I later asked readers why they had not got started investing outside of a 401k. The first part in the series dealt with the question of whether you should pay off debt or invest. This part will deal with how to actually start a discount online brokerage account.

When I polled readers, 18% said that the reason they have not invested is they didn’t know how to start an online broker account. Hopefully this post will do an adequate job in removing that barrier.

What is a Discount Online Broker?

A discount broker differs from a full-service broker in that YOU make the decision on what to invest in and actually execute the trade on your own. That may sound scary at first, but it’s really not so bad.

There are plenty of discount online brokers out there that have helped drive the cost of trading for amateur investors down significantly over the years. A discount online broker is really all you need. Full-service brokers charge exorbitant fees and don’t necessarily have your best interests in mind.

What Can you do Through an Online Broker?

There is a pretty long list of things that you can do through a discount broker, including:

• Putting your money into a money market account. If you leave your cash sitting, most will offer a nominal savings rate, much like a bank.
• Investing in a CD.
• Buying and selling stocks.
• Buying and selling stock options.
• Buying and selling index funds and other mutual funds.
• Buying and selling bonds.

And it’s relatively cheap to do all of them. Stock trades at most discount brokers are $7 or less and many offer no-transaction fee mutual funds, index funds, and ETF’s (more on what each of these is down the road…).

To put it simply: an online broker is a one-stop shop for you to invest your money in just about anything.

The Best Online Brokers: A Comparison

To get started, you need to pick a broker. There are a lot of good ones out there. Most offer relatively cheap trades. Some charge annual fees. Others have high minimum opening contributions. Some have better customer service and trading tools than others. Depending on your situation, the best discount broker for you might vary.

I generally look for accounts that don’t charge BS maintenance or inactivity fees or annual fees. I also look for low costs to trade stocks and funds and an easy to use interface. Here are a few of my favorites (none of these have inactivity or maintenance fees, and only 2 have annual fees):

TradeKing:

I have both my Roth IRA and Traditional IRA with TradeKing. TradeKing does not charge fees on their IRA’s and stock trades are only $4.95 each. Check out my TradeKing review for a full run-down.

• Stocks: $4.95/trade
• Mutual Funds: $14.95/open
• Minimum Opening Deposit: $0
• Annual & Inactivity Fees: $0 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee
• Promotion: Reimbursement of up to $150 in transfer fees.

Zecco:

I have an investment account with Zecco because they offer $4.95 stock trades. They once offered 10 free trades per month if you had a balance over $25K, but they no longer do that, unfortunately. Check out my Zecco review for more on them.

• Stocks: $4.95/trade
• Mutual Funds: $10/open
• Minimum Opening Deposit: $0
• Annual & Inactivity Fees: $30 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee

Scottrade:

I have had investment accounts with Scottrade. They have always maintained a flat $7 trading fee while others have shifted their fees around to gain new customers. One nice thing about Scottrade is that they have over 500 local branches that you can visit.

• Stocks: $7/trade
• Mutual Funds: $17/open
• Minimum Opening Deposit: $500
• Annual & Inactivity Fees: $0 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee

OptionsHouse:

OptionsHouse has the lowest prices of the group at $3.95 for stocks and $9.95 for mutual funds. Don’t let the ‘options’ in the name scare you. You can do all of the standard stock and mutual fund investing with Optionshouse that you can elsewhere. They aim to make a platform that is friendly to options traders.

• Stocks: $3.95/trade
• Mutual Funds: $9.95/open
• Minimum Opening Deposit: $1,000
• Annual & Inactivity Fees: $0 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee
• Promotion at the moment: Open a new IRA and get 100 free trades and up to $125 in transfer fees. Use promo code IRA FREE. Or you can open a non-retirement account and get a free Dell computer monitor.

Vanguard:

My 401K is housed with Vanguard. What I really like about them is they have an extensive list of very cheap index funds and ETF’s under their brand and they don’t charge you for trading in and out of them. If you want to invest in their index funds and ETF’s and have a large enough balance to avoid the $20 annual fee, then Vanguard is a great choice.

• Stocks: $7/trade, branded ETF’s & index funds are free
• Mutual Funds: $35 (if you go with Vanguard, just invest in their funds for free as they have the best index funds and ETF’s out there)
• Minimum Opening Deposit: $0
• Annual & Inactivity Fees: Vanguard charges a $20 account fee on IRA’s and other accounts if you have less than $50,000 in assets. If you have more, there are no fees. There are also $0 inactivity fees.

