Lesson 15: Liquidity

Gold
I use this image whenever I can. Just look at that sheen.

Imagine I come up to you and allow you a choice. Because I am a very generous, benevolent man I offer you either $100,000 in cash or gold bars worth $100,000. Which offer makes more sense to choose? The time value of money is not relevant in this instance as you will gain the assets at the same time.  Your gut may be leaning towards the cash. Ignoring the obvious allure of shiny gold, you may realize that gold isn’t that useful in terms of purchasing everyday goods and services. You may also realize that there are additional steps you will have to take to turn that gold into cash such as finding someone to buy that gold and give you cash in return.  This concept of transforming an asset (gold in this case) into cash is known as liquidity.

Key Points

  • Liquidity is defined as the ease in which an investment can be converted into cash with little to no loss of value.
  • Cash is the most liquid of all assets.
  • There is a hierarchy of liquidity when it comes to investments.
  • Markets play a key role in maintaining liquidity of investments.
  • Imbalanced markets can create liquidity problems.

What is Liquidity?

Liquidity is a characteristic of investments that describes how easily an investment can be quickly converted into cash with little to no lose in value. An investment which cannot be easily converted into cash or can only be converted to cash quickly with loss of value is said to be illiquid.  Though there is no established scale for measuring liquidity, a rough hierarchy can be built to compare different assets’ liquidity.

Cash is the Most Liquid Asset

River
The other “liquid asset”. Image courtesy of nature.org.

Cash is commonly like water in the world of finance. When valuing a company you may create financial models that measure future cash “flows”. Keeping with this comparison cash is the most “liquid” asset and thus is used as the basis for measuring liquidity

Why is the cash the most liquid asset? As I referenced to earlier if you walked into a shop or a restaurant and tried to pay with gold coins or a very valuable, rare painting, you may find yourself in an undesirable situation. Cash is the most liquid because it is the currency we use in everyday commerce.  If we instead used shells or cigarettes (both of which have been used as currencies in certain economies) as currency, the shells/cigarettes would be the most liquid asset you could possess.

What is the Hierarchy of Liquid Assets?

As we established above cash is the most liquid of all investments. The diagram below places other common investments along a rough scale of liquidity.

 

tri2
What Links Liquidity and Markets ?

These rankings beg the question “What determines whether an investment is liquid or illiquid?” The answer is really simple: Is there a well functioning market that puts buyers and sellers together to exchange the investments?

Near the top of the liquidity scale are assets that have large exchanges and are traded frequently (stocks, bond, ETFs). Further down the scale you come across assets that are not as widely traded or are highly specialized (financial derivatives, commodities, real estate). The least liquid assets are incredibly specialized or lack a centralized market (rare art, antiques, cars).

The presence of a market is not enough to make an asset liquid. The market must be efficient with relatively equal supply and demand. Said differently the market cannot be buyer or seller dominated. In this instance the investment may be sold at a high premium or a deep discount due to the abundance or scarcity of the investment.

Gold diamond
A gold diamond…close enough. Image courtesy of vivalididiamonds.

For example let’s assume there is a new type of gold discovered called “diamond gold”. Furthermore let’s assume that Diamond Gold Inc. is the sole supplier (seller) on the diamond gold market.  In this instance because Diamond Gold Inc. controls the supply of diamond gold it can charge a high price for the diamond gold, reducing the trading of diamond gold, and rendering it illiquid.

What happens to an asset’s liquidity if the market is dominated by people wanting to sell a certain type of asset? This question was answered in the real estate crash that accompanied the 2008 Recession.

Liquidity and Risk: A Lesson from the 2008 Recession?

Foreclosure
Now imagine an entire street full of these things. Image courtesy of vinafengshui.

While the 2008 Recession is deserving of its own website, let’s look at a small aspect of the 2008 recession: the real estate market.  When home values began to plummet home owners were desperate to try to get rid of the “hot potato” that was their
homes.This flooded the real estate with homes (many of which were previously foreclosed on). As simple economics would dictate with this flood of supply buyers could pay a deep discount for homes that under normal circumstance would have a much higher value.  

Remember the aspect of liquidity in which the asset is converted “without significant loss of value”? In a market flooded with supply this tenant is violated as assets can only be sold at significantly lower cash values. Though this is a simplification of the complex 2008 Recession the effect of illiquidity was easily noticeable in the pummeled real estate market of the time.

Definitions

  1. Liquidity: a characteristic of investments that describes how easily an investment can be quickly converted into cash with little to no loss of value
  2. Illiquid: a characteristic of an investment in which an investment cannot quickly or easily be converted into cash without loss of value
  3. Currency: a medium of exchange that has value and is used to purchase goods and services

Further Reading

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Lesson 14: Financial Derivatives

L13.1 Chart
Image courtesy of investspec.com

Up to this point the assets discussed have been “real” assets.  Said differently the assets (stocks, bonds, commodities) had some level of intrinsic value because they represented some sort of claim either to ownership of a business (stock), debt to be repaid (bond), or some physical good (commodity). There are other assets that have value because they represent a claim to these “real” assets. These assets are known as financial derivatives and are some of the more interesting and colorful financial instruments.

Key Points

  • A financial derivative is a security whose price is determined or derived from the price of the underlying asset.
  • Common types of financial derivatives include options, swaps, futures, and forwards.
  • Financial derivatives are traded either on exchanges or in over-the-counter (OTC) markets.
  • The role of financial derivatives in the market is to help mitigate risk from entities who do not wish to bear risk to entities better suited to manage that risk.

