Discovering Investment Vehicles

 In the investment world, there are many different types of investment vehicles in which to place your money. Which vehicle you choose depends on your goals. It depends on your time range, your objective, your risk tolerance, and the rate of return you are attempting to achieve.

This chapter will explain many investment vehicles that you may have in your investment portfolio. 

 Checking Accounts

Checking accounts are best used as your everyday type of account. You can deposit payroll checks and other income and then pay your expenditures. This account is like a revolving door with money coming in and going out rapidly. It has a quick cash flow. It is generally best to keep approximately two months’ of expenses in this account so it can handle the cash flow and emergencies.

Be sure to shop around at banks, savings and loans, and credit unions for the best service and lowest rates. Focus on avoiding the monthly service charge as this can add up quickly over several years. Shop for other fees such as low balance charges, ATM fees, check charges, and other fees.

Don’t buy your checks from your bank; instead buy them from one of the many mail order check-printing companies available in newspapers and magazines.

Look for an account that offers interest with checking. If the fees are low enough, it can add a small amount to your account.

Savings Accounts

Savings accounts are found at banks, savings and loans, and credit unions. You receive interest for placing your money in an account there. The interest rate however is usually quite small, under 5% per year.

Bank savings accounts are backed by the Federal Deposit Insurance Corporation (FDIC) insurance. Many people, usually older ones, clamor after savings accounts because of the insurance, remembering back to the days of bank failures. They generally have no risk tolerance and don’t realize or care that they are receiving a much lower interest rate for the insurance.

The 1980s highlighted how poorly much of the savings and loan industry was run and showed that banks are not perfectly safe, either. The FDIC insurance system is just an insurance system. If there were ever such an economic disaster in the U.S. that money in savings accounts declined in value, the whole U.S. banking system could be in jeopardy and the FDIC insurance system could collapse. 

Bank CDs

This investment vehicle is an extended type of savings accounts. A bank CD (certificate of deposit) is an interest-bearing bank investment that locks you in for a specific period of time. Generally the bank offers certificates from 6 months to 5 years. This locked-in time range allows the bank to pay you a higher interest rate than a standard savings account. If you need to withdraw funds from the CD prior to maturity, the bank will charge you a penalty for early withdrawal. Like savings accounts, bank CDs are also backed by FDIC.

There are two primary considerations in planning for your investment in a CD:

1) Term: The most popular type of CD is the 6-month certificate, but CDs are available with maturities ranging from 7 days to 15 years. During the term of your CD, the money you’ve invested is relatively costly to liquidate. If an emergency arises which requires you to withdraw your money before maturity, you’ll be penalized for it. This penalty is known as early withdrawal penalty and will vary from bank to bank. Thus you’ll want to consider carefully when you’re likely to need the money before you invest in a CD.

2) Rate of Return: The interest paid on a CD will vary not only according to the term of the certificate but, from time to time, as interest rates fluctuate, as well as from bank to bank. Don’t buy your CD at the first bank you visit. Check the Internet for rates, contact your investment advisor for the highest rates available. Ask about how the bank credits the interest earned to your account. The more frequently interest is credited, the better for you, since each time your account grows through an interest payment, the amount of money you have working for you grows as well.

Who Should Purchase CDs?

Generally, certificates of deposits should not be in an investment portfolio because there are so many alternatives. Millions of people own them because of their safety, convenience, and confidence in their bank, yet investors lose because they deny the chance for higher yields, which come with accepting more risk. However, there are certain times when CDs do make sense.

1) Emergency savings: We recommend an emergency fund equal to at least three months of expenses. A short-term CD (three months or less) can be a good choice for emergency savings since the funds are relatively liquid.

2) Short-term goals: Savings for a car, house or any other item in the next one to two years can make a good justification for CDs.

3) The parking lot theory: An inheritance, lottery, or any windfall may give you a large sum of money. However, you may need a little time to decide where to invest. CDs make a fine short-term parking lot for those funds. 

Treasuries

The U.S. Treasury Department provides for the enormous financial needs of the federal government. Much of the money the Treasury raises comes from the sale of securities to the general public. These securities are known as Treasury obligations and consist of Treasury bills, notes, and bonds.

Conservative investors often invest in Treasuries because they are safe and secure and are a good alternative to bank CDs. In comparison with similar obligations issued by corporations, Treasury obligations usually pay a yield, which is one or two percentage points lower. However, many people are willing to accept the slightly lower yield in exchange for absolute safety.

Treasury Bills

Treasury Bills (T-Bills) are short-term federal debt, sold in denominations of $10,000, with $5,000 increments thereafter. T-Bills are issued in original maturities of 13, 26, and 52 weeks. The first two are auctioned weekly, while the 52-week bill is auctioned every 28 days. They can be purchased through brokers or directly from the Federal Reserve. They are issued on a discount basis under competitive bidding, with the face amount payable at maturity. The investment return on bills is the difference between the cost and the face amount. Bills may be sold prior to maturity at a competitive market rate, which can result in a yield greater or less than the original acquisition rate. T-Bills are an extremely safe type of investment vehicle.

