Stocks, mutual funds, ETFs, and indexes

Investment jargon is designed to confuse you

Walk into any bank or open up the business section of any online news website, and you’ll quickly get bombarded and confused by what appears to be an endless number of complicated investment options. Mutual funds, ETFs, derivatives, options…

It’s so overwhelming. I don’t know where to start… I can never understand this!

Finance people work hard to make you believe this false reality. They can only charge you the big bucks if they can make you believe their products are hard to understand and their advice better than what you can deduce on your own.

This isn’t by mistake. It’s by design.

In this post, we break down key concepts you should be aware of when you consider investing in the stock market. Understand these concepts and you will acquire the minimum tools required to create your own financial advice and filter out the bullshit.

Stocks, aka Securities

Stocks, shares, securities, assets. These are all just different ways of describing the same thing: an investment vehicle that can be bought on the stock market. These terms can be used interchangeably.

Funds (Mutual funds & ETFs)

A fund is essentially a managed pool of money invested in various stocks or securities. The money belongs to investors, who decided to invest in the fund.

The fund is typically managed by someone, usually a team of “financial professionals”, working for the fund. The fund is typically owned by a company or bank.

Just like you, these financial professionals have to put bread on the table too. So, they get paid a salary. Where does this salary come from? You guessed it: It is taken as a fee from the investors’ money pool.

Management Expense Ratios (MER)

You have bills. I have bills. We all have bills. Funds are no different. They cost money to operate. There are many different types of fees a fund has to pay to operate profitably.

The largest component of operating expenses is the fee paid to a fund’s investment manager or advisor. Other costs include record keeping, custodial services, taxes, legal expenses, and accounting and auditing fees.

For now, we don’t need to break down fees. We just need to be aware of the fact that the fund’s total fee is called its MER and that the golden rule of investing is: the lower a fund’s MER the better it is for you as an investor.

High MERs mean your profits are reduced significantly. MERs can range anywhere between 0.1% (for cheap funds) to 3% (for expensive funds).

Loads

A load is a commission charge that compensates an intermediary (usually a bank) for distributing shares or units of a mutual fund.

Loads vary by share class and are determined by the mutual fund company.

For example, Citibank could charge investors a 2% load to invest in a mutual fund offered by ACME Mutual Fund. This means an investor who tries to buy ACME’s mutual fund will pay 2% of the initial investment as a commission to Citibank.

Super… As soon as you buy it, you are down 2% while the financial professionals go out drinking on your 2%.

Stocks

As we’ve covered in our post about stocks and our post about companies, stocks represent partial ownership of publicly listed companies.

One way you could invest in the stock market is to pick individual companies and purchase their underlying stock.

This is generally a good idea when you strongly (and we really mean strongly) believe in a company or have a good enough reason to believe the company will do well in the future.

We won’t go into how you can make such a judgement, as we are not financial advisors nor do we pretend to be.

Mutual Funds

Mutual funds are one of two types of funds out there (ETF being the other). When investors pour new money into a mutual fund, the fund company must take that money and go into the stock market to buy securities.

Along the way, they must pay various fees and commissions, which ultimately harm returns of the fund. The same thing happens when investors remove money from the fund.

Mutual funds can usually be purchased through the investor’s bank. And because investors blindly trust the advice of their bank (after all, “they keep my money safe”), mutual funds which may not perform as well as other investment options remain popular today.

Exchange Traded Funds (ETFs)

An ETF is a newer way to pool investors’ money into a fund. These funds differ from mutual funds in that they are traded not at the investors’ bank, but on a stock exchange! In other words, anyone and everyone who has access to a stock exchange can freely purchase an ETF representing an investment fund.

The mechanics of how ETFs differ from mutual funds are not that important to cover, but if you are interested you can read more here.

The beauty of the ETF system is the fund is shielded from trading fees. The fee for putting new money to work (or redeeming money from the fund) is typically paid by a middle-man, which means the ETFs typically have lower fees than mutual funds.

Indexes

Indexes are an extremely important concept. So put down your iPad/phone/cigarette, and pay attention.

Say you are an engineer who works in the energy sector, specifically in oil. Now say that you believe this sector is going to do well over the next 3-5 years. You’re not sure whether your company will do well. You’re not sure which company in the oil sector will do well, but you are certain the oil sector will do well overall.

What if there was a way to capitalize on this knowledge? What if you could invest in the entire oil sector in one shot without picking individual companies to invest in? There is a way (don’t pretend you’re surprised). This concept is called indexing.

An index is a representation of a specific group of companies in a specific sector, industry or geography.

When we talk about an energy index, we mean a collection of companies that accurately represent the energy sector. A US index is a collection of companies incorporated in the USA. An emerging market index tracks companies incorporated in emerging markets like Brazil & India.

We often say indexes track the companies that make them up. What this means is if an index contains 20 companies, the aggregate performance of that index should be exactly the same as the aggregate performance of the companies making up that index.

For example, the price of an imaginary index that tracks Apple, Google, and Facebook should behave similarly to a portfolio made up of Apple, Google, and Facebook.

Actively vs. Passively Managed Funds

Both funds and ETFs can be actively or passively managed.

A passively managed fund is one whereby the fund managers need not make their own decisions on which underlying securities to buy or sell in the fund. In fact, most of the time the decision on which securities to buy or sell is made with a fixed set of rules that rarely changes. These rules are often so systematic that computers can do the decision-making!

An actively managed fund has fund managers who make decisions every day or every week. They decide which underlying securities to buy and sell. Sounds like it would be a more effective way to manage a fund, doesn’t it? Alas, another financial industry trick.

“Active” sounds cooler and more effective than “passive”. Obviously. But don’t fall for this trick. Passively managed funds do not necessarily perform worse than actively managed ones. In fact it is usually the opposite. 90% of active money managers cannot outperform passively managed funds.

Conclusion

Funds come in all shapes and sizes, and can be primarily differentiated using the performance of their underlying securities, their expenses (MERs) and their loads.

Two main types of funds exist as far as we are concerned: mutual funds and ETFs.

Both mutual funds and ETFs can have different investment objectives. For example, a fund can have the objective of tracking companies in emerging markets with a $200M+ market cap. Another fund can have the objective of tracking oil drilling companies.

Indexes represent and track certain sectors or geographies and can be used as the objective of a mutual fund or ETF.

Understand these key concepts and you will be well on your way to learn more about effective investment strategies moving forward.

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