What is a Financial Derivative?

Financial derivatives are a type of financial security whose price is derived from the price of the underlying asset it represents. As opposed to “real assets” whose value comes from the perceived increase in value or the cash flows generated by the real asset, a derivative represents some sort of claim on the real asset. By existing independently of the real asset, the derivative can be traded separately while its value is largely related to the value of the underlying asset.

A Story of Opals and Options

Behold the opulent opal. Image courtesy of stephen-universe.wikia

Let’s assume I, a rare gem seller, have a rare opal (a physical asset) for $1,000.  You want to purchase the gem but are concerned that you may not be able to sell the gem at a higher price and thus will not profit off of the transaction.

Along comes a man who doesn’t know whether the gem is worth more or less but thinks it is worth less than you bought it for. Let’s call him the Pessimistic Guy.  The Pessimistic Guy is willing to sell you a piece of paper saying that he will buy the gem for $800 despite what it’s true price is.  The cost of this piece of paper is $100.

The paper in this situation is commonly referred to as an option as it gives you the option (but not obligation) to sell the underlying physical asset.

So what are the possible outcomes in this scenario?

There are quite a few depending on whether you buy the option and whether the gem is worth more or less than the price you purchased it for as seen by the table below.

Opal table

One of the most notable trends in the table is that if the option is purchased the most you can lose is the difference between the agreed upon purchase price ($800) and the
original  purchase price ($1,000) minus the additional cost of the option ($100).

In this case having bought the option the most you can lose is $800 – $1,000 – $100 = -$300

Though a simple example this reveals one of the main uses of derivatives. In the situation where you bought the option there was an absolute limited loss. The concept of unlimited/limited loss will be discussed in the future as it is both key to understanding the role of derivatives and is a fascinating concept.

What are the Common Types of Financial Derivatives?

There are four primary types of financial derivatives. Though only briefly discussed here, each will receive a more in depth analysis in future lessons.

1.Options: As seen in the example an option is a type of contract that enables the holder to exercise an option (usually buy or sell) on an asset. In the example above you purchased a put option. A put option enables you to sell an asset (the opal) at an agreed upon price ($8) before a predetermined maturity date. In the example we did not set a maturity date for the sake of simplicity. The opposite of a put option is called a call option as it enables you to buy an option at an agreed upon price.

2. Swaps: A swap is a type of financial derivative in which two entities exchange some sort of financial good or instrument.  Though it may seem like commodities may commonly be used in these swaps the most common instrument involved in financial swaps is interest rates.  An interest rate swap is a derivative in which two entities exchange cash flows in order to guard interest rate risk or to participate in speculative finance.

3. Forwards: A forward is a contract in which two entities agree to buy/sell an asset at an agreed upon price at a future date.  Forwards are commonly thought of as the simplest of the derivatives, though with modification can become complex. Forwards are commonly used in the commodity market and are used to hedge against price fluctuations.  For example I could agree to buy 1,000 bushels of wheat in three months for $50/bushel regardless of the market price of a bushel of wheat at that time.

4. Futures: A future is a highly standardized contract in which two entities agree to buy/sell an asset at an agreed upon price at a future date. A future may seem very similar to a forward. It is! A future is simply a highly standardized forward that is traded on an exchange instead of an OTC market (as forwards are).  The purpose of futures is to eliminate a risk known as counterparty risk that is present in forward contracts.  This will be addressed in more detail but for now just know that with more standardization comes the ability for a future to eliminate a type of risk that forwards inherently possess.

How are Financial Derivatives Traded?

Like stocks and bonds financial derivatives trade on both exchanges and over-the-counter (OTC) markets.  The OTC is the larger of the two for trades involving derivatives because of its looser regulatory standards.  Derivatives traded on exchanges (mainly futures) are predetermined and standardized to eliminate counterparty risk. Counterparty risk is the risk that the opposing entity in an agreement will be unable to fulfill its contractual obligation.  This risk is present in OTC contracts as the agreements are private agreements and lack an intermediary that can ensure the fulfillment of the contract.

Why Do Financial Derivatives Exist?

These very interesting and colorful financial instruments exist to satisfy one of the most important goals of finance, to minimize risk.  Through different arrangements an entity (business,person, bank, etc.) is able to essentially sell off some of its risk to some other entity that desires that specific risk.  This may seem abstract now but after some concrete examples in the next few lessons it will make sense why some entities benefit from the use of derivatives and why they have a place in the financial world.

Should I Invest in Financial Derivatives?

TwoPennies
These guys are back with advice.

Here’s the area where I throw in my $0.02 into the ring.

I DO NOT recommend most derivative trading for the average everyday investor.

The reasoning is very simple. Most individuals do not have the time or expertise to understand and dissect these at times incredibly esoteric investment vehicles. That being said there are a few derivatives that do make sense in some instances (a covered call option strategy is an example of one) in which a simple derivative can help minimize and hedge against risk. These instances will be covered in a later lesson.