Schwab:

Much like Vanguard, Schwab carries a number of low cost branded ETF’s that they don’t charge you to trade in and out of. Their trading prices are otherwise the highest of the group, at $8.95 each and $49.95 to buy AND sell mutual funds that are not their brand. Don’t go with Schwab unless you intend in investing in their funds.

• Stocks: $8.95/trade
• Mutual Funds: $49.95/open & sell (excluding Schwab funds, which are free)
• Minimum Opening Deposit: $1,000
• Annual & Inactivity Fees: $0 for IRA’s, $0 for non-retirement accounts, $0 inactivity fee

How to Start an Online Broker Account

Now that you’ve picked out a broker, you’re probably wondering what steps you need to take to actually open an account. Check out the minimum opening deposits required, which I listed in the previous section. Note that buying into a mutual fund is usually more prohibitive than actually opening your broker account. Many mutual funds require you to have an opening investment of $1,000 to $2,500. Stocks and ETF’s don’t have these requirements.

Once you have that sorted out, the steps are generally as follows:

1. Create a login and password.
2. Choose the type of account you want. For most of you, it will be an individual investment account (non-retirement), a traditional IRA, or a Roth IRA. You’ll then be asked whether this is a cash or margin account. Since trading on margin is risky, you’ll want to select ‘cash’ 99.99% of the time.
3. You’ll then have to fill out a ton of personal information about yourself including marital and income status, your social security, previous investing history, etc. This information is required by federal law when you start a new broker account, so everyone has to do it, despite how invasive it may seem.
4. You’ll have to fund your account. Most online brokers allow you to do this in a few different ways: via ACH withdrawal from a bank account (usually free to do), via a wire transfer (your bank usually charges for this), via a transfer from another broker, or via check. Note that most, if not all, brokers accept cash or other form of payment.
5. After you fund your account, there is usually a clearing period of up to a week for a background check and for the funds to clear.
6. That’s it. As soon as your funds are cleared, you’re ready to invest!

Estimated time to complete the application and open an online broker account is usually under 15 minutes. It’s relatively straight forward. The hard part is waiting to invest your funds until they have cleared.

Now What?

You’re probably wondering what to do now. I will go through investing basics in upcoming posts, but I can only take you so far and can’t give specific investment recommendations. Start becoming obsessed with learning how to invest. In the meantime, move your funds to a money market account that will earn you a little bit of interest while you figure out what to invest in.

One step at a time. Open your online broker account first!

How to Start an Online Broker Account is copyrighted by 20somethingfinance.com without consent to republish.

Closed end funds are not the easiest concept to pick up by amateur investors. They are a little bit like stocks and a little bit like open-ended mutual funds (what most people commonly think of when they think of ‘mutual funds’). As such, they are a little off the beaten path for most investors. To understand what they are and how they are priced, you first have to understand how mutual funds work. Once you understand, you might be tempted to invest in them since they often trade at premiums or discounts to their values. If you’re an amateur investor, it could be a risky game to get into. They can also provide unique opportunities.

Closed End Funds vs. Open End Funds

Open-ended funds rule the mutual fund world. Most funds in your employer’s 401K fall into the open end category. When comparing open-end funds to closed-end funds there are two main factors to consider:

1. How many shares there are.
2. How they are priced.

How Many Shares

The first difference between the two is how many shares there are. Closed-end mutual funds are offered up in an IPO. This means that there is a set number of shares which are offered on a stock market. The number of shares does not change as a result of new investors putting money in the fund. If you buy shares, it’s because an investor was selling theirs. With open-end funds, on the other hand, there is a limitless number of shares. You do not need an investor to sell you their shares. You buy new shares, and new shares are created for you. There is no exchange of shares from one investor to another.

How Open Ended Mutual Funds are Priced

You may be wondering how the share price of open-end funds is calculated. Open-end fund share prices are bases solely on the net asset value (NAV). This is basically how much the total value of all its investments are worth, divided by the number of total outstanding shares. The NAV is the price you buy or sell a share at. This NAV is calculated at the end of each trading day.

How Closed End mutual funds are Priced

Much like with open-end funds, closed-end funds have a calculated NAV (total value of underlying investments divided by number of shares). However, this is often not what the shares are priced at. Since shares are traded on the open market, the shares can trade at a discount or premium to the actual NAV, based on perceived value of the investor.

Where can you Buy Closed End Funds?

Any old online discount broker provides a platform to buy and sell closed end funds.

Closed End Funds Trading at Discounts to NAV or Premium?

