Is Rackspace Officially Dead?

RXT

It’s hard to overstate the importance Rackspace played in San Antonio’s imagination about itself in the year 2009, when I first arrived in town. A scrappy mid-sized technology company, launched by 3 college kids in their proverbial dorm room, had established an early-mover advantage in the growing technology service known as cloud hosting, and was using that advantage to fend off the biggest names in tech: Amazon, Microsoft, and Google. With the cult slogan “Fanatical Support,” hopefuls wondered if Rackspace could do for San Antonio what Dell had done for Austin. Would rackers overmatch the difficult competition and transform sleepy Alamo city into a tech hub?

The relentless, one-way drop in RXT shares from $20 two years ago to just over $2 shares as of this writing tells us that David did not, in fact, slay Goliath. The stock’s chart over the last two years is just a Matterhorn-shaped downward slope with no bottom in sight.

The equity market capitalization dropped in that period from $4 billion to around $250 million by mid-May 2023, approaching one-twentieth of its former size. Looking at that kind of chart in May I naturally ask the fundamental question: “Is Rackspace dead?” And also the technical question, “what the heck is wrong with RXT shares?”

Now, here I want to distinguish between a company and its shares. A good company can be a bad stock investment. And in certain instances a bad company can be a good stock investment. And everything in between. I will mostly save the judgment about whether Rackspace is a good company with good long-term prospects, “the fundamentals,” for a future column. Today I mostly want to discuss “the technicals,” which addresses the question “What the heck is wrong with the stock?” rather than the more profound question of business prospects.

Still, we’ll do 3 sentences on the fundamentals, and then the rest of the column on the specific technical issues that may have plagued RXT, the stock, for the past two years, and in particular the last few months. And then a technical change in stock market plumbing announced last month that reflects RXT’s changed prospects.

The Fundamentals

RXT reported a loss of $612 million for the quarter ending March 2023, following a full year loss in 2022 of $805 million, on $759 million in quarterly and $3.1 billion in annual revenue, respectively.

Rackspace
Rackspace Stock Over 3 Years

As of March 2023, the company reports $3.3 billion in long-term debt at an average of 5.5 percent, not due until 2028, giving it attractively-priced debt service, and a runway of 5 years before it needs to refinance the debt. 

Cloud computing services, as an industry, are projected to grow between 15 and 20 percent annually for the next 5 years, so an experienced provider that merely maintains market share with the natural tailwinds of the industry could be positioned to grow nicely.

Fundamentally, we have 5 years to find out whether Rackspace is dead.

The Technicals

So then what technical forces are crushing RXT, the stock, these past 2 years?

Technical analysis seeks to explain the current and future price movements of a stock according to the supply and demand dynamics specific to the stock. This is distinct from studying the fundamental revenue, cost, debt, and cash flows of the business itself, as we did above.

The largest holder of RXT remains private equity firm Apollo Global Management with 61 percent of the company’s shares. In 2016 Apollo took the company RAX private from the New York Stock exchange. Apollo then relaunched Rackspace via IPO under the ticker RXT in August 2020 on the tech-oriented Nasdaq. In part because Apollo still owns most shares, the supply of tradable shares, or “float,” is quite small. Very few individual, or “retail” investors own any shares. 

The volume of share transactions in RXT has declined over the past year, along with the stock price. A year ago between $5 and $8 million worth of shares traded hands per day. That has slowed to an average of less than $2 million per day over the past two months. 

A low “float” of the shares, the declining dollar amount of trading, and a price approaching $1 per share all tend to further depress interest in a stock among professional investors. 

Non-Apollo shares are mostly owned by Small Capitalization Index Mutual funds. My strong belief is that this particular fact is the absolute key to understanding the one-way price movement of RXT over the past months.

Russell_2000

The top mutual fund holders of RXT are all ETFs and index funds, from Vanguard, iShares Russell, and Fidelity. RXT shares are also held in some “technology,” and “total market” index funds. 

A major technical problem for RXT of this ownership is that each of these indexes is “market-weighted.” This means that as the market capitalization of the company drops, the automatic weighting of the company within that index drops. That makes the indexes forced sellers of the company’s shares as prices decline, in a self-reinforcing vicious cycle. 