Definitions

  1. Financial derivative: A type of financial security whose price is derived from the price of the underlying asset it represents
  2. Options: A type of financial derivative that enables the holder to exercise an option (usually buy or sell) on an asset
  3. Swaps: A type of financial derivative in which two entities exchange some sort of financial good or instrument
  4. Forward: A forward is a type of financial derivative in which two entities agree to buy/sell an asset at an agreed upon price at a future date
  5. Future: A type of financial derivative in which two entities exchange some sort of financial good or instrument
  6. Counterparty risk: The risk that the opposing entity in an agreement will be unable to fulfill its contractual obligation

Further Reading

The MyRA : A Retirement Account for Millenials

confused1
“What is this “retirement” you speak of?” Image courtesy of FutureTraining.org

If you’ve read my posts on traditional IRAs or Roth IRAs you may have walked away a bit confused. That’s ok. Retirement accounts are a confusing topic for the majority of Americans.  The U.S. Treasury picked up on this intimidating complexity and has very recently released a simple alternative for those wishing to save for retirement. This new type of account is called a MyRA. Let’s explore this new invention a bit further.

Key Points

  • A MyRA is a starter retirement savings account that enables those with low income or those new to investing to begin saving for retirement.
  • The benefits of of the MyRA include near guaranteed appreciation, account is linked to you, no related fees, and simplicity
  • The limitations of the MyRA include max contribution limits, limited returns
  • The MyRa is best for those earning low income, or someone just starting to save for retirement.

What is a MyRA Account?

Eggs
Behold the eggs of your financial future. Image courtesy of USNews.com.

A MyRA account is a specialized Roth IRA account that invests and holds only United States Treasury retirement savings bonds.  These savings bonds are backed by the full faith and credit of the U.S. Treasury meaning unless the U.S. government defaults on its debt, you have a riskless investment.  In addition the MyRA is relatively simple to set up and has no fees or costs associated with its operations.  The MyRA account is best suited for those who do not currently have access to an employee sponsored retirement plan (such as a 401k or IRA) or those who currently have low income employment.

Benefits of a MyRA Account

1. Guaranteed Risk Free Appreciation: Arguably the best part of the myRA is that you have risk-free appreciation. This means that there is no risk you will lose value in your investment.* When you invest these funds into the MyRA account, the U.S. Treasury then invests these funds in United States Treasury bonds.  The average annual return over the past ten years has been 3.19%.  A good assumption when calculating future returns would be to err on the side of pessimism and predict an annual return of 2.5% ( Which is much more than the 0.5% most people earn on savings accounts in banks).  Though this return may barely outpace inflation, a 2.5% return is better than a 0% return or a 0.5% you would earn in a standard bank savings account.

*Assuming the U.S. Treasury does not default on its debt.

2. The MyRA is Tied to You: Most retirement plans are employer sponsored (meaning that your employer manages most of the account and may match your contributions) and thus are attached to that employer.  This is not the case for the MyRA.  A better way to think of the MyRA is that instead of being attached to your employer, it is attached to you. What this means is that should you change jobs and get a new employer, it is very simple to have this new employer direct funds to the MyRA for you.  Another option is to set up a recurring or one-time contribution from a checking or savings account.  This added flexibility makes the MyRA great for younger adults or those who are switch
ing jobs or locations frequently.

Simple_pic
Image courtesy of susanlazarhart.com

3. Simple Setup:  Set up for these accounts are free and can be completed in a few minutes.  The simple setup is  on myRA.gov, clicking the “Sign Up” option, and going through the step by step process. The instructions are pretty straight forward and you will have a functional retirement account setup pretty quickly.

4. No Associated Fees or Minimum Balance Required: From a cost perspective the MyRA is a great choice. There are no maintenance fees (fees for a third party to handle the account) and no penalty for contributing too little funds or having a low balance in the account.  As the investor you have total control over how much or how little you wish to contribute.

 

Limitations of a MyRA Account

1. Contribution limits:  Similar to the Roth or Traditional IRA the MyRA has a annual contribution limitation.  The max contributions to all IRAs combined cannot exceed $5,500 ($6,500 if age 50 or older).  The example below illustrates what this could look like.

Ex. Let’s assume I have three IRAs, a traditional IRA ,a Roth IRA and a MyRA. In 2015 I contribute $2,000 to my Roth IRA and $3,000 to my MyRA. How much could I contribute to my traditional IRA?

$5,500 – $2,000 – $3,000 = $500

Thus I could contribute $500 to the traditional IRA without going over the contribution limit.

2. Max Value Limitations: As the MyRA is designed to be a “starter” retirement account, there is a limitation on the max value the account can reach.  Once an account reaches $15,000 in total value (principal + interest earned), the account must be transferred to a private sector Roth IRA.  Before this point is reached the investor is contacted and informed how to transfer the funds to a private sector Roth IRA where the principal and interest can continue to compound.

3. Interest Withdrawal Limitations:  The MyRA does have a strikingly similar limitation to the Roth IRA in the way of withdrawal.  At any point you may withdraw the money you personally invested into the account with no penalty. However, the withdrawal of the interest earned can be taxed if it is not distributed in a qualified distribution.  A qualified distribution is only allowed after five years of the first contribution and you are 59 ½ years old or meet certain criteria (buying a first home).  The purpose of this is to encourage savers to treat the account as an account for retirement and thus save for the age of  retirement.

Ex. Let’s assume December  2015 I contribute $1,000 to a MyRA account.  The account earned a 3.00% return over the year and thus the account is now worth a combined $1,030.  At December 2016 I can withdraw any to all of the $1,000 I personally contributed. However if I withdraw the $30 earned in interest, the $30 will be subjected to additional taxation.

