Financial Basics 5 - Types of Investments

This post contains brief information on the different types of investments available.  In a later post I will discuss which one of these types I recommend (Index tracking ETFs).

Toronto Stock Exchange 

From the "Types of Investment Accounts" post you will recall the 3 level hierarchy (for saving and investing accounts)

• Bank or Investment company
• Type of account (TFSA, RRSP, RESP, Taxable)
• Type of investment

I have already discussed the first two, so now it's time to discuss the third one.  

If you have a self-directed savings or investment (or Trading) account (like BMO Investorline), there is a multitude of possible investments you can buy in that Trading account.  Here is a brief description of each:

Stocks

When you buy stocks you are buying part of a company.  The stock (or capital stock) of a company is the equity of the company after debts are subtracted.  The stock is carved up into shares.  Shares in a company are also known as equities.

I'd suggest you read the Wikipedia entry.  Wikipedia - Stocks

You could also read the first 3 entries in Jim Collins' Stock Series.  Stock Series

Bonds

Bonds are one of several fixed income investments available to the individual investor. Later on I am going to recommend holding Bond ETFs (depending on your risk tolerance) so it is important to understand a little about bonds.

From an investment perspective there are two important things to know about bonds. First, they are a fixed income source in that the return to the investor is a certain % income on a regular basis for a fixed period of time.  Sounds pretty safe, right?  Well, the second thing to note is that the value of the bond you are holding can change. Generally if interests rates are rising, the value of the bonds you already have will fall.  The converse is also true, that if interest rates fall, the value of the bonds you already have will increase.

You can do a search for the explanation, but it goes basically like this. Say you buy a bond for $1000 and it has a 3% interest for 3 years.  You will receive $30 per year interest (and your $1000 back at the end when the bond matures).  Say by the end of the first year you want to sell it to someone else.  It has 2 years left at $30 interest per year, or $60 total. But, in that first year market interest rates have gone to 4%. So someone could buy a new bond at $1000 and earn $40 interest per year or $80 total.  Your bond will get $20 less interest than a new one so you will have to discount it by that much to make it the same total value as the new bond.  The person buys your bond at $980, gets $60 interest and sells the bond for $1000 to receive another $20 to make a total of $80 - the same as if they bought a new bond at 4%.

Here's the Wikipedia link for Bonds Wikipedia - Bonds

Mutual funds

A Mutual Fund is a managed investment fund where money from many investors are brought together to purchase many stocks, bonds and other types of securities.  Mutual Funds are an easy way for the individual investor to buy many stocks or bonds, by just purchasing a single product.

There are 1000s of different mutual funds available for purchase in Canada.  There are many different companies and different types of funds.  Mutual funds (like ETFs) can be designed to be representative of the whole stock market or just part of it (a sector).  For example a Canadian Equity mutual fund may invest in stocks which are part of the Canadian TSX stock market.  The benchmark for this fund might be the S&P/TSX Composite Index.

Most mutual funds in Canada are actively managed funds, which means the fund manager tries to maximize value and income by picking stocks he/she thinks will be winners.

The converse to an actively managed fund is a passive fund, where the fund just holds a pre-determine set of stocks or follows the holdings of an Index.  An example of an index is the S&P/TSX Compostie Index or the US S&P 500 Index.  A mutual fund or ETF that follows one of these indices, then holds exactly the same proportion of the stocks that make up the index.

Actively managed funds sound like a really good idea, but in practice doesn't work that well.  I have read much where people say that 70 to 80% of actively managed funds do not beat the benchmark index. Need reference.

One very important consideration for mutual funds are the expenses incurred to operate the fund. This is the management expense ratio (MER) which is the % of the fund value that is spent on expenses and commissions to run the fund.  There are some low MER mutual funds, but before you buy a mutual fund you should find out what the MER is and determine for yourself whether you are receiving valuable management of your fund to justify the cost.

Here's a good article on issues facing the mutual funds industry today.

You will see in the next section that ETFs are traded like stocks, in that they are traded on an exchange and must be bought or sold when the market is open.  If you want to buy or sell mutual funds the order can be made at any time, but the trade will not happen until the end of a trading day and are made at the price of the Mutual Fund set at the end of the day.  Typically orders up to 2:30pm will be made on the same day.  It will take several business days for the trade to clear, so if you are selling you will have to wait 2-5 days for your cash.  

When you trade Mutual Funds through the bank or your self-directed account there are no obvious trading costs, but there are hidden costs.  The cost to administer buying or selling of a Mutual Fund is hidden in the management expense ratio (MER).  There can be additional fees to buy or sell mutual funds and are very specific to each fund, fees to buy are called front-end load and fees to sell are called back-end load. 

If you are going to buy Mutual Funds be very careful of these fees.  

Here's a short article on Mutual Fund fees.

Here's a post by Boomer and Echo on the upcoming disclosure rules on mutual fund fees - CRM2: A New Age of Enlightenment for Investors?  Why wait for July 2016 to find out what the fees are on Mutual Funds. Switch to ETFs now!

Exchange Traded Funds (ETFs)

An ETF is an investment fund that is traded on stock markets, much like the way stocks are traded. To buy or sell an ETF, the market must be open and you place a buy or sell order as you would for stocks.

Here's an article at Wikipedia explaining ETFs

Traditionally ETFs were only Index funds (they tracked to a particular index) but now there are actively managed ETFs in existence.  Similar to mutual funds, you need to be aware of the MER for any fund you are considering investing in.  I consider a low MER for an ETF to be < 0.2% and high is over 0.5%.  For comparison, the MER for actively managed mutual funds is typically over 2%. The lowest cost ETFs are the index tracking ones and some of the specialty ETFS have a higher MER.  

So you don't think that 1 or 2% fees make a difference, then think again!  I've seen this example on many blogs and websites.  Conventional wisdom is that you need an investment portfolio of 25 times the income you want to have in retirement.  For example of you want $50,000 income you will need investments totaling $1.25 million.  In other words you withdraw 4% of your investments as income - see Jim Collins' article on the 4%. There are a number of ways to arrive at the 4% rule, some of them quite sophisticated, but one way is that it is equivalent to a 6% return on investment less inflation of 2%.  If you invested in Funds with a MER of 1% higher than low fee ETFs then the 6% drops to 5% and is only 3% higher than inflation.  Now you don't need 25 times the income desired, you now need 33 times (1 divided by 3%) or $1.65M.  So 1% fees means you have to save $400,000 more to have the same income in retirement.  Yikes!

I use the following ETFs in my portfolio:

XBB - iShares Canadian Universe Bond Index ETF
XIU - iShares S&P/TSX 60 Index ETF
XSP - iShares Core S&P 500 Index ETF (CAD- Hedged)
XIN - iShares MSCI EAFE Index ETF (CAD-Hedged)

For additional dividend income I also use the following

CDZ - iShares S&P/TSX Canadian Dividend Aristocrats Index ETF
ZUT - BMO Equal Weight Utilities Index ETF

There are many other good ETFs you can use besides the list above.  More about that in the next post on Portfolios.


Disclaimer:  These posts are not fully comprehensive financial advice.  You should seek your own qualified investment, tax and legal advice.