Treasury Notes

Treasury Notes are similar to T-Bills except they mature in one to ten years and are sold in denominations of $1,000 to $100,000. Treasury notes, like T-bills, pay interest rates determined by auction. However, they are not sold at a discount. Instead, they pay interest every 6 months at a rate fixed at the time of purchase. In this respect, they resemble corporate bonds. Treasury notes can be bought and sold on the secondary market.

Treasury Bonds

Treasury Bonds are similar to T-Bills and Notes except they mature in five years or more and sell in denominations of $1,000 to $1,000,000.  

U.S. Savings Bonds

These bonds are issued by the U.S. Treasury and are designed for the conservative investor. Presently, they pay a flexible interest rate based upon 85 percent of yields on five-year government treasury securities. The rates change each May and November. 

If you hold the bond for five years, you will receive the average of all the rates in effect while you owned the bonds, but they pay a fixed rate if cashed before five years. You can buy a $50 bond for $25 or a $10,000 bond for $5,000. The maximum amount of bonds a person can purchase during one year is $15,000 ($30,000 face value).

The most common U.S. savings bond is the Series EE, which the United States Treasury began issuing on January 2, 1980, to replace the series E bond. Series EE bonds also have a guaranteed minimum yield if the bonds are held for five years. Call your local bank for current minimum yield. Presently, U.S. savings bonds are exempt from state and local taxes, and federal tax is deferred until the year cashed. As of January 2, 1990, Series EE bonds that are used for higher education are exempt from federal tax. Note: They must be bought in the parent’s name, not the child’s.

U.S. savings bonds Series HH are sold at face value, with $500 being the minimum investment. The bonds mature in ten years. The interest is paid every year; therefore, when the bond matures you have already received your interest. Interest is taxed each year.

Money Markets

A money market account is offered by mutual fund companies and brokerages. They are like a mutual fund that invests in short-term issues such as Treasury Bills, bankers notes, and corporate commercial paper, which is issued by the largest and most credit-worthy companies and U.S. government securities.

There are hundreds of money market funds that invest billions of dollars. Money market funds are closely regulated by the U.S. Securities and Exchange Commission. Money market funds’ investments can exist only in the most credit-worthy securities and must have an average maturity of less than 120 days. Money market funds maintain a constant $1-per-share price.   

Even though this vehicle is NOT insured by FDIC, it is considered to be a safe investment, and to date no major money market fund has lost investors’ principal investments. If the lack of insurance on money market funds still spooks you, consider a fund that invests exclusively in U.S. government securities. These money markets are virtually risk-free because they are backed by the full strength and credit of the federal government. These types of accounts typically pay a lower interest rate, usually ¼ percent less (even though the interest is state tax free).

Municipal Bonds

When a city, state, or county needs funds to build schools, roads, or water and sewer facilities, they offer bonds. Because municipal (muni) bonds are tax-free, the interest rates offered are lower than regular bonds of similar type. Tax-exempt municipal bonds yield about 85 percent of compatible taxable instruments; the investor in the 28 to 39.6 percent tax bracket has a chance to lock in excellent returns.

Municipal bonds that offer higher interest rates than what is presently being offered are most likely to be called in, because the issuer will want to redeem them with new ones paying lower yields. When a bond is callable, it may be redeemed by the issuing agency prior to the maturity date, usually within 10 years after issue, and usually at a premium. Of course, this places a lid on potential profits, which may be a significant loss to you if interest rates decline greatly after the bond is issued.

As with any investment, risk is a factor to consider in purchasing municipal bonds. Like corporate bonds, municipal bonds are rated by two major independent rating services: Moody’s and Standard & Poors. The AAA rating is the highest; the C rating is the lowest. In general, the lower the rating, the higher the yield. However, we don’t recommend that you purchase bonds with a rating lower than A, since the slightly higher interest rate you may be offered on the lower-rated bond isn’t worth the sacrifice in safety. Also, when financial times are uncertain, investors will look for high-quality bonds even though they do produce a lower yield.

A technique when investing in municipal bonds is known as laddering. What is done is that you purchase bonds maturing in different years. Therefore, if rates have risen when a bond matures, you will be able to reinvest the proceeds into an instrument paying the new high yield. Conversely, if interest rates should fall, a portion of your holdings will still earn interest at the higher rates.

When a municipality issues muni bonds, the city’s or state’s credit is on the line. If bonds are somewhat lower-rated, the municipality must pay higher-than-normal interest on the issued bonds. To save money, it may purchase insurance that guarantees that all payments of principal and interest will be made on time. Thus it may appear that the insurance is free to the investor, but that is not true. Since the insurance raises the quality of the municipality’s credit, the yield on the bond issued will be lower. Because the cost/yield difference between an insured and an uninsured bond is narrow, the insurance has become a “good buy.”

Municipal Bond Funds

A municipal bond fund is similar to a money market fund: its shares are highly liquid. Each fund sells or redeems shares at its net asset value (NAV) at any time. The managers of a municipal bond fund are constantly trading. Thus the fund as a whole never matures but goes on indefinitely buying and selling bonds to take advantage of changes in the marketplace.