$1,000 * (1+3%) =   $1,030

4. Limited Returns: The final limitation of the MyRA is related to one of my initial lessons on risk and return. The risk of the MyRA is close to zero. As a result the return on the investment should be relatively stable and low around 3.00%.  Though this may not seem like a great return, it does beat inflation and is a higher return than most bank savings accounts.

 

How To Get a MyRA Started

Nestegg_Pic
This is your nest egg. There are many like it, but this one is yours. Image courtesy of protectmyid.com

If you are a young or low income earning individual who wants to start saving for retirement and currently has no retirement savings plan with your employer, the MyRA is the retirement account for you.

To get started go to MyRA.gov, click the “Sign Up” button, and be on your way to building your
nest egg!

Definitions

  1. MyRA: A specialized type of Roth IRA with features designed for those new to saving for retirement.
  2. Maintenance Fees: Fees charged by an account manager for handling an account.

Further Reading

Lesson 13: Commodities

Gold bars
There’s a certain beauty to the color.

Ever wondered how the price of gold or oil is determined? No? Well let’s discuss it because you should know it anyway.  The prices of these and other goods are determined within large exchanges such as the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX), but let’s first establish what makes a commodity a commodity.

Key Points

  • A commodity is a basic good which is nearly identical to other commodities of the same type and is commonly traded on exchanges.
  • Common commodities include metals, agricultural goods, and energy products.
  • Commodity prices are determined on commodity exchanges.
  • Trading commodities is much closer to speculation than investing.

What is a Commodity?

A commodity is a commonly traded good that is interchangeable with other goods of the same type. For example wheat grown in Iowa is for the most part indistinguishable from wheat grown in Kansas.  Agricultural products with their nearly perfect similarities  are a great example of commodities.  Whether the corn is grown in Iowa or Kansas it is still corn. Though commodities are interchangeable, different grades or quality of the commodity can be traded. For example, there are varying qualities of oil and natural gas traded.

Types of Commodities

The common classifications of commodities traded are metals, agricultural goods, and energy products.

  1. Metals: This group is composed both industrial and precious metals. Industrial metals include metals such as zinc, copper, and nickel that are commonly used  in the construction of many goods.  Precious metals include metals such as gold and silver that derive their value not by their industrial applications, rather for their intrinsic rarity.
  2. Cattle
    Delicious proto-steaks

    Agricultural Goods: This group is composed of both food products and livestock.  Food products includes foods such as corn, wheat, sugar, milk, and orange juice.  Livestock is comprised of lean hogs, live cattle, and feeder cattle.  (The difference between feeder cattle and live cattle? Feeder cattle is cattle that will be placed on a feedlot, fattened, then slaughtered to produce delicious steaks or burgers).

  3. Energy Products: This group is the most diverse of the three major groups.  It includes products such as ethanol, natural gas, propane, and gasoline.  Energy products have various uses including construction of petrochemical products to providing fuel for homes and vehicles.

Commodity Exchanges

Like stocks or bonds, commodities trade on long standing markets (most of which predate the largest stock and bond markets).  The largest commodity market in the U.S. is the Chicago Mercantile Exchange (CME) followed by the New York Mercantile Exchange (NMEX) which together account for the majority of commodity trades made in the U.S.A. There are also many large international commodity exchanges such as the London Metal Exchange (LME) based in London, UK and Euronext which is based in several major European cities.

How does an exchange ensure that the wheat or livestock being traded is actually worthwhile grain or animals and not disease ridden goods?  Exchanges establish a basis grade which establishes a minimum accepted standard that a tradable commodity.  Also called a “par grade” or “contract grade” the purpose of the basis grade is to ensure that when trading commodities it is truly “apples to apples” trades.

Trading Commodities

There are two primary ways to trade commodities: spot and futures markets.

  • Spot Markets: When trading commodities in the spot market an investor is buying or selling the commodities at that very moment.  This trading is done at the spot price, which is simply the market price of the goods at that time.  A different way to look at spot markets is that when trading in the spot market you are truly trading “on the spot”.  
  • Futures markets: When trading commodities in the futures market an investor is not buying or selling the commodities directly but is instead trading futures contracts.  For now just know that a futures contract is a  highly standardized contract that obligates the holder to buy or sell a set amount of goods at a set price. These contracts tend to greatly fluctuate in price based on the perceived value of the underlying assets and predictions of future market circumstances.

Speculation vs. Investing

TwoPennies
Pictured: My $0.02

Now that you are more informed about commodity trading here is where I throw my $0.02 in.

I DO NOT recommend commodity trading for the average everyday investor.

Commodity trading is a highly specialized field in which highly savvy and well informed traders and investors operate and seize on market opportunities. In addition most trades are made “on margin”. This means that losses and gains become greatly magnified as the transactions are highly leveraged. A final reason is simply the speculative nature of commodity trading.  There are limitless variables which can alter commodity prices and result in enormous volatility in the prices of commodity.

If as an investor you really want to invest in commodities, my recommendation is to get exposure through ETFs or mutual funds based in commodity-related businesses. For example an oil and gas mutual fund would own stock in different companies directly involved in the production and distribution processes.

 

Definitions

  1. Commodity:  A commonly traded good that is interchangeable with other goods of the same type.
  2. Basis grade: The minimum quality of a commodity that must be met in order to be traded and is established by the commodity exchange on which it will trade.
  3. Spot market: A market in which commodities or securities are traded for cash and settlement is immediately effective.
  4. Spot price:  The current market price at which an asset is bought or sold for immediate payment and delivery.
  5. Futures market: A market in which commodities or securities are traded via futures contracts for delivery on a specified future date.

