In the January issue, we built a portfolio using index funds but did not stop to explain. For our purposes, a fund is a collection of investments. They come in a variety of styles but we will focus on the two most common: open end mutual funds and exchange traded funds (ETFs). An index fund is one that invests in the same components of an index, like the S&P 500 for example.
Let’s set ETFs aside for now and look at mutual funds. A mutual fund is a pool of money that is managed by a fund manager. Shares of the fund are bought directly from the fund. When sold, they’re sold directly back to the fund. The shares are valued every day at the close based on the investments held to determine the price per share. The share price is called NAV or Net Asset Value. This is the price the shares can be sold for. It the fund is a no load fund, they can be bought for that same price. If a fund has a load (commission), it will show a POP price. Discount brokers will say there’s no statistical evidence that paying the load leads to better results so why pay the fee? Advisors who sell loaded funds will have a different story.
All funds will have an annual charge that’s used to pay management fees called an expense ratio. A fund’s focus is supposed to be evident in its name. If a fund is managed to play the market it will have higher fees. Sometimes these funds beat the indices and sometimes they don’t. Comparing their return of the last 5 and 10 years is a good indication but doesn’t guarantee anything. One of the advantages of using index funds is the lower fees. Index funds won’t outperform or underperform the market. They are the market.
For the portfolio we built, the index funds are easy and straight forward. The name of the fund should clearly describe its focus. For the more adventurous, managed funds come in a variety of flavors that can focus on a specific industry and/or theme. Some funds will use derivatives to magnify the markets. Stick with the index funds. They’ll get you there with much less drama.
Market risk is everywhere. It can be diluted with diversification.
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