In theory, and as often happens with other stocks, institutional value investors (non-index investor) sometimes jump in to purchase shares in this scenario, which helps to break the vicious cycle. But for most value investors RXT’s float is too small, the trading volume is too small, and most importantly, value investors don’t love annual losses larger than the market capitalization of the company. So far they’ve stayed away.

But I suspect the biggest problem with RXT is the specifics of the Russell 2000 index that happened last month, which determines ownership of small capitalization index funds.

The Russell 2000 index is comprised of US small-capitalization companies, in particular those ranked numbers 1,000 through 3,000 on the list of US companies, by size.

As of 2022, the literally smallest Russell 2000 index company – the 3,000th ranked company on the list – had a total market cap of $240.1 million. Interestingly, RXT breached that bottom floor of market capitalization last month.

Russell 2000 Index Over 5 Years

The Russell 2000 index makers set April 28th 2023 as the annual cut-off date for determining who is in or out of the index. On that date, RXT had an approximate market capitalization of $320 million. This put RXT on the bubble of being dropped by the Russell 2000 index. The result of that would be further forced selling by the index holders.

New IPOs allow companies to be added quarterly. Other additions or subtractions due to growth, merger, or shrinkage happen just once a year. Companies are subtracted from the Russell 2000 index on an annual basis, and May 19th was the announcement date for whether RXT would remain in the index.

Let me not hold you in further suspense. Despite being on the bubble, RXT did not get dropped from the Russell 2000. The size of the smallest company to remain on the Russell 2000 list dropped to $159.5 million in 2023, 33 percent below the previous floor. RXT was saved in a sense because the standards for inclusion got easier!

RXT actually got added to the Russell Microcap Index for the first time on May 19 2023, the index for even smaller companies with a market capitalization going all the way down to $30 million.  

But even though they were not removed from the Russell 2000 list this year, the risk of subtraction from the index, plus the vicious cycle of lower prices leading to lower market weighting, could explain much of the past few months’ price action in RXT. 

Getting put on the Russell Microcap Index is somewhat analogous to relegation to a single-A baseball league down from the triple-A league where it had previously played. The stock may take a long time to ever attract major league investors. Or it may never again attract them.

Languishing in obscurity is ok for profitable companies that can put together a good fundamental track record of profit over time. It could get back on the list and in that sense be eligible again for the majors. For a company with $3 billion in debt due in 5 years, and a string of annual losses, it may be a harder slog. Time will tell.

A version of this ran in the San Antonio Express News and the Houston Chronicle

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Ask An Ex-Banker: Mutual Fund Investing

passive-vs-active-investing

Editor’s note: Paul recently purchased The Financial Rules For New College Graduates, then had some followup questions regarding mutual fund investments. Readers of the book…feel free to pepper me with your followups…

Dear Mike,

I’m on board 1000%1 when it comes to 100% equity mutual funds, the questions in my mind now are: “Which one(s) and how many?”
passive-vs-active-investing
1) I’m finding many front-end load (5.50%-5.75%) managed funds with anywhere from 0.89% Expense Ratio to 1.40% (with the 1.20% range being the most common). I’m assuming that the lower the expense the better, but am I overstating the importance of this number? 
2) Without splitting hairs about what the top 10 holdings are, the turnover within the fund itself, the risk and return vs category, how long the managers have been there and what their philosophy is, what are some of the key things you’d look for before settling on a fund?
3) I’ve compared the 1 yr, 5 yr, 10 yr and Since inception returns of the funds. Many funds have returned 7-9% while some are well into the 10% and even 11% range. Would you put any stock (no pun intended) in those numbers when comparing and contrasting funds? Are these funds even worth looking into when an Index fund, through Vanguard for example, matches virtually every move the S&P 500 has made, returning the same 10.33% without the commission charge and SIGNIFICANTLY lower expense ratio (0.04%!!!)?
4) And, of course, is 1 fund enough, or would you explore the idea of having several?
Thank you for being willing to even read through this! Hopefully I haven’t strayed TOO far away from the simple approach I’ve attempted to internalize with your teachings.