Common sense would lead you to believe that a closed end fund trading at a discount to its NAV would be a good buy. And especially one trading at a 5, 10, or 15% discount. Similarly, it would intuitively make sense that one selling at a 10% premium to its NAV would be ripe for selling.

So why do closed end fund prices vary so much from the NAV? That’s one of the true mysteries behind them – and probably a good reason why amateur investors should be careful in getting into that game. Who’s to say that a closed ended fund trading at a 5% discount to its NAV won’t end up trading at a 15% discount to its NAV? Not me.

Related Posts:

• Index Funds Vs. Mutual Funds
• ETF’s vs. Index Funds
• Zecco Review
• TradeKing Review

What are Closed End Funds? is copyrighted by 20somethingfinance.com without consent to republish.

What is TradeKing?

TradeKing is an online discount broker that has a low fee trading structure and strong customer service. Plain and simple. I’ll get into what types of accounts you may want to consider opening or moving to TradeKing in a bit. You can trade stocks, funds, options and other equities through TradeKing.

Trading Fees:

Let’s cut right to what most of us care about the most when it comes to investing online with a discount broker – the fees.

• Stocks: $4.95 (online and even broker assisted on the phone)
• Options: +$0.65 per contract

Other than Zecco, which charges $0 for trades (for accounts over $25,000 in balance, otherwise they are $4.50 per trade), and OptionsHouse (geared towards options traders) at $2.95 per trade, TradeKing’s trading fees are the lowest price of any legit discount broker that I am aware of.

I have my non-retirement account with Zecco because of their low priced trades (check out my Zecco review), and my IRA’s with TradeKing. I’ll tell you why I went with both in the next section.

Other Fees:

Here’s where TradeKing really excels. Whereas some discount brokers try to nickel and dime you with account inactivity fees and IRA fees, TradeKing does not. If you trade lightly or not much at all, you don’t have to worry about getting an account inactivity fee or account maintenance fee (they don’t have either). They also don’t have an annual IRA fee (Zecco charges a $30 IRA fee, which is why I chose to move my IRA’s to TradeKing instead).

TradeKing’s price to buy in to mutual funds is a little bit higher than some discount brokers who offer a number of no-fee funds, at $14.95 to initially buy into a fund, but still very competitive to other broker’s funds with fees (i.e. E-Trade funds cost $19.99). If you prefer ETF’s over funds, that’s not really an issue. Here is a complete list of TradeKing fees.

Minimum Balances:

TradeKing has no minimum balance for their accounts. This is a key factor for someone just getting into investing for the first time, who might not have a lot of money to put into an account right from the get go.

How is the TradeKing Customer Service?

The one time that I called in, I got someone on the phone right away, that person spoke great English, and they followed up with a promised email with documentation minutes after the call. This year, Smart Money rated TradeKing #1 in customer service in 2010 and gave them a 5 star (out of 5 ranking).

For those who like the chat customer service option, TradeKing offers live chat support 8 AM – 6 PM Monday through Friday. No complaints here.

Trading Tools at TradeKing:

TradeKing certainly doesn’t skimp on their tools. With all of the discount brokers I’ve used and the tools included for free in their interfaces, TradeKing can’t be beat in this area. Quickly summarizing each of their tools:

• MarketGrader Research Reports: This is basically an analytical analysis tool that grades stocks (not dissimilar from Morningstar) and whether analysts predict then to outperform or not.
• Technical Analysis: For experienced traders who use the charts, TradeKing provides chart pattern recognition, price forecasting and full educational support.
• Interactive Charts: includes volatility and technical indicators.
• Maxit Tax Manager: A cost-basis and tax reporting tool to help make things easier around tax time.
• Other Tools: probability calculator, profit & loss calculator, options calculator, options scanner, and stock screener.

Banking Services:

This might be an area where you’d be disappointed if you were interested in banking services in addition to trading services. TradeKing is not a full-service bank, so don’t expect a debit card, checking account, mortgage loans, or other bank related services.

Final Thoughts:

It’s one of the two discount brokers I use at the moment, so obviously, I like them. Good service, account security, low trading fees, and no other fees to screw you over. I’d recommend using them for both a regular trading account and a retirement account.

TradeKing Promotions:

• TradeKing is currently offering $150 in reimbursements for those who switch a non-retirement account to them.
• They also offer a $50 referral fee if you refer a friend ($50 for both you and your friends).

TradeKing Review is copyrighted by 20somethingfinance.com without consent to republish.

