Alpha generation is a topic for another book, the remainder of this one will focus on efficient generation of beta returns. There are four ways that investors can purchase diversified portfolios focused on beta returns: active mutual funds, index mutual funds, portfolios of individual stocks, and ETFs.
Mutual funds are entities that buy a diversified mix of stocks on behalf of their own shareholders. There have traditionally been many advantages to owning shares in a mutual fund versus owning a diversified portfolio of individual stocks. These include convenience, the ability to split transaction costs over multiple owners, and the benefits of professional management.
Mutual funds come in two varieties: “active” and “passive.”
- Actively managed funds try to pick stocks that will do better than the overall market, while still owning diversified portfolios. Many fund companies hire hundreds of analysts and portfolio managers that meet with company management and do other extensive research on a company’s prospects, trying to determine whether the prevailing stock price is too high or low. These kinds of funds attempt to deliver alpha returns and beta returns at the same time. Although they will largely track the market (beta), they may do a percentage point better or worse depending on the skill or luck of the portfolio manager (alpha).
- Passive funds, also called index funds, are a kind of mutual fund exclusively devoted to delivering betareturns. Instead of hiring analysts to research which companies to buy, index funds just buy every share in a broad market index such as the S&P 500. Although index funds will not be able to beat the market by definition, this strategy ensures that they will do at least as well as the market (before fees). Because they have no need to hire hundreds of analysts like actively managed funds, index funds are able to charge lower fees.
Exchange-traded funds (ETFs) are index funds that are traded on an exchange, like stocks. For investors focused on achieving beta returns, this offers several advantages:
- Unlike mutual funds, ETFs can be purchased easily through a discount brokerage just like stocks.
- Tax advantages. ETFs are less likely than mutual funds to generate taxable gains until you sell the shares.
- Lower fees. ETFs often have marginally lower fees than index mutual funds.
ETFs also do have a couple disadvantages relative to mutual funds:
- Because ETFs are purchased like stocks, you will usually have to pay a small commission to your discount broker every time you trade. However, many brokerages now offer a selection of commission-free ETFs (see below).
- Mutual funds are required to redeem shares at their net asset value on a daily basis. With ETFs, there is no such requirement, you are dependent on there being someone else to buy your shares if you want to sell them. However, this is not really an issue except for some small ETFs that might be thinly traded.
Index funds may be a better vehicle for small investors who want to invest a small amount every pay-period or every week (called “dollar-cost averaging”) since mutual fund companies like T. Rowe Price or Vanguard do not charge a transaction fee to enter a fund. However, many discount brokerages have responded by eliminating commission charges on eligible ETFs. For instance, Vanguard ETFs can be traded commission-free at discount brokerage accounts set up at either Vanguard or at TD Ameritrade.
For those with greater than $50K or so in savings, ETFs may be the most effective way of achieving beta returns, as they combine extremely low fees with the ability to easily buy and sell shares. Those with smaller nest eggs or that expect to be making frequent transactions may want to look at index mutual funds, or at least ensure that they are getting commission-free trades on ETFs.