–Paul F, Boston, MA

 

Dear Paul,

All great questions, I’ll take them one at a time

1. Front-end Load, Back-end Load – From my (consumer-driven, not industry-driven) perspective, these are all terrible, terrible fees and should be avoided. Never get a fund with them. Basically unconscionable. Can’t justify them at all. Only reason to pay these is if you are totally captive to an employer-sponsored plan and you have no choice of a no-load fund. If you are setting up your own investment plan, just eliminate them entirely.
Keep-it-simpleOn the other hand, from an industry (sales-driven) perspective, load funds are great. Makes the salesperson rich at the direct expense of the investor.
About the annual Expense Ratio…at this point 1% is kind of the industry marker. Less than 1% is a reasonable deal for an actively managed fund, over 1% is a little pricey for an actively managed fund. As I say in Ch.14 of my book, I don’t actually think paying for active management makes sense, but if you really want it then 1% is kind of the inflection point between cheap and expensive.
And finally, you are NOT overstating the importance of these numbers. They are – especially in the long run – the absolute key to not turning over between 20% and 50% of your lifetime investment gains to your investment managers. That’s not an exaggeration, its just math you can model out in a spreadsheet.
2. Fund factors to look for – For me (my big bias) the expense ratio is the #1 consideration. After that, of course you want to understand how active versus passive they are (my bias is for passive), how quick turnover is (my bias is for low turnover as it reduces costs and increases tax efficiency), how concentrated they are within the asset class (a case can be made for either diversification or concentration, depending on your overall goals and the rest of your investment plan), where it is in the risk spectrum (for a 20-something person I think you want to maximize risk in all long-term holdings. I still do and I’m in my mid-40s, and I will continue to maximize risk for my whole life, but that’s my bias for all my investments).

3. Time Horizon – For comparing returns, the 10 year and longest time horizons are the only relevant data points. I would ignore 1 to 5 year returns as essentially noise, since the right investment horizon is decades. If the manager is consistent in strategy, the long-term return will be what that particular market sector offers in the long run, which is all I’m looking for in an investment manager.

4. On Number of Funds – I’ll suggest a book for further reading by a guy I like: Lars Kroijer “Investing Demystified.” He doesn’t agree with me on my “risk maximization” point, but he and I agree on the efficient market hypothesis as a good starting point for most people. The reason I bring him up is he makes a case for owning a single “All World Markets” fund, which should be available from major discount brokers. After reading Kroijer you’d have a better sense of how many funds you’ll need. Whether just 1, or more.

As for me, I have just 3 funds in my 401K retirement account. All 3 are 100% equities:
1. US Small Cap,
2. Non-US Developed markets (Europe, Japan, NZ), and
3. an Emerging markets fund
I’m pretty happy with that and will probably never change it. Maybe I’ll re-balance once in a while if one starts to get too big relative to the others. But again, Kroijer’s book will probably explain well why that view makes sense to me.
I hope that helps!

Please see related posts

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  1. Not sure about your math there, but OK

Hello Houston

The Houston Chronicle recently started running my stuff, and I’m excited.

In honor of my introduction to Houston, I’d like to offer a personal story about my very first trip to Houston. Best of all, this anecdote has a pithy financial moral at the end.

In Spring 2001 I lived in New York City and sold emerging market bonds for Goldman Sachs. “Emerging markets” means Latin American, Asian, Eastern European, Middle Eastern and African bonds – all very volatile products. It was a super-fun job. I had recently picked up a new client – a couple of clever guys who operated a hedge fund within a successful pipeline company in Houston.

houston_chronicleI set up a visit to Houston because, of course, I already knew this company’s reputation. They dominated not only their pipeline business but had financially engineering their way into oil and gas trading, water-rights and paper-trading, and now a sophisticated, relative-value, emerging market bond hedge fund. (If the words “relative-value emerging market bond hedge fund” make perfect sense for you, then congratulations. If they don’t, then this column is for you.) Anyway, Fortune Magazine named them “America’s Most Innovative Company” for six years in a row. These guys were my kind of client.

First trip to Houston

We drank cocktails together in a fancy Houston bar while I listened to my clients describe the keys to their success.

“We just have the smartest guys in every business we tackle, and we know how to go after a business and make money off it.”

I was so convinced. I’m not kidding.