One advantage that municipal bond funds have is that buyers can invest a much smaller amount of money than they would need to buy a municipal bond on their own. Most municipal bond funds require an initial investment of at least $1,000. Any time thereafter you can buy additional shares in the fund. You have the option of receiving a check for your monthly earnings or having them automatically reinvested to purchase additional shares in the fund. Whenever you wish, you can sell your shares back to the fund. However, since the value of the bonds in the fund’s portfolio fluctuates over time, you may or may not get back your original investment when you sell your shares.

Bonds

Bonds are a type of loaner-ship. This is where you invest (loan) some money and that organization pays you back interest for using the money. In a way you are a bank. The types of organizations that may sell bonds are corporations, local, state, and federal government, foreign governments, and other entities.

When investing in bonds, you should be aware of some of the terms. Principal is what you originally invest. The maturity date is the date on which the loan must be paid in full; it can range from one day to thirty years. If it is less than one year, it is called short-term debt, if it matures within a few years then it is called intermediate bonds, and if longer than ten years, it is called long-term debt. Interest is the money you receive in return for loaning your money.

There are three types of risk involved in bonds: (1) the interest will not be paid; (2) the principal will not be returned; (3) the market value of the bond might decline due to rising interest rates, making your investment worthless. For example, if you’re holding a bond issued at eight percent, and rates increase to ten percent, your bond decreases in value. Because why would anyone want to buy your bond at the price you paid if it yields just eight percent and they can get ten percent elsewhere?

Unless the Federal Government defaults, there is “no risk” when you loan money to the government. So government securities are the safest of all debt instruments available. However, government securities, like other bonds, can lose market value if interest rates rise.

Corporate bonds can be purchased the same way as stocks—through a brokerage firm. Government bonds can be purchased from commercial banks or a Federal Reserve branch bank. Corporate bonds have more risk than government bonds due to the fact that corporations are less stable than the U. S. Government.

High-yield bonds, also known as Junk Bonds, are speculative bonds that have a poor rating. These bonds pay a higher interest rate but are a higher risk. Generally bonds with a B or lower rating are classified as high-yield bonds. 

Mortgage-Backed Securities

Mortgage-backed securities are investments in a portfolio of home mortgages and are sometimes referred to as "pass-through" securities because homeowners’ mortgage principal and interest payments are "passed through" to investors.

The most well-known mortgage-backed security is the Ginnie Mae, which is issued by the Government National Mortgage Association (GNMA). Ginnie Maes carry the "full faith and credit" guarantee of the Federal Government and generally pay a slightly higher rate than Treasury bonds.  Ginnie Maes require a $25,000 minimum purchase, with $5,000 increments, from brokers, but can also be purchased indirectly for $1,000 through units in a Ginnie Mae unit investment trust. They can also be purchased through mutual funds that invest in U.S. government agency securities (minimum amounts vary per fund).

Two other mortgage-backed securities that are not backed by the federal government are Freddie Macs, issued by the Federal Home Loan Mortgage Corporation (FHLMC) and Fannie Maes, issued by the Federal National Mortgage Association (FNMA). They also require $25,000 and typically pay a higher rate than Ginnie Maes to compensate investors for the extra risk of not being government-insured.

The biggest disadvantages of all three mortgage-backed securities are an uncertain maturity and irregular monthly payments. Although the mortgages in their portfolios are issued for 30 years, the average life of a mortgage-backed security is only 10 to 12 years because homeowners frequently move or refinance. Also, if investors spend the part of their monthly check that is a return of principal, instead of reinvesting it, they will have nothing left when the last mortgage in their Ginnie Mae portfolio is repaid.

Collateralized Mortgage Obligations

Collateralized mortgage obligations (CMOs) are another type of mortgage-backed security. CMOs were developed to address investors’ concern about receiving income from other mortgage-backed securities in unpredictable increments.

With CMOs, the portfolio of mortgages is divided into various classes, called tranches, thus offering investors a choice of estimated maturity dates to match financial goals. Investors in a particular tranche typically receive semi-annual interest payments that differ from period to period and from other tranches. Tranches with a longer maturity generally pay a higher return to compensate investors for incurring greater interest rate risk. The principal portion of mortgage payments corresponding to all tranches goes to investors in a single tranche until that tranche is retired. Each tranche gets its principal back when all the tranches before it have been repaid. CMOs are available in $1,000 increments through brokerage firms and pay a higher yield than comparable mortgage-backed securities.

The two disadvantages of CMOs are their complexity and the fact that principal prepayment can still come sooner (or later) than expected. Just as with other mortgage-backed securities, investors must realize that principal is being repaid throughout the life of a CMO, not at maturity like bonds. Investors who mistakenly think that CMO payments are just interest may inadvertently spend their principal.

Zero-Coupon Bonds

Zero coupon bonds (zeros) are issued at a deep discount but don’t pay interest until they mature. Zeros are usually sold in denominations of $1,000 per bond, at prices far below par value. During the term of the bond you receive no interest—hence the term zero coupon—since coupon means interest in bond terminology.