 Further Reading

Who Wants to Be a Millionaire? (The Power of the Roth IRA)

PFT Retirement Plans Roth IRA Millionaire Pic
This is another method. Hope you brushed up on geography!

Want to get excited?  What if I told you there is a way to near guarantee you will retire a millionaire? If I sound like one of those charlatans who will now tell you the “Five Secrets to Stock Picking” or “How to Predict the Market”, you should recheck the site name. Unlike those methods, my method requires a great deal of time and a great deal of patience (a hint of luck also never hurt).   So what is this “magical method”?  First we need to discuss the primary tool of the method: the Roth IRA

I’ve continued to make hints at this mysterious “Roth” designation. You will soon see why this type of account makes it easy for someone to accumulate wealth.  Deluxe RV and golf courses here we come.

Key Points

  • A Roth IRA is a type of investment account that allows the owner to receive tax-free qualified distributions at the age of retirement.
  • The benefits of using a Roth IRA include one of the most beneficial tax treatment of all retirement accounts and the ability to contribute is limited only by the life of the owner.
  • The limitations of a Roth IRA include distribution limits and contribution limits.
  • The Roth IRA is arguably the easiest and most efficient way to ensure a high net worth at the age of retirement.

What is a Roth IRA?

A Roth IRA is an individual retirement account that does not allow for tax deductions, but instead allows for tax free qualified distributions.  If you recall the traditional IRA or even the traditional 401k you may recall how you were allowed to take the contributions off of your taxable income for a given year. This is NOT the case for the Roth IRA.  The Roth IRA forgoes this benefit in exchange for another. The primary benefit of the Roth IRA is that qualified distributions are totally tax free. Said differently the investments you make are enabled to grow totally tax free. As you can imagine, this seemingly small benefit creates a huge benefit to the investor.

What are the Benefits of a Traditional IRA?

1.Tax treatment: The Roth IRA behaves a bit differently than the traditional 401k and IRA. Those investment accounts allowed a reduction in the current year’s taxable income, but when qualified distributions were eventually made those withdrawals were taxed as regular income. In stark opposition to this the Roth IRA does not allow for a reduction in the current year’s taxable income, but instead forgoes this opportunity for a greater opportunity down the line.

Qualified distributions from a Roth IRA are tax free. This means the investments made are allowed to grow and then be withdrawn at the time of retirement completely tax free.  To illustrate the astounding benefit of this let’s use a very quick example.

PFT Retirement plans Roth IRA Scrooge McDuck
I don’t recommend swimming in your new wealth though…just don’t.

Say you had both a traditional and Roth IRA and by the time you reached age 60 they were each worth $1,000,000. Let’s also assume if you become $1,000,000 wealthier you will be placed in the 25% income tax bracket.  If you withdraw all your funds from the traditional IRA, $250,000 of the $1,000,000 will be eaten away by taxes.  Yikes.  If instead you withdraw the funds from the Roth IRA, the amount of taxes you will owe is $0. The Roth allows the $1,000,000 to stay intact and does not affect your taxable income. That’s a pretty awesome deal!

2. Limited to life of owner: The other benefit of the Roth IRA over its traditional counterpart is that the “life” of the Roth IRA is only limited to the life of the initial owner. This has two implications. One implication is that while you must cease contributing to a traditional IRA at age 701/2, you can contribute to a Roth IRA till you pass away. The other implication is the lack of MRDs with a Roth IRA. A Minimum Required Distribution (MRD) is a required distribution that is a characteristic of a traditional IRA. Basically when an individual reaches age 701/2 that individual is required by law to take some amount of distribution from the traditional IRA each year. This constraint is not present in the Roth IRA.

Limitations of a Traditional IRA Plan?

1. Distribution Limitations: Delayed gratification is once again harsh mistress. Before going into too much depth it should be noted that your contributions to the Roth IRA are always distributable without tax consequence. Said differently you can withdraw the money you invested into the Roth IRA at any time and suffer no penalties.  The Roth IRA has two conditions that must be met in order to receive both your contributions and the earnings that the contributions have accumulated.

  1. The Roth IRA must have existed for five years.
  2. You must be of age 591/2 or a qualified first time home buyer.

If either of the above conditions is not met, the distribution is subject to a 10% penalty tax in addition to the taxation of the earnings.  Said differently if you withdrawal from the Roth IRA early, the entire benefit of the Roth IRA disappears. Be wary about early distributions.

2. Contribution Limitations: There are two limitations to contributions to the Roth IRA.  The first is that your AGI (Adjusted Gross Income) must be below a certain range depending on your marital status of your tax filing.  A link to the table with the 2014 values can be found here. As you can see from the table at certain income levels you may not be able to invest in a Roth IRA. Let’s assume you can. This brings us to our second limitation which is the amount you can contribute in a given year.

Your combined contribution to the Roth IRA and any other IRA account can be a max of $5,500 if younger than age 50 ($6,500 if older than 50) in a given year. To use an example suppose I have set up both a Roth IRA and traditional IRA. If I contribute $3,500 to the traditional IRA, the max amount I can contribute to the Roth IRA is $2,000 ($5,500 – $3,500 = $2,000).

