What the Heck is an ETF? More on Understanding Funds

When I first started this blog several months ago, I added a snappy little glossary definition of ETF's, figuring that I would not be able to get many of you excited about them as a topic. But the other night I got a question from a reader about these increasingly popular investment vehicles, so I have decided it's time to give you the fully story (or at least the slightly-longer-but-not-too-tedious story)—

Let's start with my original glossary definition:

An investment fund that tracks a list of stocks, bonds, commodities or other investments. Investors own shares of the fund, rather than directly owning the investments within it. Unlike mutual funds, ETF's trade like a stock such that the price changes throughout the day.

The best known ETF's are index funds and are popular for their low costs.

If you really want to wrap your head around ETF's, you need to understand how funds in general work. A fund is a like a shared pot for which the fund manager buys a selection of investments. Those investments are usually stocks or bonds, but there are other investments they can choose from as well. Once the fund manager has created that "pot", she will buy and sell investments according to whatever strategy she has laid out at the beginning—think of that strategy as the fund's "recipe." The recipe can be pretty precise: "I'll only buy stock from companies that make things out of timber." It can be broader: "I'll look for the most undervalued stocks in the U.S. market." Or it can be blended: "I'll always keep 70% U.S. stocks and 30% U.S. bonds."

Regardless of the fund manager's strategy, all of the money for these purchases comes from people like you who buy shares in the fund. And this raises the question of how you buy "into" the fund...and how you get your money out. This is where the type of fund you buy—ETF or mutual fund—makes a difference. If you want to purchase or sell one share of a mutual fund, you will always find the price of a share from the fund's Net Asset Value (NAV for short). That number is a simple calculation of how much the fund's current investments are worth, and it's only calculated once a day—at the end of the trading day. Simple!

An Exchange Traded Fund (or ETF) doesn't make things so easy. Just as stock prices slide up and down over the course of a trading day as people bid and sell them, an ETF price slides around constantly depending on how much traders in the market are willing to pay for a share in it at that moment. If everyone is betting that the fund manager is doing well, the price of a share in the ETF will go up (and vice versa).

Should you buy ETF's?

As you can see from my glossary entry, ETF's have been a particularly popular form of "pot" for a fund manager wanting to create an index fund, where the "recipe" is to have a little bit of everything on a given list (say, all companies on the S&P 500, or all U.S. oil companies). With index funds, a computer does most of the work calculating buys and sells, and the fund manager generally can charge you, the fund owner, a little less as a result. Lower fund management fees is always a good thing.

And there is one other thing you should know about ETF's vs. Mutual Funds—the taxes are different. If you own a share of a mutual fund, you and the rest of the fund's owners will share the fund's tax bill at the end of the year. These are called contribution taxes, and they come from the capital gains taxes created when the manager sells an investment in the fund for more than she paid for it. As with any investment, you will also pay a capital gains tax on your shares when and if you sell them for more than you originally paid.

On the hand, the IRS treats ETF's like a big, funny looking stock. As with the mutual fund (and other investments) you pay capital gains taxes when you sell your shares. But the IRS ignores the fact that the ETF has all of that other buying and selling going on inside it, which means no contribution taxes for you. A lot of investors and fund managers choose ETF's over mutual funds for this tax efficiency.

Have more questions about ETF's or other investments? Post something to me in the comments box below!

Have you diversified your account...or just made it really complicated?

"Diversify!" we say, and most of the individual investors I've seen seem have listened. For years brokers, financial planners and online experts have been saying that you need to have a healthy blend of different stocks, bonds and funds to invest successfully. Unfortunately, we do not seem to have done such a good job of explaining how many investments there are in a "healthy blend." I know this because I continue to see new clients walk in with respectable little investment accounts broken up into enough funds to choke a stockbroker. So how many investments do you really need?

Let's start with this fact—the whole reason that mutual funds were invented was to make diversification easy. The fund itself is meant to be an instant portfolio, a mix of different stocks or bonds that you can buy all at once instead of in a hundred different purchases. So, the easy answer to "how many funds do I need?" is often just, "one."

But, of course, there are different kinds of diversification. Buying a little Apple, a little Expedia and a little Home Depot stock will give you some diversification in that, if one goes down, the others might not. But Apple, Expedia and Home Depot stocks all have something in common—they are are all U.S.-based companies with large market capitalization (called "large cap" stocks, it means they have more than $10 billion invested in them). And we've noticed that stock markets being what they are, when people sell off one U.S. large cap stock, they often sell off a lot of others like it.

Because of this, we have a second kind of diversification—you don't just mix the stocks themselves, but also the kind of stocks...or bonds, or REIT's or other investments. This earlier post on asset allocation talks about the different asset classes we use for this kind of diversification. As much as we in the investment industry like to complicate things, most investment accounts don't need more than five or six funds to be fully diversified. Many accounts don't even need that many. A single target date fund is an easy way to hit the basics, and a simple trio of U.S. stock fund, bond fund and non-U.S. stock funds is an easy and very respectable solution for a basic investment account.

So what is the problem with being over-diversified?

The biggest problem with having too many investments in your account (aside from the mile-long quarterly statements) is that you are likely to fall into a common trap—un-diversifying your account. By this I mean that too many investors put their money into such a complex array of funds that they don't realize how many of those investments are actually the same. It's no wonder when we look at the fund names. I mean, really, what is an "advantage" fund supposed to be? How about a "blended style fund"? A "new perspective growth fund"? It's no wonder people end up choosing randomly and hoping for the best. But more often than not, this ends in a portfolio that looks diverse from afar but turns out to be a lot of different funds all holding basically the same stocks (most often, the U.S. large cap list). If you aren't going to consult with a financial planner, the only solution to this is to do your homework on what those funds really are.

There is one more kind of diversification.

So far, I've talked about simple diversification and asset allocation, but there is one more, really important type of diversification. And that's a diversification that takes into account what is outside your investment accounts. If you work for Software Company X, and more than 50% of your investment account is in similar tech companies, you should probably think about the effect a downturn in the industry might have on your finances. Likewise, if you've got most of your savings tied up in a small business venture with your cousin or a real estate venture with your best friend from college, think twice about going heavy on similar investments in your account. Your investment account is part of a much larger strategy for creating income and protecting savings. It needs to work alongside all the other resources in your life. And that might mean fewer investments in the account to balance out whatever you have going on outside the account.

Simple and Growing.

Sometimes diversification is a process, especially if you have a small account but are regularly adding to it. Don't be afraid to start with one or two asset classes that are selling at a lower price right now and then add in, say, a mid-cap stock fund or an international stock fund later. Just be sure you know the asset classes or investments types you want to have and try to limit yourself to one fund for each of them as you grow, even if that means starting with a single fund. In the end, the greatest challenge in investing isn't that complicated—make sure you have a good strategy and stick with it as you build. Investing can be difficult but that doesn't mean it has to be complicated.

Do I Need Life Insurance?

Something about the fall makes people start to wonder about life insurance. I can't explain this phenomenon, but I can give you a little primer on how life insurance works...and doesn't work. Let's start with this, though—a lot of people do not need life insurance. Are you one of them?

First, check to see if you fall into one of these categories:

1. You Are Someone's Financial Support.

The real purpose of life insurance is to fill in for the financial support that one person is providing for others if the provider dies. If someone (your children, your partner, your parents, etc...) is counting on you to provide for them, life insurance probably makes sense. How much the policy is worth and how long you want that coverage for will depend on the costs you are trying to cover.

2. You are a business owner.

Insurance companies provide "key person" life insurance policies to help cover the costs to the business of losing a key employee or owner. Those costs can range from hiring someone to fill the "key person's" place to paying off their family as shareholders, to paying the costs to shut down the business. Notice that unlike the category above, the beneficiary of this policy isn't a person—it's the business, itself. Sole proprietors are generally fine to use a standard personal life insurance policy, instead.