When the bond matures, you are paid face value, including the interest that’s accumulated over the term of the bond. For example, you may purchase a $20,000 zero-coupon bond with a six-year term for $13,500. At the end of the six years, you will receive $20,000.

One advantage of zeros is that you can invest relatively small amounts up front and choose maturity dates to coincide with times you know you’ll need the money—for example, college tuition.

One drawback to zeros, however, is that taxes are due annually on the interest that accrues, even though you don’t receive the actual payment until the bond matures. Another drawback is that zero-coupon bonds are very volatile in the secondary market, so if you have to sell them before maturity, you might have to sell at a loss.  

Convertible Bonds

As their name suggests, convertible bonds are a type of corporate bond that allows investors to "have their cake and eat it too," almost. They provide the upside potential of stocks (the opportunity to participate in company earnings) with the downside protection of bonds (a fixed return and repayment of principal at maturity).

Convertible bonds can be exchanged for a specified number of shares of common stock of the issuing company. As the price of the company stock increases, the convertible bond price also increases because the option to convert becomes more valuable. This correlation is true whether an investor chooses to convert or not. The trade-off is that convertible bonds generally convert to fewer shares of stock than you could buy for the cost of a bond. Almost all convertible bonds are callable.

Even though they are a "hybrid" investment, convertibles, like all bonds, are sensitive to interest rate fluctuations. They can be purchased as individual securities in $1,000 increments or through convertible bond mutual funds.

Preferred Stock

Although technically a form of stock, preferred stock is often listed as a fixed-income investment because it behaves more like a bond, but has no fixed maturity date. The word "preferred" refers to the fact that shareholders receive preferential treatment. They are paid dividends before common stock shareholders and, in the event of a corporate liquidation, can claim corporate assets after bondholders but before common stock shareholders.

Preferred stock typically pays a fixed dividend rate similar to the coupon rate on a bond. Share prices fluctuate inversely with changes in interest rates. Par value on preferred stock is usually about $25 per share so a round lot (100 shares) would cost $2,500. Dividends paid are a fixed percentage of par value.  Preferred stock shares are available through brokerage firms.

Common Stock

All corporations have common stock. If you organized a corporation for the purpose of manufacturing widgets, and sold one share of common stock to each of nine people at $100 per share and one share to yourself At $100, the corporation would be capitalized at $1,000 and would have ten stockholders. In buying one of these shares, you became a shareholder or part owner of the corporation. You took an equity position and will participate in the future gains, or lack of gains, of the corporation for as long as you hold your share.  

Stocks are the most common investment traded on securities markets. Companies that issue stock are from every industry and sector including: airlines, computer manufacturers, department stores, oil drillers, restaurants, and many others. You can buy stock in more than 9,000 publicly-traded companies, though chances are your portfolio will only have a tiny fraction of what’s available.

Since shareholders are part owners of the corporation, if the company does well, you may receive part of its profits as dividends and see the price of your stock increase. But if the company fares badly, the value of your investment can drop, sometimes substantially.

A stock has no absolute value. At any given time, its value depends on whether the shareholders want to hold it or sell it and on what other investors are willing to pay for it. If the stock is hot and lots of people want lots of shares, the value will go up. If a company is losing money, the stock value will probably drop. Some stocks are undervalued, which means they sell for less than analysts think they’re worth, while others are overvalued.

Investors’ attitudes are determined by several factors: whether or not they expect to make money with the stock, by current stock market conditions and the overall state of the economy.

The caution that past performance is no guarantee of future profits is absolutely valid, especially for stocks. Investing isn’t about balancing risk with reasonable expectations of reward.

Dividends

If a corporation makes a profit (earnings), the board of directors has the option to reinvest the profit back into the corporation and/or pay it out to the shareholders. The money paid to shareholders is called a dividend.

Generally, larger and older corporations pay more dividends than younger and smaller ones. Often newer and smaller companies need the profits to help grow the business.

If you are dependent on dividends for your groceries and if the price of food continues to rise, you must increase your income or reduce your intake. Most of us would probably be a lot healthier if we did the latter, but we have a tendency to reject this alternative. Therefore, you will want to select stocks that pay good dividends consistently.

We prefer stocks that have raised their dividends in at least eight of the past ten years and whose dividends today are 100 percent higher than they were ten years ago. We also prefer those that have held their dividend payout to less than 60 percent of earnings and have kept their debt under 25 percent. A record of strong and consistent dividends points to companies that are committed to similar performance in the future.

Holding payouts under 60 percent of earnings helps eliminate companies that don’t retain enough earnings to sustain growth. Keeping long-term debt low protects future earnings. But don’t reach too far for yield and jeopardize your capital. Usually the reason for the high yield is the poor evaluation that the market has given to the future prospects of the company, or it may be paying out an inordinately large percentage of its earnings, which could adversely affect future earnings. 

So in selecting stocks for dependable income, it is obvious that you will want to choose quality issues with long established dividend records rather than younger, less tested companies that have not been in business long enough to establish extended dividend payment records.

During times of market corrections, we often have calls from less sophisticated holders of income stocks who are worried that their dividend will be cut because the market price is down. If all is well with the company, we try to calm them with the explanation that short-term market prices often have no relationship to earnings. In the long term, however, they usually do.