Ever get tired of flipping between 3 or 4 different browser windows to keep track of your desired portfolio, real-time-quotes, and then to actually make the trade through your discount broker? We’ve all been there. That’s why I was pretty excited when Zecco launched a nifty little Firefox plugin last week that allows you to instantly get a real time quote and trade when the plugin (called Zap Trade) detects a ticker symbol within your browser.

Zap Trade is a free Firefox plug-in that lets investors place stock trades and get real-time quotes while visiting popular investment and research websites. Here’s how it works:

1. Click the [Z] on select sites when scrolling over a stock ticker (anything that Zap Trade detects is a ticker is highlight in purple).
2. ZapTrade opens up in a pop-up window & you can get a real-time stock quote.
3. Complete the trade, if you so choose, without leaving the site you are on.

How I am Planning on Using Zap Trade

I really like this tool because I rarely use my stock broker to research the stocks/funds that I want to buy or potentially sell off. I typically use Google Finance for most of that. What I plan on doing is creating a portfolio of stocks that I am interested in buying within Google Finance (which also offers real-time quotes) – so that all of my potential trades can be traded from in one browser. From there I can scroll over the ticker, open Zap Trade, and make a trade if the stock/fund is at a price that I want to buy or sell at.

Requires a Zecco Account

Note that to use Zap Trade, you will need a Zecco trading account. I use Zecco for my personal account because I get 10 free stock trades every month (must have an account balance of $25,000 or more, otherwise trades are $4.50/each) and they have zero annual or inactivity fees – making my cost to use them as a discount broker absolutely nothing. I have done a thorough Zecco review in the past. I’ve been very happy with them as a discount broker.

Check out the video on the Zap Trade site to see the plugin in action.

Zecco ZapTrade Makes Researching & Buying Stocks Much Easier is copyrighted by 20somethingfinance.com without consent to republish.

ETF’s (exchanged traded funds) and index funds. The comparison between the two is kind of like deciding to pull over to a restaurant that you see off the side of a road in a region of the country you’re not familiar with. If it’s called ‘Marco’s', the chances are that it’s Italian and it has some pasta, marinara, alfredo, and garlic bread inside. In much the same way, if you see an index fund and an ETF that track the S&P 500, you can reason that each is going to have some large, well-known U.S. based corporations inside.

However, since you’ve never eaten at ‘Marco’s', you’re not sure what type of dining experience awaits, how much it will cost, or what kind of gastric issues you’ll have afterwards. These differences are going to take a bit further explanation.

Differences Between Index Funds and ETF’s

1. How they Trade

• Index Funds: Index funds are a type of mutual fund. You purchase shares from the fund management company. Index funds do not trade on the open market throughout the day. Share purchases can only happen once a day – at the close of trading.
• ETF’s: Shares are purchased through a broker and are traded on the market throughout the trading day.

2. How they are Priced

• Index Funds: Are based on the fund’s holdings rather than a perceived value of that fund. Shares are priced based on their Net asset value (NAV), the same way all mutual funds are. Net asset value is (assets-liabilities)/shares outstanding.
• ETF’s: NAV is used to evaluate the ETF by investors and market forces (supply and demand) influence the share price through trading. When an ETF’s share price trades at too much of a premium or discount to it’s NAV, savy investors will typically come in to purchase or sell their shares, often-times bringing the price close to the NAV.

3. Cost

• Index Funds: Cost whatever the broker charges to get into that fund and any loads charged by the fund company, plus an ongoing expense ratio that is typically higher than its ETF counterpart. For instance, while the Vanguard REIT ETF (VNQ) has an expense ratio of 0.10%, the index fund tracking the same index (VGSIX) has an expense ratio of 0.20%.
• ETF’s: Cost is whatever your broker charges to make a trade (buying and selling) plus an expense ratio that is typically less than its index fund counterpart.

4. Functionality

• Index Funds: Generally have much less functionality than ETF’s. For starters, when you buy or sell you do it at the NAV price at the end of the trading day (you don’t have an option). If you buy or sell during trading hours, you have no knowledge of what that price is going to be on your trade. Also, funds can be limiting in that many of them have high minimum and subsequent investment amounts when purchasing.
• ETF’s: Much more functionality. You can make any type of trade that you are able to make with regular stocks, including limit orders, short selling, etc. Meanwhile, you set the price and can trade at any point during the day.

5. Tax Efficiency

• Index Funds: When you own a mutual fund you are often forced to pay capital gains taxes every tax year, even if you don’t sell any shares. Bummer, right? This is because any taxes are passed on to you when a fund sells a security for a gain.
• ETF’s: The structure of ETF’s tends to cut down on capital gains taxes that fall on you. However, you may end up paying capital gains taxes when you sell anyways. In general, ETF’s are said to have less of a tax burden, but I couldn’t find any quantifiable data behind this (if you can, please post in comments).