The smartest guys, with the best ideas, and all this awesome financial engineering? What could possibly go wrong? Personally, I planned to invest in the stock of that pipeline company as soon as I got my next bonus. Which, fortunately for me, was many months away.

For the next few months I spent a fair amount of my free time researching the company on my Bloomberg terminal. The amazing thing about Bloomberg terminals – for those of you who haven’t worked on Wall Street – is that I could find anything and everything about the company I could ever want or need. Historical earnings data and future projections. Analyst reports. News stories. Key executive bios. Charts and graphs and comparisons. I even personally knew key executives there! I loved my clients, and I loved this stock. And I couldn’t wait to get paid, so I could start investing in all those smart guys with all their innovative financial techniques.

enronBetter lucky than good

One of the most important lessons I learned in my Wall Street years is that it’s far better to be lucky than good. (That’s not the previously-promised pithy moral lesson, but it is true.)

Enron collapsed in the Fall of 2001 – before I got paid my bonus – so I never poured my own money down that rat hole. But boy was I eager to do it – only weeks before they collapsed.

Ever since then, whenever I hear people tell me about an individual stock they have bought, or plan to buy, and their reasons for doing so, I think of my clients at Enron.

What I learned from this Enron experience is that – not unlike Lord Commander Jon Snow – I know NOTHING when it comes to picking a good stock to buy. I thought I had access to EVERYTHING. And yet, I was completely wrong.

What I’d like you to know also – that promised pithy financial moral is right here – is that when it comes to picking individual stocks, you also know nothing.

My “I believe” speech, Bull Durham-style

annie_savoySo, I don’t believe in individual stock-picking when it comes to money matters and being smart.

“Well now,” you, as Susan Sarandon’s character Annie Savory in Bull Durham, might ask, “what do you believe in then?”

“I believe in getting wealthy,

Markets, cost discipline, the power of compounding,

Aggressive allocations, never selling, and neighborhood poker (if you like to gamble),

That Jim Cramer’s finance shows are self-indulgent, dangerous, garbage fires.

I believe Lee Harvey Oswald could not have acted alone.

bull_durhamI believe there ought to be a constitutional amendment outlawing variable annuities and the carried interest loophole.

I believe in index funds, entrepreneurship, selling investments only when you have to have the money and never for ‘timing” or ‘tax’ reasons, and long, slow, deep, soft automatic retirement-account dollar-cost averaging that lasts five decades.”

“Good night,” I whisper, as I turn and walk out the door, Crash Davis cool.

Leaving you/Annie/Susan Sarandon character breathless to say anything but:

“Oh my.”

 

A version of this ran in the Houston Chronicle and the San Antonio Express News.

 

 

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Not Cheering A Record-Setting Stock Market

New_highs_in_stock_marketIt’s silly season in stock market news again. By that I mean the regular “stock market reaches new highs, hooray!” headlines and commentary.

I’ll start by unpacking some reasons why this is silly news, and how you can be a much more sophisticated reader of financial news. I admit upfront that you’ll risk being a bore at cocktail parties if you repeat my commentary when people want to discuss how “the market” is doing. Sorry. (Not sorry.) But still, I want you to know these things and feel quietly smug.

I conclude with an argument for why a rising stock market overall probably isn’t even good financial news for me, or many of you, if you’re not yet retired.

But first, there’s our bad habit of noting point changes and absolute levels in stock market index values, as if the market index matters much.

In my first year in bond sales in the late 1990s, I used to call each morning upon a junior trader – a Venezuelan named Luisa who worked at the smallest customer of my desk – to give market commentary. I remember the morning I breathlessly mentioned a dramatic move in the Dow, like a 100-point drop. Luisa dryly noted that she didn’t pay much attention to point movements, but rather percent changes in the market.

Ugh, my ears burned with shame. They still do.

Mathematically, she was right. A 100 point drop means a lot if the index value is 2,000 – a 5 percent move! – but very little if the index is 10,000 – a 1 percent move. Meh.

We should all be like Luisa and only pay attention to percent changes, not point moves.

Similarly, noting that numerically pleasing round numbers like Dow 10,000 or Dow 18,000 have been breached for the first time is the financial equivalent of noting that Mercury is in retrograde while Neptune’s tilt should lead us to tread cautiously with emotional matters this week. People do pay attention to these things, but they really shouldn’t. It’s utterly meaningless.