Blue Chips

The stocks we have just described would generally be called blue chips. What is a “blue chip” stock? First, the name can be traced to the game of poker, in which there are three colors of chips: blue for the highest value, red for the next in rank, and white for the lowest value.

Occasionally someone will come into my office and say “I only invest in blue chip stocks and throw them in a drawer and forget about them.” We consider this approach to be very risky. I would prefer to see them monitor their holdings on an ongoing basis. In today’s investment world, a particular stock can drop over 50% in one day if they happen to report poor earnings or bad publicity is reported on the company.

In summary, if your desire is for income from stocks, you should: 

·         Look for companies that have a long, unbroken dividend record.

 ·         Don’t reach too far for yield and jeopardize principal.

 ·         Remember that too high a yield can be dangerous and misleading.

 ·         Favor companies producing consumer goods and services.

 ·         Select sound companies that continue to increase their dividends.

Make sure you do your homework carefully before buying any income stocks. Read the research reports and look for any potential problems the company may be having or expected to have in the future. If you do not need income now, consider companies with slightly lower yields. Often these companies are plowing back a larger portion of their earnings into expanded facilities that should in time yield higher earnings that would allow them to pay out higher dividends.

Yield

The yield on stock is the relationship of the dividend it pays to its market price. Every shareholder is entitled to the same dividend per share. However, the price you have paid for your stock may differ from the price paid by another shareholder. If you paid $50 for a share of stock and the dividend is $2, the yield on your original investment is 4 percent ($2 divided by $50). If you paid $35, the $2 represents a return, or yield, on your original investment of slightly more than 5.7 percent. You should, however, continue to calculate your yield on current market price, because you have the option of repositioning your assets.

Growth Stocks

A growth company is usually one that is increasing its sales and earnings at a faster rate than the growth rate of the national economy. The growth investor is not as focused on earnings and dividends as the income investor.

To be a successful investor in growth stocks, you must be aware of current events: supply and demand, general market trends, psychology, and money markets. In fact you must be truly current in all respects. One of the most stimulating characteristics of my profession is that every day is a new day in the market. Nothing remains static. There is no way you can be a truly top-notch investor by buying blue chips and throwing them in a drawer and forgetting about them. This only increases your risk and lowers your opportunity for gain.

There are two irreversible structural changes occurring in the United States that are permanently transforming our economic base. First, our transformation from a smokestack to a microchip economy. Second, the United States is no longer an economic fortress unto itself, but rather now a part of a global economy. And its potential for growth is boundless because its new thrust comes from our richest and most renewable resource—the human mind. 

Exchange Traded Funds

At the most basic level, exchange traded funds (ETFs) are just what their name implies: baskets of securities that are traded, like individual stocks, on an exchange. They currently trade on the American Stock Exchange.

An ETF is an investment in a particular stock index. For example, there are ETFs that invest in the stocks that comprise the Dow Jones Industrial Average, Standard & Poor's 500, and Nasdaq 100. You can also invest in ETFs that invest in certain industry sectors, such as technology, health, energy, or transportation.

Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day. They trade like stocks instead of mutual funds that trade at the end of the day. They can also be sold short and bought on margin—in brief, anything you might do with a stock, you can do with ETFs. Most also charge lower annual expenses than even the least costly mutual funds.

All currently available ETFs are passively managed, tracking a wide variety of sector-specific, country-specific, and broad-market indexes. Their passive nature is a necessity: The funds rely on an arbitrage mechanism to keep the prices they trade at roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings. Active managers, however, are loath to disclose such information more frequently than the Securities Exchange Commission requires them to.

Another advantage is that, because you buy and sell ETFs at your discretion, you only incur a tax liability when you decide to sell your ETFs. Investors in no-load mutual funds are beholden to the fund manager when it comes to possible tax liabilities.

Since you buy ETFs like stocks, you will incur a brokerage commission when you buy and sell ETFs. This differs from no-load mutual funds, which don't charge a commission for transactions. Thus, when buying or selling ETFs, it is important to control your transaction costs.

One last point about ETFs is worth mentioning. These vehicles can be extremely effective ways to diversify a stock portfolio with relatively small amounts of money. Indeed, a portfolio holding a few ETFs, especially ETFs that mimic a broad index (such as the S&P 500), plus a few individual stocks can be surprisingly diversified. Thus, ETFs allow an investor to hold fewer stocks. This simplifies portfolio record keeping and monitoring while still being prudent from a portfolio diversification standpoint.

Are ETFs Right for You?  

ETFs have several clear advantages over traditional mutual funds, but they aren't suitable for everyone.

Trading Flexibility

ETFs trade throughout the day, so you can buy and sell them when you want. However, the arbitrage mechanism isn't failsafe. Heavily traded issues such as SPDRs (which track the S&P 500) and QQQs (which track the Nasdaq 100) should trade right around the value of their underlying securities, but premiums and discounts can arise, especially for thinly traded funds. Moreover, it is not yet known how ETFs might behave in the face of a full-fledged market correction. It's conceivable that investors wishing to sell in the midst of such an event could have to part with their shares at prices below their net asset values.

