The investment world is a cornucopia of products; stocks, bonds, mutual funds, options, futures and real estate to name a few. This article will focus on stocks, bonds and mutual funds.
There are also multiple vehicles from which you can make your investment. One may invest using a tax deferred or specialized savings account such as a 401K, IRA or 529 college savings account. One may invest as an individual through a personal savings account, or as a company through a sole proprietorship or limited liability corporation (LLC). The main differential is the tax advantages offered by certain retirement, college savings and health savings accounts wherein capital gains and distributions are tax exempt. Other vehicles may affect the amount of capital an investor is able to bring to the table; for example some family members may decide to pool their resources in an LLC or a sole proprietor could use her company’s cash reserves to invest.
The fees you are charged may differ in amount and structure depending on your investment product; investing in the stock of a company and investing in a mutual fund focused on stocks will incur different costs. As a general rule, investing through an online platform rather than by interacting with a live person (for example calling your broker) will cost significantly less, as much as 4 times less.
There are essentially three ways to invest in stocks; (1) a Direct Stock Purchase Plan, (2) through a broker or brokerage and (3) through a mutual fund focused on stocks. The last method, mutual funds, will be discussed later in this article.
Hundreds of large, well-known corporations offer direct stock purchasing plans (also known as no-load stocks) through their transfer agents. Transfer agents are banks. With direct stock purchasing plans, the investor arranges to have a set amount of money deducted monthly to purchase shares of a particular company. The advantages are low fees, ranging from $0 to $5 per purchase, and low minimum purchase requirements usually of between $10 and $150 per month. A disadvantage is the investor does not have control over the buy-in price since the purchases occur on a fixed date every month. Investors can check if a company offers a direct purchase plan at the company’s website or using Computershare’s search function.
If the investor has already selected a stock in which to invest, an alternative to direct stock purchase plans is to purchase through an online discount broker. The rates for online discount range from $5 to $10 per trade and often a discount is offered depending on the number of trades. For example, E*trade charges 9.99 per stock trade but for those executing over 150 trades per quarter the price falls to $7.99 per trade.
Similarly to direct stock purchasing, government bonds can be purchased directly from the US Department of Treasury at the Treasury Direct website, saving on brokerage fees.
Certain banks are also authorized to sell government bonds. The advantage of purchasing bonds directly from the government is that the investor can avoid the broker’s fee. Some brokers sell ‘no fee’ bonds, but the price of these bonds have been marked up so that the investor is still paying a commission. Since government bonds can be purchased with no fee, it does not make sense to invest in a mutual fund or ETF focused on government bonds and thus pay a management fee.
There is a secondary market for trading treasury bonds that is primarily over the counter (OTC). Investors may access the secondary market through an interdealer broker. The largest five interdealer brokers control most of the market. They are Icap, Tullet Prebon, Tradition, BGC Partners and GFI Group.
Bonds in the secondary market trade either at a premium (above) or discount (below) their face value. Prices of bonds in the secondary market depend on whether current interest rates are higher or lower than interest rates at the time of issuance. The interest rate of a bond is fixed at its issuance. For example a $100 bond may have a 5% coupon (5% of 100 is $5). If that bond is then resold in the secondary market for $90 then the yield increases to 5.56%. In the secondary market, bond prices rise when interest rates are falling, and fall when interest rates are increasing. This is because in an efficient market, yield to maturity (the return an investor is estimated to receive if the bond is held to maturity) remains approximately the same, regardless of interest rate fluctuations. Since the coupon does not change, the bond price is adjusted.
For bonds issued by companies and not the government (corporate or high yield bonds) it is cheapest to buy new issues directly from the investment bank underwriting the bond. For example, if investment bank JP Morgan underwrites a bond issue for Unilever, an investor will get the wholesale price by purchasing through JP Morgan.