Conclusion on Index Funds Vs. ETFs:

If you’re not sure whether to go with an index fund or its ETF counterpart, your line of thinking should probably go something like this:

1. Can I even afford to get into the index fund with how much I have to invest? If not, going with an ETF is a no brainer.
2. Does the index fund provide the functionality I’m looking for (i.e. a short sale). If not, go with the ETF.
3. Other than that, it is up to you to do an analysis on which of the two options is going to cost you less for how you plan on investing with it. Think about how often you will be purchasing more, how much your broker charges, and compare the expense ratios between the two.

Regardless of which you choose, I personally use and highly recommend Zecco(for individual non-sheltered trading accounts) andfor IRA’s.

Fund Versus ETF Discussion:

• Do you tend to prefer index funds or ETF’s? Why?
• What other reasons, pro or con, have you found for buying index funds and ETF’s?

You May Also Find the Following Articles of Interest:

• Zecco Review
• TradeKing Review
• How to Start an Online Broker Account
• Passive Index Investing

ETF’s Versus Index Funds & the 5 Big Differences to Consider is copyrighted by 20somethingfinance.com without consent to republish.

What follows is a review of Zecco based on my personal experience with them, updated for 2012. I maintain my Zecco account to this date.

If you invest in stocks or mutual funds, you know how limiting trading fees can be when you want to buy or sell through your broker. If you like to dollar cost average or simply have smaller amounts to invest, you know how $8.95 (Schwab) or $9.99 (E-Trade) trading fees can cut into your returns. It’s for this reason that I decided to try Zecco, to take advantage of their $4.95 stock trades and free account with no inactivity or maintenance fees.

Discount Brokers I’ve Tried other than Zecco

In addition to Zecco for my personal account, I recently switched my ETrade IRA to TradeKing, who offers $4.95 trades and a no-fee IRA (Zecco’s IRA’s are $30 per year, but non-retirement accounts are free). Both have zero inactivity fees. I had been using Scottrade for my personal account, whose $7 trades were once considered the lowest in the business. However, new competitors such as TradeKing and Zecco have really challenged the industry. I’m a little disappointed that ETrade and Scottrade haven’t lowered their stock trade pricing to stay competitive.

Where Zecco Reviews Well:

• $4.95 trades is still among the best prices out there (only optionshouse is cheaper at $3.95). Mutual funds are only $10 to buy into, which is extremely competitive versus other online brokers.
• There are no inactivity or account maintenance fees for non-retirement accounts, a true rarity these days.
• These guys are legit. They are SIPC members and your account is insured up to $500,000 ($250,000 max in securities).
• Their trading tools are very good.
• They have a social network aspect so that you can communicate with other investors.
• Service. The one time I did call for customer service, I was on hold for less than a minute. I spoke with an native English speaking American, and he was extremely friendly.

Where Zecco Reviews Not so Well:

• IRA’s have a $30 annual fee and $30 closing fee. For that reason, I have opted to use TradeKing for my IRA. Note that this only applies to IRA’s, not regular non-retirement accounts.

Who is Zecco a Good Option for?

Zecco is an excellent option for non-IRA stock investments (i.e. for your regular trading account), which is exactly what I was looking for. For retirement savings, I would opt for TradeKing because their IRA accounts have no annual fee, zero inactivity fee, and $4.95 trades (I don’t trade much in my IRA, but when I do, I want it to be cheap). Worried about missing out on stock research? Use TradeKing for your IRA and use Zecco for non retirement stock trade.

Click here to start a Zecco account!

Zecco Discussion:

• Which online broker do you use? Why?
• Do you have any really good or really bad experiences with Zecco or another broker?

Related Posts:

TradeKing Review

My Zecco Review is copyrighted by 20somethingfinance.com without consent to republish.

Lump-sum investing does have its merits during times of consistent economic growth and/or low volatility periods. However, when the market takes gigantic losses and is highly volatile, as it has been over the past year – or you are investing in zero transaction cost accounts, the merits of dollar cost averaging have returned with a vengeance.

What is Dollar Cost Averaging?

If you’re unfamiliar with the strategy, dollar cost averaging is distributing your investment contributions over time versus large lump sum payments. An example of dollar cost averaging is the process of having a consistent percentage taken out of your paycheck each pay period and having that amount contributed to your 401K. The same kind of discipline can be used in dividend reinvestment plans (DRIPS), or manually by you with all investment purchases.