Costs

In terms of the annual expenses charged to investors, ETFs are considerably less expensive than most mutual funds. SPDRs, for example, set their annual expense ratio to just .12%.

Still, investors need to put these numbers in perspective. On a $10,000 investment, you'd save just $9 a year by choosing an ETF S&P 500 Index fund over a mutual fund S&P 500 Index fund.

The expense advantage of ETFs may also prove to be more mirage than fact for most investors. That's because you must pay commissions to buy and sell ETFs, just as you would for stock transactions. If you plan on making a single, lump sum investment, then it may pay to choose an ETF. However, if you plan to buy or sell shares more than once a year, ETFs' cost advantage could be obliterated quickly. That may be ETFs' greatest weakness. The fund companies behind them tout ETFs' expense advantages and trading flexibility as their key benefits, but the fact remains that if you trade very much, you actually end up costing yourself far more than you would with almost any mutual fund.

Taxes

With a regular mutual fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital gains distributions being paid to shareholders. In contrast, most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions. Furthermore, redemptions made by large investors are paid in-kind, again protecting shareholders from taxable events.

Keep in mind, however, that ETFs can and do make capital gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying benchmarks.

Performance

Because they are shielded from investor trading, ETFs shouldn't suffer from having to keep cash on hand to meet redemptions, or from being forced to sell stocks into a declining market for the same purpose.

An ETF is fully invested where a mutual fund must leave some money in cash to allow for withdrawals. For example, if a mutual fund has 5% in cash for withdrawals, only 95% of the fund is growing and paying dividends as opposed to 100% of an ETF.

Summary

ETFs have a lot to offer. They're flexible and low-cost, and their underlying portfolios are protected from the impact of investor trading. There are also ETFs that address specific subsectors that regular mutual funds do not. Nevertheless, look carefully before you leap.

ETFs' cost advantage isn't always as large as it might seem, and trading costs can quickly add up, if you are dollar-cost-averaging. Particularly if you're in the market for a fund that tracks a broad index such as the S&P 500, it can make a case yet for choosing an ETF over one of the mutual-fund options.

Equity Unit Investment Trusts

Unit investment trusts (UITs) are an unmanaged portfolio of professionally selected securities that are held for a specified period of time. They were first issued in the 1960s as a way to "package" and sell portfolios of professionally selected bonds, especially tax-exempt municipal bonds. The cost of a unit is generally $1,000. During the 1990s, the UIT concept was extended to stocks.

Unlike mutual funds—which are professionally managed—equity UITs are a "buy-and-hold" investment. Securities in the portfolio are held for a pre-determined time to generate dividends and capital gains for investors. At maturity, investors can take their cash and invest elsewhere or can "roll over" their balance into a new UIT.

Like their bond counterparts, equity UITs are an unmanaged portfolio of stocks that usually remains unchanged throughout the life of the trust. Some equity UITs follow a specific investment strategy such as investing in the five or ten highest yielding stocks among the 30 stocks included in the Dow Jones Industrial Average or only in stocks listed on foreign stock exchanges.

Like mutual funds, an increasing number of equity UITs also select stocks from a particular industry sector (e.g., technology) or companies located in a particular state or region of the country. Like individual stocks, UIT dividends and capital gains are taxable, whether earnings are distributed in cash or reinvested in additional UIT units. If the value of a UIT portfolio increases, that capital gain is taxed. Most equity UITs have maturities of six years or less. Shares can be sold prior to the trust’s maturity at a price determined by market conditions.

Two advantages of equity UITs are not having to worry about changes in portfolio holdings or management and tax efficiency (low taxes because stocks in a UIT portfolio are rarely traded). A major disadvantage is their up-front cost. Equity UITs typically charge a front-end load (commission) of about 3% of the amount invested.

Mutual Funds

A mutual fund is a corporation that pools large sums of money ranging from one million to several billions of dollars, pooled from millions of individual investors, just like you, who wish to save or make money. Mutual funds are run by an individual or a team of professional money managers who invest the pool of money into stocks, bonds, or other securities. The combined holdings of a mutual fund are known as the fund's portfolio.

An individual who owns shares in a mutual fund may invest as little as $25 to $50, or as much as $2,500 or more. By investing money into a mutual fund, your money is spread out and diversified among hundreds of stocks, bonds, or other securities, minimizing risk.

You do not need to buy bonds and stocks directly. You are not limited to the volatile performance of merely one or two stocks. In addition to this, you pay minimal fees, often less than 1% of your investment (per annum), while earning money with the expertise of the mutual fund managers. But, most of all, you will certainly be making more money than leaving it in a bank account where you may actually lose spending power.

The goal of a mutual fund is to provide an efficient way for an individual to make money. There are several thousand mutual funds with different investment strategies and goals to choose from. Choosing one can be overwhelming, even though it need not be. Different mutual funds have different risks, which differ because of the fund's goals, fund manager, and investment styles.