No Later Taxation: An Example

For a comprehensive example let’s look at Mr. Davis who works at Apollo Inc. Mr. Davis has been contributing the $5,500 per year contribution limit in a Roth IRA account he has with a broker.  Assuming that Mr. Davis has been working for 35 years the principal of his Roth IRA alone is worth $192,500 before taxes. That’s not bad, but the neat thing about that number is it’s grossly underestimating the value of the Roth IRA. Why? The money in the IRA has been invested in stocks, bonds, and other assets depending on the risk Mr. Davis took on.  If we assume that he earned a 8% average return over that time period the value of his Roth IRA is not $192,500…it’s around $1,025,000 before taxes.  The best part? Because the investment account was a Roth IRA Mr. Davis can withdraw that amount as a qualified distribution and owe $0 in taxes.

Mr. Davis is now a millionaire.

Conclusion

PFT Retirement Plans Roth IRA Golf Pic
Because this looks enjoyable to say the least.

The Roth IRA is an amazing tool that could easily make anyone a millionaire given enough time and a somewhat favorable return on investment.  The most difficult part is achieving the 8% average annual return over the time period that we assumed in the example.  How to achieve that constant return? That is the billion dollar question that Wall Street brokers and financiers have been trying to solve for decades.  Though I can’t guarantee a return, I can guarantee that for many people the Roth IRA is your best bet for growing a nest egg that results in you walking away a millionaire and enjoying retirement in style.

You may be wondering “How do I decide whether to put my money in a traditional or Roth IRA?”. In my next article I will tackle this subject and give you the facts to decide what type of account best suits your needs.

Definitions

  1. Roth IRA: A type of individual investment account that forgoes immediate contribution tax deduction and instead allows the owner to receive tax-free qualified distributions at the age of retirement.
  2. Minimum Required Distribution (MRD): A characteristic of traditional IRAs that requires that participants must begin distributing the funds within the account once the owner reaches age 701/2.
  3. AGI (Adjusted Gross Income): A metric calculated by the IRS by subtracting allowable deductions from gross income from taxable sources.

 

Further Reading

Retirement: What is a Traditional IRA?

PFT Retirement Plans Traditional IRA RV Pic
Nothing says “I made it” quite like this. Image courtesy of Uptownmagazine.com

We’ve already discussed the role of a 401k and its place in your retirement. The 401k is not the only type of retirement account out there. For example let’s assume you max out the 401k contribution but are still worried about putting away money for retirement (you want the exclusive RV for when you tour the country, not just the standard RV). On another note let’s assume that that your employer doesn’t offer a 401k matching program. What do you use to grow your nest egg even more?

Thus is the need of the IRA (Individual Retirement Account). It will be useful to keep in mind some of the similarities between the 401k and the traditional IRA as they both serve the same basic function: to provide financial security in retirement.

Key Points

  • A traditional IRA is a type of investment account that allows the owner to make tax-deferred investments to provide financial security in retirement.
  • The benefits of using a traditional IRA include favorable tax treatment and ease of rolling over the account.
  • The limitations of a traditional IRA include distribution limits, contribution limits, deduction limitations, and later taxation.

What is a Traditional IRA?

A traditional IRA is a retirement plan that an individual can set up for him or herself through a financial institution and usually allows for tax deductions.  An individual can set up a traditional IRA with many different types of financial institutions including banks, life insurance companies, mutual funds, or a broker.  The institution that serves as the administrator of the IRA is referred to as the trustee. A trustee is simply a person or firm that holds assets for the benefit of a third party (the third party in this case is you).

What are the Benefits of a Traditional IRA?

So why would I want to forgo the use of some of my earnings instead of putting that money in my pocket? There are a few reasons this would be a wise move:  favorable tax treatment and the ease of rolling over the money in the account.

1.Tax treatment: Like the 401k  the traditional IRA provides a way to decrease your income taxes payable in a given tax year. By contributing to the IRA the federal government is rewarding you for investing in your future retirement.

Also similar to the 401k though the contributions are allowed to grow tax free in the fund, when you withdraw the funds (a distribution) they are taxed as ordinary income.  For example, if at age 60 you withdraw $50,000 from the IRA, this $50,000 will be treated as ordinary income for tax purposes.

2. Ease of Rollover: A rollover is when you transfer the assets of one retirement plan into another (such as transferring funds from a traditional IRA to a Roth IRA).  Certain types of investment accounts are restrictive in what they can be rolled over into.  For example the funds in a Roth IRA cannot be rolled over into a traditional IRA or a qualified plan such as a 401k. Unlike the Roth IRA, the traditional IRA can be rolled over into many different investment account without consequence adding to the flexibility of the traditional IRA. For a complete chart of which accounts can be rolled over click here for a table provided by the IRS.

PFT Retirement Plans Traditional IRA Dog Roll Over Pic
On a somewhat related note here is a dog rolling over. Image courtesy of animalfair.com

 

 

Limitations of a Traditional IRA Plan?

1. Distribution Limitations: Delayed gratification is a harsh mistress. It may be tempting to dip into the funds you’ve saved in your IRA to fund a trip or do some other fun thing. Unfortunately the IRS would rather you not do this, especially after allowing you a tax break.  The deterrent for this action takes the form of a 10% additional tax if you receive a distribution (withdrawal) before age  591/2.

Another important note is that you can generally withdraw any contributions if done before the due date of the tax return in the year in which you made the contributions. Additional conditions are that you did not take a deduction and you withdraw any interest or income earned on the contribution.  For example if I made a $1,000 contribution to the IRA in November and did not take a tax deduction on it and earned no interest or other income on the contribution. I could withdraw it in December with no tax consequence.

