Historically, stocks, bonds, and mutual funds have played specific roles in traditional portfolio management. Fast forward to today…market dynamics have changed. Do those same rules apply? And how are each of these asset classes different from how they may have acted in previous decades? You might be surprised to learn how things have changed and how this might impact your investment management going forward.
Investing Basics: Bonds, Stocks, Mutual Funds And ETFs
In the world of investing, it’s critical to grasp the basic principles of each type of investment as well as the difference between stocks and bonds. Stocks represent direct ownership in a company, offering the potential for growth but with higher risk. A big part of that increased risk is known as “company risk” since you are exposed to organization-specific problems. But overall, stocks serve an important purpose since they can help your money outpace inflation. Bonds, on the other hand, are essentially loans you make to corporations or governments, typically offering lower risk and steady income through interest payments. Each bond is tied to an individual issuer, so you are exposed to the potential risk of default if that organization faces problems.
How can you address these individual risks you face with a stock or bond? Mutual funds and exchange-traded funds (ETFs) provide a solution. Mutual funds are investment vehicles pooling money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other assets. These stock and bond funds are managed by a professional team. With these investment vehicles, you own hundreds or thousands of stocks or bonds, so a single company’s problem poses much less of a threat to your money. An exchange-traded fund, or ETF, is similar to a mutual fund but is traded on a stock exchange. These ETFs offer similar diversification along with convenience and real-time pricing.
Should You Invest In Stocks And Bonds Or Mutual Funds?
As you can probably see, one of the biggest traditional benefits of mutual funds and ETFs over stocks and bonds is easy diversification. But today, are there other benefits or drawbacks? The landscape of investing has evolved over time. Stocks have always been seen as growth engines offering higher returns, but today’s market volatility and global interconnectedness add layers of complexity. Bonds, often and traditionally viewed as a safer investment and the stabilizer of a portfolio, have seen significant volatility in the changing interest rate climate.
Mutual funds, once the go-to for diversification, now compete with ETFs, which offer similar benefits but with greater flexibility and often lower costs. Unlike managed mutual funds, ETFs trade on exchanges, making them easy to buy and sell. And unlike mutual funds, ETFs allow you to maintain control of your tax ramifications. For higher net worth individuals, reducing your tax liability is a critical benefit that can yield higher after-tax results.
What else should you consider in today’s markets?
- Some good news: trading costs have been driven down by competition. Whereas the cost to buy or sell an investment in the past was often relatively high, today, these expenses are often zero or very nominal for stocks and bonds.
- Speed is also an issue. Today trades on exchanges are executed within seconds.
- As previously mentioned, bonds can carry more risk in an environment where interest rates are changing. So longer duration bonds or longer-duration bond funds may not act as the portfolio stabilizers that they did in past decades when interest rates were more stable.
But these are not the only issues to consider.
Dangers Of Mutual Funds And ETFs
Passively managed funds, which include index funds and ETFs, saw a surge in popularity over the past decade. In 2022 alone, passive vehicles experienced inflows of $747 billion globally, according to Morningstar research. This tremendous growth has not been without consequences.
- Some of the largest mutual fund firms have begun to emphasize Environmental, Social, and Governance (ESG) scores when making investments. This may lead to lower returns as the focus turns away from maximizing shareholder value, as described in this recent Wall Street Journal article.
- Some of these funds have a mandate to keep fund money invested at all times. This can eliminate any ability for the fund to position itself defensively when stocks are highly valued and positioned for a fall.
Then, there’s another big issue that is rarely mentioned in the financial media
Don’t Forget The Cost Of That Extra Layer Of Management
ETFs and mutual funds do offer fast and easy diversification. This is critical if you have a small portfolio or if you’re just getting started with investing. You can also get quickly diversified exposure to a specific sector with one purchase, which is convenient. However, all of these conveniences come with a cost.
Every ETF or mutual fund has a team of managers. These managers expect to get paid. If you’re buying these funds directly, these fees may be fine. However, if you’re already paying a financial advisor to manage your investments, you have a new problem: multiple layers of fees.
And, these fund fees compound. That means those annual, percentage-based fees are constantly eating into your profits.
