Many investors passively invest using open-end index mutual and exchange traded funds.
Some investors lump the two instruments together when discussing passive holdings. And there are a lot of similarities when assessing for investment potential.
But there are also material differences between the two, so I shall discuss them separately.
Today, a brief look at open-end index mutual funds.
An Index Fund is Still a Mutual Fund
An index mutual fund, or “tracker” fund, is exactly like any other open-end mutual fund.
There are mutual funds that invest in U.S. large capitalization stocks, Russian bonds, Canadian mining companies, etc. Pretty much any type of investments one can configure.
An index fund simply invests in a designated benchmark index for a specific investment style.
For example, the BlackRock iShares U.S. Aggregate Bond Index Fund (BMOAX) is a fund that attempts to match the total return of the Barclays U.S. Aggregate Bond index. The Fidelity® Emerging Markets Index Fund (FPEMX) seeks to replicate the MSCI Emerging Markets Index.
We have spent a fair amount of time discussing open-end mutual funds. If you want an in-depth analysis, please take a look at Mutual Funds in my category listing on the right.
I will briefly go through some of the key points and try to cross-reference to any specific posts for greater detail.
Open-End
Open-end funds are purchased and sold through each fund’s company.
Unlike most investments, you do not acquire open-end mutual funds on a stock exchange. However, often you can buy and sell open-end funds through your brokerage account as many brokerage houses will act as intermediaries between you and the mutual fund company.
If not, you need to create an account with the fund company. Something they love as your money becomes a sticky asset.
Note that investors tend to stick with a fund company (or financial institution) even if performance or client service is not great once their assets are in place. Clients find it too much a pain to go through the process of moving to a new institution. Needless to say, financial institutions often create obstacles as well that deter clients leaving painlessly (e.g., perhaps 60 days to transfer to a new institution).
Before committing to an individual financial institution (bank, fund company, etc.), realize that you may be with them for a long period. Take care before committing your assets.
Transaction Costs
A goal of passive management is cost minimization.
This should be followed in respect of any mutual fund transaction costs.
In most cases, avoid mutual funds with loads. This is especially true for index funds. Paying a sales charge for an index fund is not justifiable in my opinion.
Be careful with any brokerage commissions you are charged when trading through your account. If you invest directly through the mutual fund company, you should not be subject to commissions on trades.
Some brokerage houses offer commission-free mutual funds. Consider these as well when looking at index fund offerings.
Annual Costs
Look for index funds with low operating costs, as indicated by their expense ratios.
Passively managed index mutual funds should have little to no management fees attached. Do not pay for a service that you are not buying.
All mutual funds incur some administrative and other operating expenses. But focus on those with low expenses.
Note that larger funds or fund companies tend to exhibit economies of scale. The larger the fund, the easier it is to spread out fixed costs among investors. That tends to lower overall expense ratios. In large part, why behemoths like Fidelity, BlackRock, and Vanguard, have such low expense ratios. And competitive advantages versus smaller peers.
Match the Market Return
When assessing funds for investment, always compare a fund’s returns against its benchmark and its peers. Remember that performance is a relative concept and you need to analyze investments in proper context.
Find funds with minimal tracking error, that match the benchmark index return as closely as possible.
Risks of Open-End Mutual Funds
Counterparty Risk
As the contractual relationship is between you and the fund company, be certain you minimize the counterparty risk.
You can only sell your shares back to the fund company. Not to a multitude of potential buyers via a stock exchange. Try to be sure that the fund company will be in existence and able to repurchase your shares when you want to sell them. Note that counterparty risk may also be known as default or credit risk.
Liquidity Risk
Normally fund companies calculate a fund’s per share net-asset value (NAV) daily using closing market prices for fund holdings. And most fund companies let investors buy or sell fund shares on a daily basis at a fund’s NAV.
However, some funds may not perform valuations on a daily basis nor allow for acquisition or divestment of fund shares daily. These funds may only allow redemptions on a weekly (or longer) basis. If the market you are invested in suddenly plunges, you may be unable to sell in a timely manner.
Know the frequency in which you may buy or sell shares. The less opportunity that you have, the greater the liquidity risk.
Over-Concentration Risk
When investing in multiple index funds, watch your portfolio diversification.
Depending on the indices you invest in, there may be an overlap of securities. This may create an over-concentration of certain investments and actually reduce diversification. Always monitor the key holdings in each fund you own.
For example, Apple is present in (it seems) every US equity fund. Even if you spread your wealth around, you will own Apple in multiple funds. Watch for potential over-concentration of one investment over all your holdings.
You will also find that, in many funds, the top 10 or 20 holdings will make up a disproportionate share of fund assets.
Consider BlackRock iShares S&P 500 Index Fund (BSPAX). 500 U.S. listed companies across a variety of industries. Nice diversification. But if you review the portfolio, the top 10 companies make up 22.35% of fund holdings. Not quite as diverse as you might initially think. And yes, that ratio holds true for any S&P 500 Index Fund, not just iShares.
Here, we also see Apple and its market dominance. Out of 500 companies in the index, Apple alone accounts for almost 4% of total fund assets (as at August 13, 2018). Always an issue with capitalization weighted indices.
Note that while the S&P 500 represents a relatively large market, this tends to be a bigger issue the smaller and/or more niche market covered by an index.
South Korea is always a good example. iShares MSCI South Korea ETF (EWY) owns 114 different companies. Samsung alone is 22.28% of total fund assets as of August 13, 2018. Not to mention, many other Korean companies in the index are reliant on Samsung for their own business. While you may own the South Korean market as a whole, in reality your risk is heavily tied to the fortunes of Samsung.
Note that this South Korea fund is not a mutual fund. Next up we will start to look at the other popular passive investment, exchange traded funds (ETFs).
