet redemptions (withdrawals) of investors. For this reason, bond fund managers rarely hold bonds until maturity.
As I said previously, an individual bond will not lose value as long as the bond issuer does not default (due to bankruptcy, for example) and the bond investor holds the bond until maturity. However, a bond mutual fund can gain or lose value, expressed as Net Asset Value - NAV, because the fund manager(s) often sell the underlying bonds in the fund prior to maturity.
Therefore, bond funds can lose value. This is possibly the most important difference for investors to note with bonds vs bond mutual funds.
In general, investors who are not comfortable seeing fluctuations in account value may prefer bonds over bond mutual funds. Although most bond funds do not see significant or frequent declines in value, a conservative investor may not be comfortable seeing several years of stable gains in their bond fund, followed by one year with a loss.
However, the average investor does not have the time, interest or resources to research individual bonds to determine the suitability for their investment objectives. And with so many different types of bonds, making a decision may seem overwhelming and mistakes can be made in haste.
While there are also many types of bond funds to choose from, an investor can buy a diversified mix of bonds with a low-cost index fund, such as Vanguard Total Bond Market Index (VBTLX) and be assured average long-term returns and yields with relatively low volatility.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.