How Does Dollar Cost Averaging Perform?

If you had invested lump sum amounts on Jan. 1 of each of the last 8 years vs. spreading that amount out at the beginning of each month, dollar cost averaging would have resulted in better returns in 5 of the 8 years, and absolutely destroyed lump sum investing in 2008.

Why Dollar Cost Averaging is Good for All (Especially Newer) Investors

1. Buy More on the Cheap

If you invest all at once in one lump sum when the times are good, you don’t have any money left for when shares are cheap. Buying cheap means better gains when the market does rebound.

2. Removes Emotion

Dollar cost averaging forces discipline at times when investing doesn’t seem to be the best idea. Study after study shows that once emotion becomes involved in your investing strategies, your results are going to be impacted in a negative way.

3. Helps you Avoid Timing the Market

Adding shares on a strict, regular basis means that you avoid trying to time the market. Day trading is for experts who live and breathe the stock market 12 hours + per day. Even they struggle at times to achieve market beating returns. What are the chances you can beat the pros by clicking ‘buy’ and ‘sell’ on your lunch break a few times per day, week, or month?

4. Distributes Risk

If you were to make large lump sum payments, you can easily get burned buy putting your money in at the wrong time. Think Dow 14,000 in December of 2007 and Dow 8,000 in November 2008. At the same time, you’d have nothing left to buy shares at recent price lows.

5. Lowers Stress

Large investments all at once can result in a great deal of stress in trying to figure out if ‘now is the right time’. The answer is, nobody truly knows. Investing via dollar cost averaging removes the stress of playing the guessing game.

Final Thoughts on Dollar Cost Averaging

Everyone loves to hate the concept of dollar cost averaging (it’s not quite as dramatic or fun, after all). However, straying far from this strategy can lead to disastrous results in volatile times.

Dollar Cost Average Discussion:

• Do you dollar cost average?
• Why or why not?

Related Posts:

• Review of Zecco’s Online Discount Brokerage
• Index Funds Vs. Mutual Funds
• Emergency Funds Guide

5 Reasons why Dollar Cost Averaging is Back with a Vengeance is copyrighted by 20somethingfinance.com without consent to republish.

In this post, we’ll discuss some best practices when it comes to purchasing index funds and mutual funds, in general. Mutual funds are a great option for those who don’t have the time or savvy to purchase stocks or other types of investments. First, let’s cover some basics on mutual funds.

What is a Mutual Fund?

A mutual fund is an investment vehicle that pools money from investors and then invests that money into a combination of investment vehicles, usually in the form of stocks, bonds, and money market accounts. Mutual funds are popular investments because they allow you to diversify your money into multiple investments in order to limit your risk exposure. Also, they are managed by professional investors, and if you have a good one you can sleep easy at night.

What is the Difference Between an Index Fund and a Mutual Fund?

Index funds are a type of mutual fund that attempts to mimic the performance of a stock market index. Like a mutual fund, index fund share values are based on the net asset value of all of the stocks they have invested in. Rather than its holdings being regularly bought and sold through managed trades, index funds periodically change investments based on a set of rules or infrequent committee selected changes.

What is the Difference Between a Mutual Fund and an ETF?

An ETF is a fund that follows an index and is traded throughout the day and the price is determined through the buying and selling behavior for that ETF, while a mutual fund is only traded once at the end of the day, with it’s share price determined by taking the overall share price value of all its holdings. ETF’s are usually passively managed in following an index while a mutual fund can be actively or passively managed (index fund).

Where Can I Buy Mutual Funds?

In a previous post, we discussed how to make a stock trade. Just like a stock, you can purchase mutual funds through online brokers. Additionally you can call the individual fund companies to invest directly through them if you have a fund in mind. This is usually a great way to avoid broker transaction fees.

How Can I Buy Mutual Funds?

If you’ve purchased mutual funds through an employee sponsored retirement plan, such as a 401K, the process of purchasing a fund on your own is slightly different.