Next, there’s the problem of talking about moves in “the market” when we’re describing just a small sliver of companies.

“The market” as typically described in financial media is the Dow Jones Industrial Average – a 120 year-old marketing tool of the company that used to own the Wall Street Journal – comprised of just thirty large companies in a variety of industries. These are important companies, but a very skewed snapshot of stock market performance.

Even the more-representative S&P 500 Index – another widely used proxy for ‘the market’ – still only describes what the five hundred of the biggest companies in the United States have done, excluding another five thousand or so reasonably big companies in this country, not to mention the thousands more located in other countries.

Next, we have the topic of dividends, which account for a significant portion of stock market gains for long-term investors. The dividend yield for S&P500 stocks – aka how much cash you get paid to just hold the stuff year in and year out – is about 1.9 percent in 2016, and has ranged from 1 to 4 percent in recent decades. Which means that much of the long-term return from investing in stocks happens regardless of whether the prices for stocks even go up or down.

With a 1.9 percent dividend yield, the stock market indexes could flatline for many years and you’d still make more current income than you would invested in US Treasury bonds. By this point I just mean to emphasize that the index going up is not the key to making money in stocks in the long run. Which sort of brings me to my final point.

grinch wonderful awful ideaI don’t mean to be a complete Grinch. (Yes I do.) It seems like it should be better for existing stock investors if the market indices reach new highs rather than new lows, right?

But when I think about it, that’s not quite right either.

I personally should not celebrate high stock prices. It kind of makes the most sense depending on your age and where you are in your investing life.

Celebrating high stock market prices only makes sense if I’m a seller of stocks, not a buyer. I bought my first stock at age 24. I figure I’ll want to still accumulate more through maybe age 64. Right now, at age 44, I’m right at the hump of my investing life, my mid-point. If I have a chance to accumulate stocks over the next 20 years, shouldn’t I prefer prices to stay low rather than high?

Taking this thought process to the extreme, shouldn’t I prefer a completely flat-lined stock market for the first 39 years of my 40 year investing life, then some kind of rocket-ship price jump, in which the market zooms up by 6188 percent in the final year, when I’m getting ready to sell in retirement? (FYI 6188 percent is the cumulative returns of the S&P500, including dividends reinvested, over the previous 40 years, from July 1976 to July 2016. Or 10.9 percent annual return, if you prefer.) I recommend verifying this for yourself with an online S&P calculator for any time period.

Meanwhile, the upward climb in prices we celebrate in financial news really isn’t helpful for me, as I accumulate at higher and higher prices.

This rising stock market index news is both misleading and not something to particularly celebrate, for most of us.

A version of this post appeared in the San Antonio Express News.

 

Dow Hits New Highs Part I

Dow Hits New Highs Part II

Dow Hits New Highs Part III

 

 

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Now How Much Would You Pay? Comparing Fund Costs

A wise man wrote about investing: “performance may come and go, but costs are forever.”[1]

Let’s explore a bit how big these cost difference really become for your investment portfolio.

As a starting point, do you already have a sense for whether the cost differences between funds you may own are in the hundreds of dollars? Or maybe the thousands? Could they possibly be in the tens of thousands? Surely not more than that?[2]

(Here’s a sneak preview hint of the answer: Wall Street is very profitable.)

dont_call_me_shirley

Differences over time

To illustrate cost differences, let’s pretend you are a 40 year-old with a $100,000 mutual fund investment that will earn 7 percent annual return in the market, over the next 30 years. I know, lots of assumptions that may or may not be true for you, but we have to start somewhere.

The first key thing to know is that the average actively managed mutual fund charges 0.8 percent as an annual management fee, while the average passively managed – or ‘indexed’ – mutual fund charges 0.14 percent per year, for a difference of 0.66 percent in fees, (this according to mutual fund giant Vanguard.)

Hundreds!

For a $100,000 investment, the cost difference in fees averages $660 per year.[3] So, I guess active management costs us hundreds of dollars per year, then.