Another problem is transparency. Because you don’t get a separate invoice for the mutual fund or ETF management fee, it’s easy to forget about it. It doesn’t appear on your account statements either, since the mutual fund managers deduct their fees internally from fund assets. The fee is disclosed usually as an “expense ratio”, but you have to actively seek this information out.
As previously noted, these expense ratios are percentages. So your fee grows along with your investment.
Mutual Funds And ETFs Are Convenient For Financial Advisors But Can Cost You
Investing using mutual funds and ETFs is a very easy choice for investment managers. Research is minimized. Over the past two decades, we’ve seen this embraced. And, the financial industry has widely promoted the benefits of this type of passive investing.
The problem becomes the costs. You end up paying for two layers of managers. Do you need all that?
You also can lose control of your money and your taxes. Especially with mutual funds, taxes become the decisions of the fund managers, which can create untimely surprise tax bills for you.
Also…this whole approach can be quite simplistic. If you are paying a wealth manager, shouldn’t you expect a higher level of service than something you could easily do yourself?
Investing Directly In A Stock Or Bond: Is That Right For Your Portfolio?
Investing in stocks and bonds directly requires a more hands-on approach to money management. Individual stocks offer the potential for high returns but come with increased volatility. Bonds traditionally were considered safer, but today, with volatile interest rates and inflationary pressures, they are facing new challenges. The key is to balance these assets based on individual risk tolerance and investment horizon.
However, when owning shares of stock or individual bonds directly, you eliminate that second layer of fees. You also have complete control over your taxes, as you can decide when to sell, and use tax-loss harvesting to offset gains. Further, in the hands of a skilled wealth management team, this type of active investment allows you to implement defensive as well as offensive strategies, helping protect your wealth as well as carefully grow it.
Why Invest In Stocks Versus Mutual Funds?
Stocks offer direct exposure, but mutual funds offer diversification, professional management, and convenience. By pooling resources, investors gain access to a broader range of securities than they might be able to afford individually. This diversification can help mitigate risk. Additionally, having a professional manager allows investors to leverage expertise and insights they may not possess on their own.
Really, all of these benefits are often best-suited for those with fewer resources. On the flip side, however, is that as your wealth grows, the negatives of mutual funds may far outweigh these benefits.
Should Your Financial Advisor Invest Your Money In Stocks And Bonds Or Mutual Funds And ETFs?
The decision between direct investment in stocks and bonds versus passively or actively managed funds depends on individual goals, risk tolerance, and investment size. But it also depends on who is doing the investing. If it’s you, and you are a DIY investor, then mutual funds and ETFs might be a good choice.
However, if you’re paying a financial advisor to manage your money, why pay two layers of management fees? Plus, it is usually better for you to have clear accountability, with one financial advisor (or team) making the investing decisions. That’s not to say that advisors shouldn’t use funds at all; in many cases, such as international or sector-specific exposure, it still makes sense for your advisor to recommend an ETF or a mutual fund.
Are Individual Stocks And Bonds Better Than Mutual Funds And ETFs For High Net Worth Investors?
It can be tempting to invest in a mutual fund, but if you’re a high-net-worth investor, the downsides may far outweigh the benefits. Especially in the case of taxes, you will have far more control over capital gains when you buy stock directly. You’ll also avoid giving up management control, so you can maintain power over your investment capital.
When it comes to the bond portion of your portfolio, you’ll have far more control when owning bonds directly. However, it is still important to focus on diversifying your holdings effectively.
What About Index Funds And ETFs?
Index funds and index ETFs have been the beneficiaries of increased attention and popularity. They certainly can serve an important purpose, especially in rising markets. However, when it comes to defensive positioning, it is important to remember that these mutual funds and ETFs are passively managed. That means they simply move with the market and offer virtually no protection on the downside. As your wealth grows, you may prefer a more strategic approach where you give up a bit of upside to help lower your risk of significant losses.
Are Bonds Still Relevant In Today’s Economy?
With the significant losses experienced in the bond market in recent years, many are wondering if bonds are still relevant in today’s economic times. Bottom line, we believe they are since companies and governments now issue bonds or other debt instruments at much higher interest rates, allowing you to get paid well as the lender. In uncertain markets, that means you can get paid a fixed return to wait out challenging market conditions.