2. Contribution Limitations: The total contribution you could make to both traditional and Roth IRA plans for 2014 was $5,500 ($6,500 if you are age 50 or older). Said differently this means that assuming you are below the age of 50 the total amount of contributions you could make to any traditional or Roth IRAs in the 2014 year had to be less than s$5,500. For example I could contribute $3,500 to a traditional IRA and $2,000 to a Roth IRA but not $3,500 to both.  This number is  periodically adjusted year to year to account for inflation.

3. Deduction Limitations: I have good news and bad news. The good news is that the amount you can deduct is based on the amount of contribution you make. The bad news is that the allowed deduction may be less than your contribution depending on factors such as whether you are covered by a retirement plan at work, your marital status as of filing, and your adjusted gross income (AGI).

  • The table for the allowed deduction in 2015 if you are covered by a retirement plan at work can be found here.
  • The table for the allowed deduction in 2015 if you are not covered by a retirement plan at work can be found here.

There are a few general observations that can be gleamed from the tables. Notably if you are not covered by a retirement plan at work the amount you can deduct is generally much greater and the greater your AGI, the less of a deduction you are allowed.

4. Later Taxation: As I mentioned earlier, the funds in the traditional IRA enable a tax reduction based on the contribution made in the corresponding year. Unfortunately, when the funds are distributed (withdrawn) they are subject to ordinary income tax.

 

IRS Soldier
“Sorry I’m late, traffic was awful!” Image courtesy of offthegridnews.com

An Example

For a comprehensive example let’s look at Ms. Amy who works at Artemis Inc. Ms. Amy has been contributing the $5,500 per year contribution limit in a traditional IRA account she has set up with a broker.  Assuming that Ms. Amy has been working for 30 years the principal of her traditional IRA alone is worth $165,000 before taxes. That’s not bad, but the neat thing about that number is it’s grossly underestimating the value of the IRA. Why? The money in the IRA has been invested in stocks, bonds, and other assets depending on the risk Ms. Amy took on.  If we assume that she earned a 5% average return over that time period the value of her IRA is not $165,000…it’s around $380,000 before taxes.

Conclusion

PFT Retirement Plans Traditional IRA RV Pic
Because honestly…this is a thing. Image courtesy of Uptownmagazine.com

The traditional IRA is yet another vehicle to build that nest egg and enjoy a worry free retirement.  Together the 401k and traditional IRA provide great vehicles for putting aside retirement income, but there is a small problem.   What if instead of taking the tax deduction now due to the retirement account, you paid taxes in full now and did not have to pay the taxes later down the road when you withdraw from the account? This interesting concept is behind the “Roth” designation that has been referred to throughout this and the 401k post.  In our next lesson we will introduce the Roth IRA and the differences in operation between it and the traditional IRA.

Definitions

  1. Traditional IRA: A type of investment account that allows the owner to make tax-deferred investments to provide financial security in retirement.
  2. Trustee: A person or firm who holds and administers assets for the benefit of a third party.
  3. Rollover: The transfer of assets from one type of retirement account to another type of retirement account.
  4. Adjusted gross income (AGI): A metric calculated by the IRS by subtracting allowable deductions from gross income from taxable sources.

Further Reading

Retirement: What is a Traditional 401k?

Beach Picture
Like this…but with lots of tourists. Image courtesy of funcrisp.com

Imagine you’re on a nice beach in Florida without a care in the world.  Do you feel the soft breeze on your skin and hear the soft crashing waves on the shore and the tropical birds chirp in the distance? This could be what retirement feels like.  On the other hand imagine having to reach out to your children for help in paying your hospital bills as you didn’t realize health care costs could become so expensive. You have to keep working because you don’t think you can afford to lose your income stream. This could also be retirement feels like. I bring up these opposing visions to illustrate a simple point: retirement is a big deal.

In the next few posts I will be discussing the various retirement plans  available and how to make the most of the dollars you earn today.  It is never too early to think about retirement.  As I mentioned in Lesson 1 there is a benefit in investing today and not fifty years down the line.

Let’s begin with one of the most common terms in the world of retirement plans: the 401k. I will note that most people will be able to use a traditional 401k plan. There are some exceptions including employees of the government or nonprofit plans which I will address in later posts.

Key Points

  • A traditional 401k is an elective retirement plan which grants an employee the ability to defer some of his/her earned income in order to obtain current favorable tax treatment.
  • The benefits of using a traditional 401k plan include favorable tax treatment and employee matching.
  • The limitations of a traditional 401k plan include distribution limits, contribution limits, and later taxation.

What is a 401k plan?

Put simply a 401k plan is a retirement plan an employee enrolls in through his or her employer. There is a tax benefit associated with contributing to a 401k plan and in addition the employer generally will match the employee’s contribution according to some predetermined formula.

In general the company offering the 401k plan does not manage the plan.  It usually serves the role of the sponsor of the plan. To think of it differently, the sponsor of the plan (the company you work for) usually outsources the management of the plan to a financial service company who you contact for the actual management of your plan.  The identity of the financial service company that manages your 401k plan should be detailed in the benefit guide of your employer.  The role of the employer as the sponsor is to pay for the setup of the plan and to make matching employer contributions according to some formula.