Tens of thousands?

how_much_would_you_pay

But wait. Annual management fee costs rise as your funds grows, so the annual fee differences grow as well. Using averages, you should expect to pay your mutual fund company $65,518 total in fees for an actively managed fund that returns 7 percent over a 30-year period, compared to $12,896 for a passively managed fund also growing at 7 percent.

Um, so you’re telling me the average cost difference between an active and a passive fund is $52,622 over 30 years? In the tens of thousands of dollars?

Yes, yes I am telling you that.

Hundreds of thousands!?

But just wait. Even that comparison underplays the differences in costs. Since you are attempting through your investments to grow your money on your money, the lost growth on the money you pay in fees each year actually drags down performance even more than it at first appears.

The difference in final performance, considering the compounding effects of fees paid out of your investments, leads to a $124,141 wealth difference at the end of 30 years.

Wait, what!? Yes, you noticed that. The all-in cost of your mutual fund may end up larger than your original investment.
Pick any assumptions

You could test a wide variety of assumptions and the differences will be dramatic, even if the final numbers vary.

Crank up the annual return assumptions, and the differences become even bigger. Crank up the number of years invested, and the differences become even bigger. Crank up the amount of money invested, and the differences become even bigger. Crank up the management fee of the actively managed fund to a very typical rate, rather than the average 0.8 percent, and the differences become even bigger.

Millions?!?

How about a $1 million stock portfolio, returning 10% over 40 years, paying 1 percent for active management instead of 0.14 percent for indexing? (By the way, these are not crazy assumptions for many people) The wealth difference at the end of forty years, making the simple choice about active versus passive investing, is $11,602,001.

In a related question, have you ever wondered how Wall Street got so big?

Active versus Passive

Now, clever readers will notice something I’ve not yet addressed in my comparison of low-cost versus high-cost mutual funds.

hedge_fund_myth

What if I adopt the assumption of the mutual fund industry itself – which is built on the idea that a good reason to pay more in fees is to get better performance? Meaning, if an actively managed fund can earn 8 percent per year instead of the 7 percent per year from an index fund, then my cost comparisons become irrelevant in the face of superior performance. Right?

Ok, that’s possible.

All you have to do, therefore, is be confident about two things:

  1. Active managers typically outperform passive managers.
  2. You, specifically, (or your investment advisor) have the skill to know, ahead of time, which active managers will outperform passive (aka index) funds over the next thirty years.

Unfortunately for the mutual fund industry’s underpinning assumption – these turn out to be absurd ideas most of the time, for most funds, and for most people.

coin_toss
Picking managers: a bit like this

I’ll start with assumption number one, about the consistency of outperformance of active managers over time. The quick answer is that about 3 percent of mutual funds that achieve top performance over any five year period also go on to achieve top performance in the following five year period. Sadly, the vast majority of actively managed funds underperform their benchmark over the long run. And the longer the run, the fewer the outperformers.

On assumption number two, whether you or your advisor can select the rare winner among active managers, I don’t know. I mean, who am I to say?

Ok fine, I’ll say it: You can’t, and you won’t.

 

[1] Reminds me of the politically incorrect joke from the 1980s about the difference between love and herpes.

[2] Please don’t call me Shirley.

[3] That’s $100,000 times 0.66 percent, but you already knew that.

 

Please see related posts:

How to Invest

The Simplest Investment Approach, ever, by Lars Kroijer

Lars Kroijer on having an ‘edge’

 

 

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ETFs vs. Mutual Funds

etf_v_mutual_fundMutual funds and exchange traded funds (ETFs) do pretty much the same thing, which is allow an investor, with a single purchase, to own a diverse pool of assets – usually stocks or bonds, but also sometimes commodities, currencies, futures, bank loans or other financial exotics.

Since they mostly do the same thing, the most interesting question is usually not “mutual fund vs. ETF?” but rather a question about “asset allocation” – that is, what things you actually own within an ETF or mutual fund.

Asset Allocation

I wrote a few months ago what I consider to be the final word on the asset allocation question. To repeat:

“You should invest via dollar-cost averaging in no-load, low-cost, diversified, 100 percent equity index mutual funds, and never sell. Ninety-five percent of you should do that, 95 percent of the time, with 95 percent of your investible assets.”

What about ETFs?

