Mutual funds were created by Edward Leffler in 1924 with the aim to make investing easier for all investors. From the outset, mutual funds are cheap, convenient, diversified, professionally managed, and tightly regulated under government law, such as United States Federal Security Law.
Mutual funds become two types: mutual and index funds. A mutual fund is a type of financial vehicle made up of a pool of capital collected from different investors to invest in securities like stocks, bonds, financial market instruments, and other assets. A mutual fund portfolio is structured and maintained to match the investment objectives stated in its prospectus. Index funds are passively managed funds that try to duplicate the performance of a financial index, such as the S&P 500 or the Dow Jones Industrial Average. Both index and mutual funds are great ways to simplify investing while also reducing both investment costs and risks.
Building Fund Portfolio
To build your portfolio of funds requires you to select the right funds to achieve your desired allocation to stocks and bonds, as well as your allocation between domestic and international investments.
For example, let’s say an investor wants to build a portfolio that is 50 percent bonds and 50 percent stocks. For simple math, let’s also assume they want an equal amount split between domestic and international stocks and bonds.
The investor would need to select funds that satisfy the following requirements:
- 25 percent of the total portfolio in domestic stock index funds
- 25 percent of the total portfolio in international stock index funds
- 25 percent of the total portfolio in domestic bond index funds
- 25 percent of the total portfolio in international bond index funds
The more complex the portfolio, the more work is involved in building and maintaining the portfolio. Don’t forget to occasionally rebalance your portfolio to maintain your desired allocations.
Always remember that if this sounds too intimidating, you can always choose a robo-advisor, which can help with the construction and rebalancing of a portfolio of index funds.
Is it possible to properly diversify by investing in only one or two funds? Yes, it is absolutely possible to build a diversified portfolio using two, or even a single fund.
To build a diversified portfolio using one or two funds, you could simply invest in a domestic index fund that consists of both the global stock market and the global bond market.
It is also possible to invest in a single fund that provides you with a ready-made diversified portfolio. For example, Vanguard’s balanced index fund VBINX provides you a one fund portfolio that invests in 60 percent stocks and 40 percent bonds.
However, for a new investor who just getting started with investing, it’s important to embrace simplicity. That is why the investor would choose the idea of one or two fund portfolios. The fewer options you have, the more successful you are likely to be as an index fund investor.
As time passes and they learn, some investors can choose to rebalance their portfolio, shifting the percentage of stocks, bonds, or other assets to a new target allocations.
Investors must know that choosing each amount have to be based on their risk tolerance and long-term goals. However, as markets fluctuate, weightings may drift from their original preferences.
If you choose a portfolio to becomes too heavy in stocks, for example, it may expose you to risk during periods of volatility, with the possibility of bigger future losses. On the flip side, a portfolio overly weighted in bonds may be harder for investors to achieve the returns needed to reach long-term goals.
Before rebalancing your portfolio, or even building it, you have to review your financial plan and risk tolerance to help determine your target asset allocation. Life events like a birthday milestone, getting married, having children, or entering retirement may spark a change in risk tolerance and investing goals.
Let’s quickly review some of the basic terminologies an investor needs to know to execute a trade and buy a fund:
Index funds are investment funds that replicate an index of assets like stocks or bonds.
ETFs are investment funds that can be bought on a stock exchange like a stock.
There are generally two types of index funds: broad-based index funds and niche index funds. Broad-based index funds are a rational way to invest for the reason that they are simple, have low investment fees, are extremely diversified.
To diversify your portfolio, think about diversifying both by asset class and geography. You can use risk assessment tools to gain a sense of the right allocation to stocks and bonds. Investors have to consider the foreign withholding taxes and preferential tax treatment for domestic dividends when allocation between domestic and international funds.
Once you have an idea of your allocations, you’ll need to select the funds that match your desired allocations to stocks and bonds and domestic and international investments. Remember, index funds that track a particular index all have the same job, so all else being equal, selecting the fund with the lowest annual fees will save you financial values.
Buying funds on your own can feel intimidating, but all you need is to know some basic terminology and get some experience. If building and maintaining an index fund portfolio is intimidating, you can always choose to work with a robo-advisor that takes care of building and rebalancing your portfolio for you.
Investors must consider selling their assets in funds, whenever there are any:
- A high unexpected change of strategy by manager.
- An increase in expenses, which suggesting that the managers of the fund are taking capital from fund
- Large and frequent tax fees
- Unexpected erratic returns
Factors To Consider When Investing in Index Fund
Once an investor knows how much of his portfolio needed to allocate to domestic stocks and international stocks, the next task for investors is to choose funds that are the best fit for their portfolio.
If you are a United States investor and you need to buy a domestic stock market index fund to satisfy the domestic stock allocation of your portfolio, how do you know which one to choose? There is an ever-increasing supply of funds that seemingly do the same thing. But how to differentiate between them?
Following are three important elements that investor must consider when considering a fund for his portfolio:
- The Management Expense Ratio (MER)
- Commissions, and
- Fund structure and withholding tax implications.
Let’s briefly review two of these factors so the investors can understand their importance when selecting which funds to buy to construct their portfolio.
Management expense ratios
All index funds have one job, which is to replicate the returns of the asset or index they are designed to track. For instance, there are several S&P 500 index funds, and they all do the same thing. Even though all index funds tracking a particular index have the same job, but they have different fees and the rate of growth. Index funds are a commodity product, and the worst decision an investor can approach when selecting index funds is paying more fees than he needs to.
A Funds Management Expense Ratio or Management fee is a fee you pay to the fund which pays for all the costs of running the fund. Funds Management Expense Ratio are a percentage of the capital you have invested in the fund.
Regardless of the type of index fund, the first thing investors must look at is the Funds Management Expense Ratio of the various funds that track that index. If the investors are looking for an index fund that tracks the Canadian stock market for instance, they pull up the various Canadian equity funds and start comparing the Funds Management Expense Ratio of each fund. The intelligent investor probably goes with the fund with the lowest management fee.
Fund structure & withholding taxes
We have already covered the fact that when an investor invests in index funds or even stocks in foreign countries, he or she is likely going to pay withholding taxes on any dividends received. It’s important for the investor to consider how the structure of the fund he or she is investing in, as that could open up to a second layer of withholding taxes, especially in the most developed counties.
Broadly speaking, there are two ways funds that invest in international stocks can be structured:
- The fund holds the stocks directly.
- The fund invests in one or more other funds that hold international stocks.
In both cases, the investor could be subject to two charge levels of withholding taxes.
The first layer of withholding taxes is applied by the foreign governments where the companies are located.
The second layer of withholding taxes is applied by the domestic government.
If possible, the goal when investing in international funds should be to avoid the second layer of withholding taxes.
To learn more about how to invest in the funds and other investments, you can purchase THE FIRST INVESTOR book and receive a discount by clicking on The First Investor .