Older bonds must be purchased through a broker. As has been stated, online brokers offer competitive rates. Some of the largest online brokers are Charles Schwab, E*Trade, Fidelity, TD Ameritrade, and Scottrade. Brokers vary widely on the amount and application of their fees when it comes to bonds. E*Trade and Schwab have a reputation of being the most competitively priced, and each charges a $1 mark up per $1000 bond. In many cases, investors may have to directly request the mark up information from their brokers as markups can vary depending on the bond and may range as high as 5%. Larger institutional purchasers can often get better bond pricing and in it is in this case where mutual funds have an advantage.
Mutual funds are collective investment vehicles operated by money managers that pool capital from many investors to invest in securities. Investors share in the gains and losses of the fund proportional to their investment and can achieve exposure to many types of securities while investing a relatively small amount of capital.
Mutual funds are extremely popular among individual investors for several reasons. Firstly, it is difficult to achieve sufficient portfolio diversification of a stock and bond portfolio with less than $25,000, but this diversification can be had by investing in a mutual fund for as little as $25. Secondly, the portfolio must be actively managed and most individuals do not have the skill or the time to do so. Thirdly, most employer administered retirement plans, such as 401Ks, offer a limited set of investment options that often are restricted to mutual funds because of the broad exposure and diversification they offer.
Shares in mutual funds can be obtained directly from fund companies. Prominent fund companies include Vanguard, T. Rowe Price and Fidelity. Some fund companies provide access to funds other than those managed by the company, for example Fidelity. Such companies are known as fund supermarkets. This can be convenient for investors, however the fund supermarkets usually charge additional fees on transactions involving ‘outsider’ funds.
Characteristics to Consider
Firstly, mutual funds are required to issue dividends (disperse profits). If you are not investing through a tax deferred account, such as a 401K, these dividends are taxable.
Secondly, mutual funds charge a management fee. Mutual fund fees averaged 0.77% in 2012. Index funds charge lower fees than actively managed funds. The former simply tracks an index, the latter has a manager researching its stock picks and trying to beat an index. Over the long term most managed funds do not outperform index funds.
Another alternative is an exchange traded fund (ETF). ETFs are also funds that pool capital to purchase underlying securities. However, ETFs trade on an exchange like a stock. Whereas mutual funds are valued at a net asset value (based on the underlying securities) at the end of each day, ETFs have a market price and may be bought and sold throughout the day. ETF fees can be as low as 0.10% annually and through a process called in-kind redemptions, ETFs can lessen the tax impact of capital gains distributions.
A final type of mutual fund is a lifestyle fund (fund of funds). Lifestyle funds invest in other funds. Many add another layer of fees which lower returns to investors. We recommend that those funds be avoided; sufficient diversification can be achieved through investing in more typical mutual funds.
An investor’s choice of investment vehicle affects her tax status and level of control over the investment. Deferred tax accounts such as 401Ks provide the most tax benefit, but the least level of control. Such accounts are managed by a broker selected by the investor’s employer or another third party. There is little transparency on fees and little ability for the investor to change the broker. Additionally, a limited investment product selection may be on offer. However, such accounts allow your investments to grow sans tax impact.
Sole proprietorship may greatly affect the investor’s tax status, since the law does not distinguish between the individual and the company in this case. This means that investment gains are considered personal income and are taxed. In contrast, an individual or sole proprietor selects his broker and is not limited in his investment products.
Limited Liability Companies (LLCs) are a good fit for an individual doing a significant amount of investing. By structuring all of your investment activity under the umbrella of a company, some of the costs of investing can be expensed, lowering your tax bill.
Overall it is most important to remember to keep investments that you expect will generate significant distributions or dividends in tax deferred accounts such as 401Ks. Such investments include real estate investment trusts (REITs), actively managed stock funds, corporate bond funds, high-yield bond funds and stocks you intend to trade frequently. Tax deferred accounts will limit or eliminate your tax liability for such investments.
As always, consult with your accountant or financial planner for tax advice. Once you’ve decided in what products you which to invest, comparing the costs of investments becomes a much simpler matter