3. You are working with an attorney to avoid estate tax problems.

Trust & Estates attorneys often make use of insurance policies to move wealth to an heir while keeping down taxes. In most cases, this becomes an issue if your estate is worth more than your state and federal estate tax exemptions (an impressive $5.43 million for 2015 for the feds but $1,000,000 for my state of Massachusetts). But imagine you own a large family property or family business, both of which could easily top exemption amounts. Your attorney might talk to you about an insurance policy that allows your family to pay the estate taxes without selling up. As you might have guessed by now, if you are buying insurance for tax purposes start by talking with your attorney, rather than your insurance agent.

Don't fall into one of these three categories? Then you probably don't need life insurance. And that's good news, as it means you can start putting the money you might have spent on premiums into something you can enjoy while you are still kicking around. If, on the other hand, you do think you need life insurance, stay tuned for my upcoming post on understanding the kinds of life insurance out there and how they work.

Understanding Your Employee Stock Options

Maybe your employer offers stock options, or maybe you just aspire to a job that has them. If you plan on tangling with employee stock options in hopes of living like the next Google stock option millionaire, there are some basics you need to know. Let's start with what an employee stock option actually is. Employee stock options (ESO's) give you the right to buy stock in the company you work for at a price that your employer has set in advance. Notice that this does not mean you're given the stock for free! If you are deciding whether and when to buy those shares, start with these tips:

First, find your Stock Option Plan Agreement.

This is the contract between you and your employer that lays out all of the terms for when, where and how you can exercise your options and sell your stock. If you are looking at your agreement and find that what you've got is Restricted Stock, stop here. Restricted Stock Units (RSU's) are an increasingly popular alternative to the old stock options, but they are a completely different beast and will get their own post. If you do have a Stock Option Plan, then...

Look for the vesting period.

When an employee chooses to buy the stock offered by an ESO, we say she is "exercising her stock options." She can only do this, though, after the options have "vested." For most ESO plans, that is going to be 1-3 years after you get the options, and many plans set their options to vest gradually. For instance, 25% of your options might vest one year, the next 25% a year later, and so on. During the vesting period, the stock options are nothing more than a potential benefit of working for your company.

Make a note of the exercise price.

The exercise price is how much you would have to pay to buy the stock. The idea here is that your company is growing more valuable over time. So if shares are worth $10 a piece now, they might be worth $13 next year, $16 to following year, and so on. That price that you can get on the market for your stocks is known as the "strike price." So, in this example, if the exercise price that you paid your employer for the stock was $10 and you can now sell them in the open market for $16, you've made $3 per share. Great! Of course, the other possibility here is that your company's stock price goes down after you've bought your shares. And that's why you need to look further.

When do your options expire?

Your Option Agreement will have a time after which those options are...no longer an option. If you don't exercise them before that date, they just go away as if they'd never existed. Until that date, though, you can keep an eye on the company's stock price and keep considering whether exercising your options makes sense.

Where will you get the cash to buy your new shares?

If you are looking at options that let you buy company shares at a discount, you probably want to exercise those options, but you still need to figure out how you are going to pay for it. The simple answer is to come up with cash from your savings. Because that doesn't always sound appealing, a common arrangement is to buy on margin—meaning that you or your employer has arranged to borrow money from the brokerage house to buy the shares. The broker will take their money back when you sell your stocks. But be aware of the risks of margin trading if you plan to hold on to the stocks for a while.

Figure in the taxes.

As you've noticed, stock options don't count for anything unless you exercise them. But if you do exercise them, you have just received a form of payment from your employer. And that means paying taxes. The year in which you exercise the stocks, you will have to pay income tax on the value of those stocks (even if you don't sell them right away). We usually check with a client's accountant before giving advice on stock options just for this reason—if you are considering exercising your stock options, preparing for the extra taxes is crucial.

Know what kind of ESO you have.