Since bonds are impacted by ongoing interest rate changes, though, you may want to be careful to minimize risk in this area. That might mean considering shorter-term maturities or short-duration bonds or bond funds, depending upon your goals, of course. Or, that might mean when buying bonds in your portfolio, you purchase the bond for the long run, so you’re not subject to losses by selling it prior to the maturity date. Bottom line, owning bonds in this environment may result in higher yields, but you also must take care to make the right moves, as interest rate risk is often higher.
It is always recommended to pay close attention to the specific type of bonds you are buying. Municipal bonds, for example, can often help higher-income individuals save on taxes, providing the potential for generating better after-tax returns. Government bonds can also potentially provide lower-risk returns for the secure portion of your portfolio. On the other hand, strategically investing in corporate bonds may help you lock in higher interest rates, albeit with higher risk. Or you may want to stick to investment-grade bonds only, depending upon your risk tolerance. Of course, most bonds are rated, so be sure to pay attention to available resources and work with your financial professional to find the best investments for your situation.
Unlike stocks, bonds do require a unique knowledge set. While bonds aren’t usually considered risky, some types, such as junk bonds, may involve more significant risks. Navigating fixed-income investments in a changing interest rate climate requires specific skills and careful due diligence.
New Trends: Direct Indexing As An Option For High Net Worth Investors
Once your wealth reaches a more significant level, it may not be prudent to simply buy and sell mutual fund shares or ETFs for your investment needs. Instead, it might be better to have your wealth manager pick stocks that meet very specific criteria so you maintain more control over your investments and capital gains taxes.
But there are other options evolving for these needs. One is direct indexing, a new way to harness the diversification benefits of index funds but also make money with stocks that are under your control. Unlike traditional index funds or ETFs, which offer a one-size-fits-all basket of stocks, direct indexing allows you to adjust your holdings based on your preferences. This can help you find investments that align better with your values or goals. By having direct ownership of stocks, you can also focus on strategically harvesting tax losses and reducing capital gains liabilities, a feature particularly beneficial in volatile markets.
But direct indexing is not necessarily better than simply constructing a high-quality portfolio of individual stocks and bonds. If done with care by qualified investment managers, this actively managed approach lets you control the percentage of stocks in your portfolio, specify your exposure to bonds, and manage your tax outcome.
Fine Tuning Bond Exposure In A Higher Interest Rate Environment
Bonds are a type of fixed-income investment, which is a topic that has gained popularity as interest rates have normalized. Now that rates are higher, investors can potentially benefit from more strategic exposure to these fixed-income options. Remember that there is no guarantee that after years of outperformance, stocks will do well every year going forward. With no crystal ball, there may be times to consider having a portion of your portfolio earn a fixed interest rate while waiting for better opportunities. That’s where bonds and other securities, such as CDs or term deposits, can play a role.
But after years of bonds being somewhat out of style, not everyone knows how to find and buy a bond that will serve their portfolio well. Yes, bonds generate interest payments which can provide a fixed interest rate return, but they also often sell at a premium or discount which must be considered as part of the overall return. Then, longer term maturities found on investments such as treasury bonds can subject you to wide swings of value if you need to sell prior to maturity.
How To Find The Right Mix Of Stocks And Bonds (And Other Investments) For You
As you can see, there’s nothing simple about determining your investment strategy. And finding the right investment mix is a personalized journey. Overall, the process involves assessing your risk tolerance, investment goals, time horizon, and market conditions.
While some of the fundamentals remain the same over time, others have changed. Yes, stocks are still considered riskier than bonds but help you outpace inflation. And even though bonds are considered generally safe, they can still experience some larger swings in value, especially those with longer duration.
Funds aren’t necessarily the ideal choice, either, due to costs and limitations, although they can serve you well for specific sectors or areas of exposure. Mutual funds come with some drawbacks that can create negative tax consequences, so they must be used with care.
That’s where an experienced, credentialed advisor can help you determine the right mix of investments for wealth preservation, growth and tax optimization. At Holland Capital, we help you develop and implement a strategy to help you achieve your goals and build a financial legacy that lasts.