• Step 1: Choose a discount brokerage
• Step 2: Submit funds to your discount brokerage account
• Step 3: Select the mutual fund that you’d like to buy. Pay attention to which mutual funds your discount broker is offering transaction fee free.
• Step 4: Choose the right funds. Look for characteristics like low expense ratios (under 1.2%), no load fees, managers with good track records who have been at the fund for a while, and funds that meet or beat their category averages. You may be limited by the amount you have to initially spend to purchase the fund. These amounts vary by type of account. If you have an IRA you will usually have to pay less to start than a non tax-sheltered account.
• Step 5: Purchase the fund. You enter in a total dollar amount that you’d like to apply towards the fund, vs. a price that you’d like to pay as you do when you purchase a stock. The price you will end up paying per share will be the closing price on the day that you purchase the fund. The amount you submit to purchase is divided by that share price to determine how many shares of the fund you will be vested in. You will also need to decide whether you would like your dividends, capital gains, or both reinvested into additional shares. If you’re young and have many years of investing ahead of you, there’s little reason to not choose ‘both’.
• Step 6: Adding to your Holdings: Once you’ve completed your up front minimum contribution you are free to add more funds at a lower contribution level (typically $50 or so, but some have no minimums).

How to Buy a Mutual Fund is copyrighted by 20somethingfinance.com without consent to republish.

During a lunch recently, ‘Matt’, a colleague, and I were discussing investments and the topic turned to mutual funds. I proceeded to tell him a few funds that I had in mind and why I liked them. The conversation then turned to how I choose mutual funds, primarily how to choose a good mutual fund manager whose strategy matches your goals. When it comes to this topic, there are a few mutual fund managers that I hold in high esteem and I began to talk about them. Matt then asked the question, “well if everyone else thinks that this mutual fund manager is great, then won’t the mutual fund price become inflated?”.

For those with a strong background in mutual fund investing, this misconception is one that is easy to overlook when talking to others about mutual funds. Many investors assume that because mutual funds have a price per ‘share’, then their value is determined on the open market by investors who buy and sell shares. In the case of a certain type of mutual fund, this is the case.

However, in most cases, investors need not worry that the price of a mutual fund they are buying has been ‘pumped’. I’ve openly promoted certain mutual funds on this site, but in every case they’ve been open ended funds (we’ll discuss later). My promotion of these funds has no effect on the share prices of these funds. Let’s take a look at why this may be.

How Net Asset Value (NAV) Determines a Mutual Fund’s Share Price

Net Asset Value (NAV) is the total value of all of a funds assets minus it’s liabilities divided by the number of outstanding shares for that fund. For instance, if a mutual fund has $100 million in assets and $10 million in liabilities, it’s net assets are $90 million. If this same mutual fund happens to have issued 9 million outstanding shares to investors, then it’s price per share (or NAV) is $10. Here’s the formula:

NAV = (assets – liabilities)/shares outstanding

The Difference Between Mutual Fund and Stock Share Prices

Stock share prices

Stock share prices are determined on the open market based on investor’s perceptions of the value of a share. Often times, these perceptions are based on a number of factor’s including the stock’s current earnings per share, and expected future earnings per share. A number of macro and micro economic factors are taken into consideration, but the important thing to know is that a stock’s share price is fluid and based on perceived value. If more people want to buy the stock than sell it, the share price trends upward. If more people want to sell the stock than buy it, it will trend downwards.

Mutual fund share prices

Mutual fund prices are based on the fund’s holdings rather than a perceived value of that fund. For instance, let’s assume that a mutual fund owns a total of 10 different stocks, which wrapped up a trading session at $20 per share. For simplicity, let’s say that this fund has zero liabilities and owns 2 shares of each stock. Meanwhile, the fund has sold a total of 10 shares. This fund would have a NAV of $40, here’s how: NAV = ($20 x 10 stocks x 2 shares – $0 liabilities)/10 shares = $40. The price of a share is not at all based on demand for that share.

Fund Share Prices: The Law of Supply and Demand at Work

The main reason why a stock share price can be influenced by outside factors and a mutual fund’s price cannot comes down to the law of supply and demand. At any given time, a company only has a certain limited number of shares available that are trading on the market. These shares are released during an initial public offering (IPO). Companies can later release more shares (secondary offerings), if they’d like, but it often has a large devaluing effect on the already existing shares.

At the same time, mutual funds create as many shares as there are demand for, and sell and buy them back from you at the NAV price. They do not trade on the open markets, as stocks do. You typically get the price of the fund at the end of that trading session if you purchased before the closing bell, or at the end of the next trading session if you purchased after hours. In the case of mutual funds, unlimited supply equals an asset with a value that is not influenced by outside demand (or lack of).

The Exception: Closed End Funds Prices

There is one exception to everything we’ve discussed thus far, closed end funds. Everything mentioned in this article prior was in reference to ‘open ended’ mutual funds, which make up the vast majority of mutual funds out there. In contrast, a closed end fund is a certain type of mutual fund that has a limited number of shares that trade on the open market, much like a stock.