Employee stock options come in three flavors. A Non-statutory ESO is the standard, and they are pretty much as I've described above. But there are twists with the other two ESO types. A "Reload ESO" just keeps shoveling more stock options into your basket as you use up the old ones. So if you exercised 25% of your options this year, the company will replace those with new options. For these new ones, though, your exercise price will be reset to this year's market value.

But your ESO may actually be an ISO, an Incentive Stock Option plan. These are designed to keep you out of trouble with taxes. And to do that they force you to hold on to your stock for a year between the time you exercise the options and sell the stock. With these you pay capital gains tax, a much lower rate than you standard income taxes. There is a downside, though—you run the risk of buying stocks only to watch their value drop during the year you have to hold them. That scenario is always disappointing, but it can be a big problem if you borrowed to cash to exercise your options.

 So, should I exercise my options? And when should I sell them?

Assuming your options worked as hoped and are worth some money, the question of whether to exercise stock options almost always comes down to taxes. Don't ever exercise a stock option until you have a good estimate of how it will affect your tax bill and whether the "hit" will be worth it.

Where most people get frustrated is in the question of how long to hold their company's stock once they have it. This, too, might be a tax question. If you have held on to your shares for a while, you will pay a capital gains tax on the amount your shares have gone up in the meantime (over and above any tax you paid on that initial exercise price).

But the bigger issue here is whether continuing to hold your employer's stock is keeping you from putting that money in investments that are better suited to your plans and sense of risk. Think of it this way: if you did not already own company stock, and I offered to sell you the same amount of shares in your company or in something else (another company, an index fund, bonds, etc...) which would you choose? If the answer is something other than your employer's stock, it's probably time to sell up.

Think Like An Investor

I came up with this post after meeting with a favorite client today. She's a charming and intelligent woman with a good career and a 401k who, until recently, had never thought of herself as an investor. Investments were complicated things designed for wealthy people. And then she realized that she wanted to buy a home. Part of our problem with the term "investor" is that too many of us picture this when we hear it:

There is some kind of vague understanding out there that "real" investors have special access to a supply of financial jargon, legal tricks and overpriced cuff links that somehow make sense of those relentless scrolling stock prices on CNN. And let's face it, throwing in tax references (tax-deferred, capital gains, tax efficiency) isn't helping. It's enough to make any reasonable person throw her hands up. And it's no surprise that so many of us, even when we actually have investments, don't think of ourselves as investors.

Watching the determination with which my client approached her goal of homeownership really brought home what we are doing wrong when it comes to investing. Buying a home is a form of investing, but where talk of 401k's and index funds makes people feel overwhelmed and anxious, talk of mortgage calculations and down payments has a completely different effect. People who feel empowered as they approach home ownership. And that's important. Because while I am the first to point out that homeownership isn't a good investment for everyone, the real estate industry has done something right by making clear that every buyer should feel like she belongs at that proverbial homeownership table just as much as any coiffed businessman in navy suit.

Since the great home building boom of the 1950's, Americans have understood that our economy depends on the willingness of  "average" middle-class people to buy homes. But we seem to have forgotten that our economy depends on those same people to hold up everything else, as well,—grocery chains, cars, professional services, restaurants, charities, and yes, stock markets. Because no matter how wealthy our wealthy class gets, they are never going to make, hold or spend enough money to sustain a modern economy (feel free to ask me why "trickle down theory" was a clever illusion).

All of this leaves us with a dilemma. Most of us believe that we are cut out to be investors in housing, even if we aren't quite ready, yet. And we believe (even if we have temporarily forgotten) that we, in fact, are the U.S. economy when we work and when we spend. But we don't seem to realize that we are also the "public" behind publicly traded corporations and the only reason that stock markets are worth tracking. The hard truth is that we depend on these markets to ensure that we have funds to live on after 65 and that we have the money to buy homes (or to help our children buy them). So how do we convince one another to demand a little more clarity around the retirement plans and investment accounts on which we depend? How do we claim our places at this other table?