You probably noticed I said ‘mutual funds,’ not ETFs. Well, 95% of the time you could substitute ETF for mutual fund and get the same result.

The rest of this column is about the 5% of the time when it makes a difference. The factors that make up that 5% include timing, minimum investment amounts, costs, liquidity, and availability of assets.

Timing

I like to call ETFs “mutual funds with ADHD” because you can trade them at any time of the day that markets are open, including multiple times a day if you like. This contrasts with mutual funds, which you can only buy or sell based on the end-of-day price, after the 4pm market close.

This feature of ETFs is not an advantage from my perspective. Since the right holding period for investing in stock markets is somewhere between 5 years and forever, the ability to trade in the middle of any day, for an individual, should be wholly irrelevant.

Minimum Investment

Some mutual funds and some mutual fund companies require a minimum investment such as $10,000, or $5,000, or $2,500. Or, different prices apply for different minimum investments. ETFs, by contrast, often can be purchased for as little as $100.

mutual_fund_v_etf

As a result, for newbie investors with their first $500 or $1000, ETFs can be the first step needed to get ‘in the market.’ Which is nice.

Costs

ETFs and mutual funds come in both high cost and low cost varieties.[1] For myself, I almost always seek out the low cost flavor, which tend to be in ‘passive’ or ‘index’ funds, rather than ‘active’ or ‘managed’ funds.

Vanguard – the giant brokerage and mutual fund company – reports that among ‘active’ strategies the average ETF is cheaper than the average mutual fund. Among ‘passive’ strategies, however, the average mutual fund is cheaper than the average ETF.[2]

The key to understanding your costs, of course, is to go beyond the ‘average,’ and to actually figure out the specific cost of any mutual fund or ETF you’re thinking of buying. Depending on the size of your portfolio and the time you have to invest, minimizing management fees will save you tens to hundreds of thousands of dollars over your lifetime.

So, it’s worth taking those five extra minutes and figuring out the fees, for a return on your time spent of, like, infinity.

Finally, depending on your brokerage company, purchasing some funds and ETF may incur ‘loads’ when you buy, and transactions costs when you buy and sell. Naturally, avoid if possible.

Liquidity

ETFs appear at first to offer better liquidity than mutual funds, because of the moment-to-moment prices for trading ETFs, rather than the once-a-day price of mutual funds. That kind of liquidity advantage, however, should be irrelevant, since your investment holding period ought to be measured in years, not hours or minutes.

In another sense, however, ETFs may in certain cases be less liquid than mutual funds. As you move on the spectrum from plain vanilla to more exotic ETFs, it’s possible that the illiquidity of the underlying assets raises the cost of transacting in ETFs.

During this past August’s market turmoil, for example, traders reported that certain ETFs in relatively illiquid assets such as bank loans or corporate bonds mispriced during the trading day.

As an individual investor, you should assume the ‘mispricing’ will not be in your favor in these situations. Market makers will raise the cost for investors of getting in and out of these illiquid ETFs through a larger wider gap between the price you can buy or sell the ETF, known as the ‘bid-ask spread.’

Availability of assets

Some brokerage or mutual fund companies where you do your investing may have a better inventory of products in ETFs versus mutual funds – or vice versa – making it necessary to buy one rather than the other. Because most of the time mutual funds and ETFs in the same assets do the same things, normally you can substitute one for the other without worry.

As always, the choice of ‘asset allocation’ – what underlying things you’re buying – matters more than the packaging, whether wrapped in an ETF or a mutual fund.

 

[1] To give you a benchmark for high or low costs, some active mutual funds and ETFs charge 1.5% fees or more, while some passive mutual funds and ETFs charge 0.15% fees or less. That’s an order of magnitude of ten times the cost between the low and high cost varieties.

 

[2] The average index ETF charges a 0.29% management fee, while the average index mutual fund charges a 0.14% fee. So index mutual funds are cheaper, on average, than index ETFs. The average actively managed ETF charged a 0.62% fee, while the average actively managed mutual fund charges 0.80%. So actively managed ETFs are cheaper than actively managed mutual funds, on average. Source: Vanguard webinar on ETFs v. mutual funds.

 

A version of this appeared in the San Antonio Express News

 

 

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