Money from a mutual fund is made when the stocks, bonds, or other securities increase in value (a capital gain), issue dividends, or make interest payments. When investing in a mutual fund, the income you make is the result of income received from dividend-paying stocks, and interest from bonds. If the fund sells a holding whose value has increased, you make money. Even if the fund does not sell that specific holding, the fund itself will still increase in value, and in that way you may also make money. Therefore the value of the shares you hold in the mutual fund will increase in value when the holdings increase in value. Capital gains and income or dividend payments are best reinvested for younger investors.

Retirees often seek the income from dividend distributions to augment their income. With reinvestment of dividends and capital gains distributions, your money increases at an even greater rate. When you redeem your shares, what you receive is the value of the shares.

What Is A Mutual Fund?

Although their popularity has mushroomed in recent years, mutual funds have been around a long time. The oldest mutual funds in existence today are more than 70 years old, having survived the Great Depression, World War II, and other turbulent economic and political events. In all, investors have entrusted more than $5.5 trillion to more than 12,000 mutual funds in the United States. (Source: Investment Company Institute, December 2001.)

Before making any investment, you should try to learn as much as you reasonably can about the asset you plan to purchase and how it works. Many different types of mutual funds are offered to individual investors, and the characteristics of each type will determine whether it is appropriate for your investment goal—whether it be funding your retirement, paying college tuition, or some other purpose.

The idea behind the mutual fund is simple: Many people put their money in a fund, which invests in various types of securities to pursue a specific financial goal. Then, each investor shares proportionately in the income or investment gains and losses that the fund's investments produce. Because investors may sell their shares or buy new shares each business day, mutual funds are called "open-end investment companies."

Each mutual fund has a manager, or investment advisor, who directs the investing of the fund's assets according to the fund's objectives. Some common objectives of mutual funds are long-term growth, high current income, stability of principal (the amount of your own money that you put into an investment), or some combination of the three. Depending on its objective, a fund may invest in common stocks, bonds, cash investments, or a combination of these three types of financial assets.

Major Fund Categories:

Fund Objectives/Goals:

Types Of Mutual Funds

Making Money With Mutual Funds

Of course, when you invest any money there is always some degree of risk, but the bottom line is this: in the long run, stocks bonds and other securities increase in value and make money. In the short term, stocks are volatile. The amount of volatility, if any, depends on the nature of the stock. Stock issued by large and established companies are less volatile, steady growers. Stocks of new and smaller companies tend to have more volatility but greater growth potential over the short run.

The volatility and aggressiveness of a mutual fund also lies with the manager's investment strategies. These will be described in the individual mutual fund's prospectus—an informational booklet that describes a fund’s returns, risks, portfolio, and investment strategy.

One way investors insure their failure and doom is to become nervous and sell out as soon as the value of the investment drops. In the short term, fluctuations in the value are normal and are to be expected. Do not sell on down fluctuations, because down fluctuations will almost certainly go back up, in the near to immediate future.

You probably have heard of market crashes. But, if you had kept your investments in the stock market of the Great Crash of 1929, instead of pulling out at a loss, you would have eventually recovered your loss and much more! Remember this, mutual funds are never as volatile as stocks themselves, because of the fact that a mutual fund consists of a portfolio of several stocks it is practically impossible for all to go down, even in a market crash.

When the investors all pulled out their money, instead of holding out, they contributed to the declining prices of the stock, which contributed to the severity of the crash and the Great Depression. Investor panic and the "herd mentality phenomenon" essentially resulted in the Great Depression, which could have been avoided.

Once you are invested into a mutual fund, when to sell becomes another important issue. A bad mutual fund is a fund that does consistently poorly, losing money, even in a good market when other mutual funds are making money. These funds can easily be avoided in the first place, by comparing their five-year return averages with other mutual funds.

A simple rule to follow is this: if the three to four year return is negative, do not buy the fund in the first place. If you check your mutual fund's performance every day, either through the phone, newspaper, or computer on-line service, and see short-term volatility, don't pull out, this is normal.

If you are seeking a specific goal, and have attained the amount desired, then pull out that amount of money. Partial redemptions can easily be made, usually over the phone if you desire.

Money invested in mutual funds for the purposes of retirement—in  IRAs (individual retirement accounts) or 401k plans (company retirement plans)—can be withdrawn at age 59½ without any taxes. Withdrawing early will incur a heavier tax penalty.

The Advantages Of Mutual Funds

There are four key attributes that help make mutual funds America's most popular medium for investing.

Diversification

A single mutual fund may hold securities from hundreds of different issuers, a level of diversification that few investors could achieve on their own. By pooling their money, mutual fund shareholders are able to spread their assets among many different securities, sharply reducing the risk of loss from problems with any one company or institution.

Professional Management

A professional investment manager—who has access to extensive research, market information, and skilled securities traders—decides which securities to buy and sell for a mutual fund. Professional management can be a valuable service, because few investors have the time or expertise to manage their personal investments on a daily basis or investigate the thousands of securities available in the financial markets.

Liquidity

Shares in a mutual fund may be sold whenever you want. At your request, a fund is required to redeem shares any business day, based on that day's closing price—at the net asset value. Net asset value is the share price, or market value, of a fund's total assets, less its liabilities, divided by the number of shares outstanding.

