Sometimes, the easiest way to start investing is with a mutual fund. You can invest almost any amount, and you have choices for investing in big caps, small caps, bonds, Europe, Asia, industry sectors, and specialty funds. And there are benefits to investing in mutual funds, such as dollar-cost averaging, the ability to have exposure to different sectors, and reducing non-systematic risk through broad diversification. But fund managers face some challenges that you, as a trader, don’t.
1. Costs. Funds may have a lot of overhead they need to pay for to cover expenses.
2. Risk Adjustments. Depending on the terms of the fund, the manager may be required to be fully invested at all times and may not, for example, be able to sell some of her portfolio if she thinks the market might drop.
3. Strategies. Most funds don’t allow the manager to use options either to manage risk or potentially enhance returns. Let’s explore.
The Fund Manager. Mutual funds can wind up underperforming their benchmark index simply through fees. Sales or redemption charges may be taken off your principal when you buy or sell a fund depending on the share class. Management and certain fees to pay for the costs of running a mutual fund, like legal, marketing, transaction costs, distribution, and investment advisor expenses get charged every year. The percentages may not seem like a lot when you read them in the fund prospectus, but they may cause a fund to underperform its benchmark over time.
The Trader. As a self-directed trader, you have to pay commissions when you trade. But let’s compare commissions to fees. If you had $50,000 invested in an S&P 500 benchmark fund that had a 0.25% management fee, for example, that’s $125 every year that would come out of the fund’s returns. If you bought $50,000 of an S&P 500 ETF, you’d pay $9.99 in commissions (for an online order through TD Ameritrade), which is about 0.02%. (And to boot, TD Ameritrade offers a commission-free trading program for many ETFs.)
ETFs have management fees, too. On average, ETFs have a 0.44% expense ratio. According to the 2015 Fee Study by Morningstar, the as-set-weighted expense ratio of all mutual funds and ETFs combined was 0.64% in 2014. (Be sure to read the ETF’s or fund’s prospectus carefully to understand all the fees involved.)
Of course, if you trade more and generate more commissions, you can erode your returns significantly, too. But your level of trading is something you can control. And you have to compare the costs apples-to-apples. Mutual fund investments are usually long-term, buy-and-hold. If you bought and held a portfolio of individual stocks that tracked an index, you would pay commissions when you enter and exit the positions. The commissions may or may not be lower than the fees on a similar investment in funds or ETFs held over some amount of time. But commissions on individual stock positions are only charged once if you don’t make any changes to your portfolio, while fees on funds and ETFs are charged on a continual basis.
The Fund Manager. When you buy shares of a mutual fund, you own a proportion of all the stocks in that fund, just like all the other people who bought that mutual fund do. The fund manager manages the portfolio for all the investors, and can’t adjust the risk of the fund for the benefit of one specific investor. In other words, aside from the dollar amount of the investment, the risk you have in a fund is the same the same as for everyone else who bought that fund.
Now, if you want to ride out market volatility, you can hold your fund for the long term. But if you want to tailor the risk of your investments, like adjusting risk if you anticipate potentially adverse market conditions, you have to do it yourself. The fund manager doesn’t do it for you. If you’re invested 100% in a stock fund and want to reduce your risk, you may consider redeeming some or all of your shares, or allocate them to a money market fund or a bond fund or a different equity fund that may be less risky. You go online or call the fund company or your broker and make the adjustments. It’s not hard, but that’s why a mutual fund isn’t necessarily a hands-off investment if you want to actively adjust your risk based on your market opinion.
The Trader. As a trader, you may have the same risk tolerance and expectation of market volatility as the mutual fund investor to make the same types of adjustments to a portfolio, but you can be more precise. For example, you can look at the delta of your long market portfolio and consider buying index puts or selling call spreads to reduce the overall delta number to a level you’re more comfortable with.
These types of trades can be done ahead of events that might make volatility higher, like Fed meetings or releases of government data such as unemployment. You might consider reducing your portfolio’s delta before these events, and restore the delta to previous levels after them—maybe on the same day.
Now, you can redeem (i.e., close) part of the fund position if you want to reduce your risk exposure. But the price you get for your fund shares is their net asset value for that day, which might be lower or higher due to the news event. The major downsides to an active approach like this are that with frequent trading and repositioning comes increased transaction costs, and you could potentially experience more losses or missed opportunities due to volatility or trying to forecast the market. So, use this approach with those risks in mind.
The Fund Manager. Some fund managers can only buy shares of stock to build a portfolio that tracks an index.
The Trader. If you’re approved to trade options, you may choose to use a variety of option strategies to help manage risk and/or potentially generate income on stocks in your portfolio. Just keep in mind as you read the following list that options trading is subject to significant risks and is not suitable for everyone.
- Sell calls. Selling covered calls against each stock in your portfolio can potentially reduce their cost basis and enhance returns in exchange for the obligation to sell the underlying stock positions at the strike price of the option. Mutual fund managers typically can’t do that.
- Short puts. You may be able to short out-of-the-money puts instead of buying stock, to take advantage of time decay in exchange for taking on the obligation to purchase the stock at the option’s strike price if the stock price drops.
- Collars. An options trader may also collar the stocks with long out-of-the-money puts financed by short out-of-the-money calls. Collaring provides some short-term downside protection for reduced upside potential, but can be a useful strategy if you believe the market might drop in the short term. Note that multiple-leg option strategies can entail substantial transaction costs, including multiple commissions.
- Vertical spreads. You can make bearish speculations on the market with long put verticals or short call verticals, for example, both of which may be allowed in qualified IRAs.
- Volatility options. You may even trade options in volatility products like the CBOE VIX, which can rally if the market sells off. Your average mutual fund manager can’t do any of that.