Often times, these funds will trade at a discount to their NAV and investors will purchase them hoping to make a gain if the fund starts trading closer to it’s NAV. You may find it hard to believe that a closed end fund would trade at a discount to it’s NAV, but it does happen on a regular basis. In general, if you don’t understand the reasons why these funds would sell at a discount to their NAV, you’re probably better off steering clear of them and sticking with open ended funds.

Mutual Fund Share Price Discussion

How did you think mutual funds were valued?

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How is a Mutual Fund’s Share Price (NAV) Determined? is copyrighted by 20somethingfinance.com without consent to republish.

Let’s take a look at index funds and compare them to actively managed mutual funds. It’s important to understand the distinction between the two, because you may have the option of both within your employer sponsored retirement plan. In order to truly understand index funds, you need to first take a step backwards and discuss what they are ‘cloning’ – stock market indices.

What is a stock market index?

Stock market indices measure the composite value of a group of stocks. Indices can be chosen through a set of rules or hand selected by committees. One of the more popular indices is the S&P 500, which is a committee selected group of 500 large cap (market value) stocks, mostly domestic, that are meant to resemble the market as a whole. Another example of a market index is the Russell 2000, which includes 2000 small cap stocks. You’ll also find indexes that measure different sectors of stocks such as international, health care, real estate, REIT’s, and just about any other way you can group stocks.

What is an Index Fund?

Index funds are a type of mutual fund that attempts to mimic the performance of a stock market index. Like a mutual fund, index fund share values are based on the net asset value of all of the stocks they have invested in. Rather than its holdings being regularly bought and sold through managed trades, index funds periodically change investments based on a set of rules or infrequent committee selected changes. A lot of them take the human decision element out completely.

The first index fund was created in 1975 by Vanguard founder John Bogle. Some believe that Bogle’s philosophy was based on the book A Random Walk Down Wall Street by Burton Malkiel, which argued that one cannot consistently outperform the market averages. To this date, Bogle (now retired from Vanguard) and Vanguard remain strong advocates for investing in index funds, and Vanguard is now the second largest mutual fund company in the world.

Why Index Funds are Better?

Proponents of index funds point towards data that shows that they consistently outperform their actively managed mutual fund peers due to the following reasons:

• Usually they have lower management fees (because they aren’t actively managed).
• They trade much less, so turnover ratio is lower. As a result capital gains taxes can be lower.

Comparing index funds to mutual funds often times will make them look favorable. There are mutual fund managers out there whose goal is to meet the market indexes, not consistently outperform them. Because they’re actively managed, their fees are higher and their turnover ratios are higher.  Also, in general, there are some horrible mutual fund managers out there. It makes sense to check their histories before you purchase any of their shares.

A Real Life Comparison of Index Funds versus Managed Mutual Funds

My opinion is that you should take advantage of what is offered to you. Vanguard is my employer’s 401K plan administrator and within my plan I have the option of both index and mutual funds. Let’s take a real life look at an index fund versus a comparable mutual fund within my 401K plan.

Index fund – Vanguard Total International Stock Index (VGTSX): expense ratio = 0.27%, no manager, has outperformed the MSCI EAFE international stock index in four out of the last five years.

Actively managed mutual fund – Artisan International (ARTIX): expense ratio = 1.21%, manager is Mark Yockey who started with the fund in 1995 (good longevity). ARTIX has only outperformed the MSCI EAFE international stock index in two out of the last five years.

The Results

Over the last five years, VGTSX has outperformed ARTIX with a total return of 146% to 100% (with almost 1% lower management fees). This is a significant difference. In this case, being presented with these two funds for international exposure, I would opt for the index fund (VGTSX) every time. However, if I was doing the same comparison within a personal IRA and had other actively managed options to choose from, I would do my research and look to see if I could find an alternate actively managed fund with a lower expense ratio, low turnover, a seasoned manager, and better returns than ARTIX and VGTSX. One needs to look no further than DODFX, which returned 189% over the same period of time, with a team of 9 managers and only a 0.66% expense ratio.

You’ll find a number of investors who invest solely in index funds because they buy into the Bogle rhetoric that index funds are superior in every way in the long run. In many cases, they are. However, there are always exceptions and you should do your homework.

If you have the option of choosing between the two, take a look at the results of the mutual fund managers available to you. When presented with limited options, I have opted for index funds. I’m starting to see the Bogle way, myself.

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Should I Invest in Index Funds or Managed Mutual Funds? is copyrighted by 20somethingfinance.com without consent to republish.