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Mutual Funds and ETFs

There are two major investment vehicles that are available to average investors and that can provide many advantages: Mutual funds and Exchange Traded Funds (ETFs).

The Advantages of Mutual Funds

Advantage #1. Diversification. Each mutual funds invest in a variety of stocks or bonds. This helps reduce the damage from individual stocks that may decline while giving you more chances to take advantage of the stocks that may rise.

Warning: As we mentioned earlier, some mutual funds specialize in narrow industry sectors and may not give you a broad enough diversification over various sectors. And even those that do may still not give you the diversification you need beyond the stock market — in a wide range of asset classes, including bonds, natural resources, real estate and even foreign assets.

Advantage #2. The mutual fund industry usually gives you accurate information.

You can find out most of what you need to know about the people making the investment decisions on your behalf, what the bottom-line performance is, and how much they’re charging you for the effort.

You can make apples-to-apples comparisons of their performance, the risk and the costs vs. those of any other mutual fund. You can get the information promptly and for free. You can slice and dice the information almost any way you want — sorting funds by category, yield, safety, performance, and a host of other criteria. And you can do this without relying on anyone — whether salesperson or adviser — all from the comfort of your living room.

Moreover, the data is usually accurate, conforming to legal guidelines and standards regarding exactly how it’s calculated and when it’s disclosed.

We wish we could say the same about some other investment products we’ll be discussing in later chapters — such as annuities and life insurance policies, or even real estate.

Advantage #3. Mutual funds offer the best protection from failure or fraud. When you put your money into a brokerage account, you can be adversely affected if the brokerage firm fails. If you put your money into a cash-value life insurance policy, you can get hurt if the insurance company fails. And even in a bank, any money beyond $100,000 could be in jeopardy.

But when you invest in a mutual fund, your money is segregated from the assets of the management company. No matter what, the securities and funds of the mutual fund are held in escrow at a separate financial institution. This is an SEC requirement. No mutual fund can do otherwise. This is also true for mutual funds that are managed by a brokerage firm or bank. So even if the broker or bank fails, your money in the mutual fund will remain separate.

Needless to say, none of these protections guarantees investment success or protection for losses. If the mutual fund managers screw buy investments that go down, your investment goes down as well.

But there are also thousands of mutual funds that never put a penny of your money in risky investments and are rarely subject to losses.

So the key question is: Which mutual funds, when and how much? If you’re looking for a simple, one-sentence answer, you’ve come to the wrong place. Instead, let us take you through four different approaches, starting from the most elementary and simple to the most complex and powerful.

The Advantages of Exchange-Traded Funds

Exchange Traded Funds (ETFs) are investment holding companies, whose shares you can buy just like any stock. When the investments these companies hold go up, the ETF’s share price rises. When they go down, it falls.

In other words, with some exceptions, ETFs are typically not designed to beat the performance of a particular index. They’re designed to match it.

ETFs offer you the diversification, convenience and other advantages of mutual funds. Plus, they also let you ...

Advantage #1. Lower investment minimums than mutual funds:Because ETFs let you start with as little as $200, you can diversify your assets across many sectors or countries and even take a flyer on a developing trend — without betting the farm.

Advantage #2. No loads and marketing fees (called “12b-1”). Some mutual funds charge a sales commission or “load.” With an ETF, you do have to pay a small broker commission, but never a load. In addition, many mutual funds charge investors for their own marketing expenses (through 12b-1 fees). These do not exist with ETFs.

Advantage #3. Lower expenses. Since most ETFs generally follow a set index, once the composition of that index is established, you do not need to pay for expensive research and portfolio management. So expenses are usually lower.

Advantage #4. Free from most trading limitations. ETFs were made for trading. So you can usually buy and sell whenever you want as often as you want. Trading in and out on a whim or too frequently is not recommended. But in today’s rapidly changing markets, ETFs give you the ability to avoid the buy-and-hold approaches that can often cause missed opportunities, or worse, debilitating losses.

Advantage #5. Because ETFs are traded like stocks, they generally give you the same trading flexibility that stocks offer. You can use “stops” to protect your profits or cut a loss. You can get in more cheaply with limit “buy” orders. You can even buy options on ETFs. At last count, there were over 200 ETFs that had options, with many options available on each one.

Advantage #6. Great diversity of asset classes:

Two Disadvantages of ETFs.

Disadvantage #1. The same structure that gives ETFs tax efficiency can also lower their qualified dividend income, or QDI, which can affect investors’ bottom line.

Disadvantage #2. Sometimes, it’s so, so easy to trade ETFs, investors wind up overdoing it, raising their costs and defeating the cost efficiency advantage of ETFs.

So don’t jump in and out on a whim. Just remember: Although the cost efficiency of ETFs is rock-solid, the more you trade, the more you’re going to chip away at that rock. That’s because you must pay commissions to buy and sell ETFs, just as you would for stock transactions. And commission fees can add up.

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