As the old saying goes, "If all you have is a hammer, everything looks like a nail". The trouble is that, in the real world, everything isn't a nail. The best tool for the job depends not only on the job itself, but who exactly is wielding the tool.
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Even 88 years after their introduction in the US, I'm firmly of the belief that less active investors of modest means are far better served by using open-ended mutual funds than buying individual stocks or bonds themselves. For portfolios under $50,000, they remain the ideal option.
Open-ended funds offer effortless diversification within nearly every market sector that would be nearly impossible to achieve with a smaller account. Gone are the days when every mutual fund held the same basket of S&P 500-centric stocks. Competition has not only lowered prices but expanded choice as well, including low-minimum funds that focus on commodities, foreign exchange and small-cap stocks. With three or four funds, you can allocate $20,000 across a wide range of assets for virtually no cost.
The rock-bottom costs are another clear advantage for open-ended funds: most carry no transaction costs ("load") and their extremely low cost of ownership -- Vanguard charges 0.17% for its flagship Index 500 (VFINX), or $17 per $10,000 -- make them ideal choices for long-term investments.
The biggest advancement in the past decade has been the development of exchange-traded-funds, or ETFs, which have allow one to enter or exit positions during the trading day, unlike open-ended funds in which one can only transact after the close.
Yet for those who are truly investing for the long term, the ability to tweak exposure at just the right hour or minute of the day is irrelevant. More useful is the advantage of open-ended funds in allowing you to increase (or reduce) your exposure in small increments at no cost. Even at discount commissions, paying $7 to buy or sell $200 worth of stock is far too much of a vig for consistent success.
As the size of one's account grows, so does the ability to diversify without the use of a fund, meaning larger investors are usually better served by opting for direct investments in stocks or bonds. The advantages aren't just lower costs (unlike mutual funds, direct stock ownership doesn't levy a percentage-based management fee), but even more importantly control. As regular readers know, how you manage a portfolio is arguably even more important than what is actually in it. Direct ownership allows one to cut losers, enhance winners and manage a portfolio with far greater precision than by simply owning a fund, which is more akin to picking the jockey than the actual horse.
Direct ownership also permits far more flexibility to enhance return, including the ability to write call options against individual stock holdings, something that's impossible with open-ended-funds.
It's a luxury only afforded by the fact the impact of commission shrinks as one's account size grows. Trading twice a week at the average discount commission will run an investor over $700 a year, or roughly 7% of a $10,000 account. The same level of activity costs the $100,000 a mere 0.7%. If an extra $1.00 or $2.00 per trade has a meaningful impact on your portfolio, you're probably better served by using less expensive open-ended funds.
Besides long-term holdings, many investors maintain a "fun account" for taking flyers on options, or dabbling in futures such as Chicago Mercantile Exchange's (CME (CME) ) e-Mini contracts. But there's a much better tool for those looking for more action than a simple stock account. It's not long-shot options, penny stocks or highly volatile ETFs, but an even superior choice for those who want to actively trade.
I'll reveal it in this space, one week from today.
—Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC
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