Hello and welcome to the wonderful world of passive income! There are many ways to generate passive returns, but my personal favorite is the stock market. The stock market can often feel like an overwhelming place full of gamblers and “gurus” alike. Because of this, investing in the stock market can feel incredibly daunting, exciting, scary, and everything else in between. What if it didn’t have to be? The stock market has ways of generating passive income that create consistent, safe returns over the long haul. If that sounds good to you, then you are in the right place! Today, we will differentiate between three types of funds: mutual funds, exchange-traded funds (ETF), and index funds. We will go over what they are, the benefits of each, and how they can be a part of your passive income strategy!
Purpose of Funds:
So let’s start with the basics; why the heck invest in a fund, and can it really generate passive income? When you hear about any type of mutual fund, index fund, or ETF, think of diversification. The basic idea of diversification is not putting all your eggs in one basket. When you have one asset, let’s say a stock, and that stock goes down, your entire investment goes down. If you have multiple stocks and one goes down, not as big of a deal. Diversification seems like a bright idea, right? The hard part of investing in the stock market for the individual investor whose job is not managing stocks is having a well-diversified portfolio of investments. The reason funds exist is so individual investors can have a well-balanced portfolio without the headache of selecting and maintaining an actively managed portfolio.
How Do They Work?
When thinking of funds, think of swimming pools. The people in the pool are the companies that make up the fund portfolio. The people outside the pool represent the investors in the fund. They can join the fund (pool), but they don’t have any say on what companies (or kids) are in the pool (portfolio). Lifeguards (fund managers) dictate what kids (companies) are in the pool and manage the pool entirely.
Mutual Funds:
A mutual fund is a professionally managed investment fund that pools money from all of its investors to purchase securities such as stocks, bonds, and other securities at the manager’s discretion. The combined total of all the assets in the fund is known as the fund’s portfolio. There are many mutual funds to choose from based on the kinds of securities they invest in, the investment objectives, the type of returns they seek, and the general timeline of investments.
When you buy a share of FB, it is both an investment for you and purchase of an actual company. A mutual fund works the same way. When you purchase a share of a mutual fund, you buy partial ownership of the mutual fund and its assets. The only difference between FB and a mutual fund is that FB is in the technology space while the mutual fund is in the business of investments.
Ways They Generate Income:
Investors earn a return from mutual funds very similar to that of buying a regular share of stock. Typically gains from the mutual fund are passed on to the individual investor to either reinvest for more shares or given as cash. Investors can earn income on a mutual fund in three ways.
- Receiving dividends on stocks and bonds held in the portfolio.
- Selling their shares in the market for a profit if the fund has increased in value
- Capital gains the mutual fund passes down to the individual investors.
Fee Structure
Mutual funds will classify their expenses into either annual operating fees or shareholder fees, and these typically are around 3%. Mutual fund managers also typically charge commissions when shares are purchased. Commissions are classified as either “front-end,” which means fees are paid once you buy the shares, or “back-end,” which means expenses are paid when you sell the shares.
Key Takeaways
- Mutual Funds are actively managed meaning the manager of the fund is actively buying and selling securites in an attempt to maximize profits and minimize loses.
- Mutual Funds trade similiarly to a stock but they can only be purhased at the end of each trading day instead of during the day.
- Actively managed mutual funds tend to have higher fees and commissions than less active funds.
- Mutual Funds can generate consistent passive income even with the relatively high fees.
Exchange-Traded Funds (ETFs)
ETFs still follow a similar structure to that of mutual funds but with a few key differences.
- ETFs cost substantially less for an entry position because of the ability to buy a single share.
- Similiar to a stock, ETFS can be sold short. (We will go into what this means later in our investing series. If you are a long-term investor, this really has no impact on you.)
- Typically ETFs have favorable tax strucutres compared to that of mutual funds. Since ETFs are passive managed, the tend to realize fewer capital gains and thus less taxes.
- ETFs still have an expense ratio (commission) that is charged to invest. Vanguard’s S&P 500 ETF (VOO) has an expense ratio of .03%.
Investors earn a return from ETFs very similar to that of buying a regular share of stock. Individual investors receive the ETF gains as capital gains. ETFs give the investor more flexibility over the investment because you can trade it during the day. This offers investors a greater sense of liquidity, which is always a nice thing to have.
Types of ETFs:
There are three structures of ETFs which are Open-End Fund, Unit Investment Trust, and Grant Trust. They each serve a distinct purpose with rules about how they can invest.
Exchange-Traded Open-End Fund:
This is by far the most common ETF in the marketplace today. Open-End Funds have very specific diversification requirements on how much they can invest in a single stock. This protects you from having all your money in one company. Additionally, this structure gives management the most flexibility in how they manage the fund. Because of this, they can use strategies to replace an entire index without owning the entire index.
Exchange-Traded Unit Investment (UIT):
The main differentiator from the Open-End to the UIT is that a UIT attempts to fully replicate an entire index. For example, the SPDR S&P 500 ETF is structured as a UIT. They need to attempt to own every company and replicate the S&P 500 to the best of their ability. Also, UITs cannot reinvest dividends automatically, so they pay cash dividends quarterly.
Exchange-Trade Grantor Trust:
ETFs that invest in commodities prefer the Grantor Trust. The main difference is that in this structure, the individual companies own the underlying shares inside of the company. Instead of just owning a piece of the fund, you own a portion of what the fund owns directly. The investors get voting rights inside of this structure with the individual companies that the ETF owns.
Index Funds:
Index funds are passively managed ETFs or Mutual funds that match an index such as the S&P 500. They try to provide broad, diverse market exposure, low operating expenses, and very minimal portfolio turnover. They follow their specific benchmark regardless of market conditions. Warren Buffet has been recommending index funds for years touting them as the best investment most individual investors can make. The idea is that market on average will outperform any stock over time.
Sometimes less is more and with ETFs and mutual funds, they offer consistent safe passive returns. Just remember that the best investors of all time are dead people. They don’t try to time the market, they just let compounding do its thing. When markets get go down, like they will do from time to time it is crucial to stay the course. To quote the famous philosopher, “Just keep swimming.”
Buy the fear, sell the greed, and as always you got this!