A very important term to become familiar with is the term elective deferral. An elective deferral is simply the portion of your paycheck that you are choosing to put into the 401k.

What are the benefits of a 401k Plan?

So why would I want to tell my employer to funnel some of my earnings into my 401k plan instead of putting that money in my pocket? There are two main reasons: tax treatment and contribution matches from your employer.

1. Tax treatment: Taxes suck. Luckily the 401k provides a way to decrease your federal income tax payable.   Your elective deferrals do not show up as taxable income. Said differently the income you choose to defer (put off until retirement) does not count as your taxable income in a given year.   The federal government is rewarding you for investing in your retirement.

IRS Soldier
“Did someone say that taxes suck?” Image courtesy of offthegridnews.com

 

If you think this sounds too good to be true, you’re correct. Though these contributions are allowed to grow untaxed in the fund, when you withdraw the funds (also called a distribution) they are subject to taxes as ordinary income.  An example would be if you have invested in a 401k plan and at age 65 withdraw $50,000 from the plan, this $50,000 would be reflected as ordinary income and subject to taxes.

2. Employer matches: Who likes free money?   By contributing to a 401k plan, this is a possibility.  Most corporations as part as their benefit package offer “401k-matching”. What this means is based on a predetermined formula your employer will contribute to your 401k fund. For example a company may match 25% of your contributions up to $2,500 per year.  Meaning for every $1.00 I set aside in the fund my company will contribute $0.25.  Getting paid for investing in your retirement is a pretty neat thing.

PFT Retirement Plans Traditional 401k Vest Pic
Vesting is surprisingly not related to clothing. Image courtesy of honeybuy.com

There are some caveats to be aware of.  While you always have a claim to the money you contribute to the plan, you may not always be able to have total claim to the employer’s contributions.  Many companies enact a vesting condition in their contributions. Vesting refers to an amount of time that must pass before you have claim to some asset.  This is generally done to ensure you will remain employed by that company for a longer period of time. An example of a vesting schedule would be that you vest 100% in the company’s contributions after five years with vesting beginning at 20% in year one and increasing by 20% each subsequent year.

Let’s use a quick example.  Say John Galt works for Eos Inc.  and Eos has a 25% matching contribution and the vesting schedule is 20% each year for the first five years at the company.  Mr. Galt has been working at the company for three years and contribute $5,000 to the 401k plan each of those years. How much principal does Mr. Galt have claim to (assuming the fund did not earn a return)?

 

John Galt’s contribution to the plan:

3 years * $5,000 = $15,000

Eos Inc.’s contribution:

3 years * 20% of our $5,000 yearly contribution * 60% vesting limit

3 * $1000 * 0.60 = $1,800

Total principal in the fund = $15,000 + $1,800 = $16,800

Limitations of a 401k Plan?

1. Distribution Limitations: Waiting is hard.  At some point that $15,000 may look very tempting to withdraw and go spend on a new boat. Unfortunately the IRS would rather you not blow your 401k and has put in place deterrents to discourage that action.  The deterrent takes the form of a 10% additional tax if you receive the distribution before age 59 ½.  The reasoning is sound. The 401k is to provide you with retirement income, not a boat.

That being said the ways the elective deferrals can be distributed without incurring additional charges include: you die, become disabled, or become unemployed; your employer terminates the 401k plan; you reach age 59 1/2  or incur significant financial hardship.

2. Contribution Limitations: There are two annual limits that every 401k owner should be aware of:

1. The limit on the amount you as an employee contribute to the plan 2. The limit on the total amount that can be contributed to the plan.

The annual contribution limit for the employee in 2015 is $18,000.  This ceiling has increased in increments of $500 for some years and is expected to so as the IRS adjusts it for costs of living and inflation.The annual total of elective deferrals and employer matching contributions cannot be greater than $52,000 or 100% of your compensation, whichever is less.

3. Later Taxation: As I mentioned earlier, the funds in the 401k plan can’t avoid the tax man forever.  When the funds are distributed to you (and hopefully not with the added 10% tax) these distributions will show up on your taxable income.

IRS Soldier
“Did someone say Tax Man?” Image courtesy of offthegridnews.com

An Example

For a comprehensive example let’s return to Mr. Galt who works at Eos Inc.  Mr. Galt has been contributing the $5,000 per year and has been matched by his employer 20% of his contribution.  Assuming that Mr. Galt has been working for Eos for 30 years the principal of his 401k alone is worth $180,000 before taxes. That’s not bad, but the neat thing about that number is it’s grossly underestimating the value of the 401k. Why? The money in the 401k has been invested in stocks, bonds, and other assets depending on the risk Mr. Galt took on.  If we assume that he earned a 5% average return over that time period the value of his 401k is not $180,000…it’s around $400,000 before taxes.

Conclusion

Senior couple
Pictured: Golden Years. Image courtesy of gainesvilletoday.com

Retirement is important to everyone.  Why should someone start early? Growth. What may not be clear is that your 401k will allow you to allocate and invest the funds as you choose. Said differently a 401k is just another type of account for saving and investing, but with an emphasis on retirement.  If done correctly, your fund can grow quite dramatically over the years of employment and you won’t have to worry about money when you reach your golden years.

In the next few posts I will be discussing other retirement plans that exist including the Roth 401k, IRA, and Roth IRA.

Definitions

  1. 401(k): A type of retirement fund which allows employees to defer funds in order to obtain favorable tax treatment and to obtain matching employer contributions.
  2. