Personal Finance Guide

Archive for the ‘Investment Strategies’ Category

With most mutual funds managers underperforming the stock market benchmark such as the S&P 500, added to the fact that most of them carry mutual funds expenses, it is easy to see why investing in Index Funds is attractive.

Index Funds hold all or a representative sample of the stocks or bonds in a particular market benchmark. The expenses of Index Funds are also very very low, especially when compared to mutual funds. An index fund aims to match the performance of the market. It does not try to beat the performance of the market.

Considering that most mutual funds underperform the market in the long run, aiming for the average of the market return does not sound so bad. You would at least beat 60% -70% of all mutual funds out there most years and over the long run.

Tax advantage

Since Index Funds don’t trade as often as mutual funds do, you will incur less capital gains tax. This does not apply to you if you are investing in a tax-qualified accounts such as a traditional IRA. You will not incur any taxes on your gains until you sell your investments.

Which Index Funds to invest in?

There are index finds that specialize in all sorts of stocks and bonds. There are Index Funds for small cap stocks, mid cap stocks, large cap stocks, international stocks, long term bonds, technology only stocks, to name a few.

It is most important when investing in Index Funds to bear in mind that the lesser the fees of the Index Funds the closer the performance will be to the market. For example, check out the Vanguard Index 500 fund for expenses and read its prospectus.

Most investors expect professional investment managers such as those managing mutual funds to outperform the stock market. However, this is seldom the case. Mutual funds rarely beat the stock market benchmarks such as the S&P 500, an index of the share of 500 large US companies. After all if the investment managers who work round the clock on choosing the right investments don’t outperform the stock market, why pay extra money to buy into their mutual funds? Isn’t it best to invest in index funds?

Research has shown that the majority of stock investment managers lagged the stock market in 12 out of 20 years from 1976 to 1995. Moreover, more than half of stock mutual funds managers have fallen short of the stock market ’s average return over longer periods as well. For example, less than 20% of the 402 US diversified mutual funds that had been around for the 10 years managed to beat the S&P 500 ’s 14% annual return for the 10 years to April 1, 1996.

The reason most mutual funds don’t outperform the stock market averages is because the professional investment managers at mutual funds, banks, insurance companies, etc are the market. The portfolios they manage account for half the value of US stocks and account for the bulk of the trading in those stocks. Therefore, their investment returns are the stock market returns. There are also mutual funds annual operating expenses. When you deduct mutual funds expenses, you are further away from stock market averages.

How did investment managers beat the stock market in some years?

Nearly 87% of all investment managers beat the stock market performance in 1977. Many stock mutual funds that outperformed the stock market (such as the S&P 500) invest in smaller cap stocks when small cap stocks are performing well, better than large cap stocks. These small cap stocks are smaller than those in the S&P 500.

• When to invest in Index Funds

What is currency risk?

Currency risk or currency exchange risk is the gain or loss from changes in the relative value of foreign currencies vs home currency. That is why currency risk is sometimes called foreign currency risk or currency exposure risk. 

As with stock, bond or mutual fund trading, some investors love to trade currencies. If currency trading is your area, then you want to make sure you have currency risk management system in place to manage your currency exchange risk. Global risk factors on the currency market are not the same when you invest in US stocks using US currency. 

Foreign Currency Risk example

The currency exchange risk depends largely on the exchange rate of the foreign currency you are investing in relative to your home currency. You often hear that the dollar is weak today or the dollar is strong today. When the dollar is weak, the dollar is cheap to buy. Vice versa, when the dollar is strong, it is expensive to buy or invest in the dollars. If you don’t plan your currency investing properly, currency exchange risk will dwindle down all your investments.

Exchange currency risks of a multinational corporation

When a company is a multinational corporation with businesses in many countries, foreign currency exchange risks become important factors affecting their profits. If the company has an office in Brazil, for example, the company needs to pay attention to the currency risk of Brazil and not necessarily foreign currency exchange risk of other foreign countries. If the corporation does not have an office in Japan, for example, the Japanese Yen will not become a currency risk for the corporation. 

Foreign currency exchange risks for bonds and stocks

Consider foreign bonds that pay coupons in foreign currency or foreign stocks that pay dividends in foreign currency. The coupons you received or the dividends you received will largely depend on the currency exchange rates. If you are expecting $1,000 in dividends, you may be surprised to receive only $500 because of the currency exchange risk.