Convenience

Mutual funds offer a variety of services that can make investing easier. Fund shares may be purchased or sold by mail, telephone, or by the Internet, and your money can easily be moved from one fund to another as your investing needs change. You may arrange to have automatic investments made into a fund to steadily build an investment portfolio, or to redeem some of your shares automatically to meet monthly living expenses. You can have distributions of fund income paid directly to you or automatically reinvested in more shares of your fund. Extensive record keeping services are provided to help you track your transactions, assist you in completing your tax returns, and follow your fund's performance. You can monitor the price of your fund shares daily in newspapers, by telephone, or via a variety of online services.

The Disadvantages Of Mutual Funds

There are some disadvantages associated with investing in mutual funds that you should consider before investing.

No "Guarantees"

Unlike bank deposits, mutual funds are neither insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other agency of the U.S. Government. The market value of a mutual fund may fluctuate, even if the fund invests in government securities. Mutual funds are regulated by the U.S. Securities and Exchange Commission (SEC) and by state securities officials, who require funds to provide full disclosure of information an investor needs to make an informed decision. But this regulation does not eliminate the risk of an investment falling in value.

The Diversification "Penalty"

Because a mutual fund typically holds a large number of securities, fund shareholders give up the chance to earn the higher returns that are sometimes achieved by holding a single security or a handful of individual securities. In other words, just as diversification eliminates the risk of catastrophic loss from holding a single security, it limits the potential for a "big score" from holding a single stock or bond whose value shoots up. It also is important to understand that diversification does not protect an investor from the risk of loss from an overall decline in financial markets.

Potentially High Costs

Mutual funds can be a lower-cost way to buy securities when compared with buying individual securities through a broker. However, a combination of sales commissions and high operating expenses at some funds may offset the efficiencies that can be gained through mutual fund ownership. It's important for you to compare the costs of mutual funds that you are considering, because high costs can significantly erode the returns you receive as a shareholder.

The Nuts And Bolts Of Mutual Funds

People invest in mutual funds because they have specific goals they want to reach, such as building a nest egg for retirement, putting a child through college, or saving for a major purchase. Understanding how funds work and how they can help investors reach their goals will help you choose the investment most appropriate for your situation.

There are two basic ways a mutual fund investor may make money from fund shares: current income and capital gains.

Income

A mutual fund may produce current income for its shareholders from the fund's investments in interest-bearing securities—such as bonds or cash investments—or from dividends paid on common stocks owned by the fund. Such income, whether earned as interest or dividends, must be paid out each year to fund shareholders in the form of income dividends. Depending on the fund, income dividends may be paid monthly (for money market funds and bond funds), quarterly (for many balanced funds and stock funds), semiannually, or annually. Fund shareholders can choose to receive income dividends in cash or to have the dividends reinvested in more shares of the fund. A shareholder designates the method of payment when an account is opened, but may change the selection at any time.

The annual income produced by the fund, expressed as a percentage of the fund's current market value, is known as its yield. For example, a fund with a share price, or net asset value, of $20 that pays out $1 per year in income has a yield of 5% ($1 ÷ $20 = .05).

Not all mutual funds seek to produce investment income. For example, many stock funds—especially growth and aggressive-growth funds—primarily seek price appreciation from the securities they hold and may produce little or no income from interest or dividends.

Capital Gains

When the securities that a fund has purchased rise in value, or appreciate, the fund has an unrealized capital gain. Such unrealized gains remain in the fund, raising the market value of its shares. This gain, or appreciation, is "on paper" until an investor sells the shares.

If the fund itself sells securities at a profit, a capital gain is realized. These realized capital gains are periodically paid out to shareholders in a capital gains distribution. When a fund pays out its realized capital gains, the fund's share price is reduced by the amount of the distribution since the shareholders, not the fund, now have the proceeds. As with income dividends, the proceeds of capital gains distributions may be received by a shareholder in cash or reinvested in more shares of the fund.

Of course, stocks and bonds fall in value as well as rise, and funds from time to time may incur capital losses, which reduce the market value of fund shares. Likewise, an individual investor may suffer a loss by selling shares for a price lower than the investor paid for them.

Measuring Mutual Fund Performance

Figure 1

A mutual fund's investment performance is best measured by its total return. A fund's total return is the change in the value of an investment in the fund, taking into account any change in the fund's share price during the period and assuming the reinvestment of income dividends and capital gains distributions. Figure 1 shows the average annual total return for cash investments, bonds, and common stocks from 1926–1998, how much of that return came from income, and how much from capital gains (or capital losses, in the case of long-term bonds).

Total return may be negative if a fund's share price has declined during the period being measured. Figure 2 provides an example of how to calculate a fund's total return.

Figure 2

Total Return Calculation   Purchase price (per share)…............................ $50 Income distribution………………..................... $2 Capital gains distribution…………..................... $1 Share appreciation (shares now worth $52)........ $2     Total Return   Income + Capital Gains + Appreciation Original Purchase Price   $2 + $1 +$2     =       $5     =    10%                         $50                     $50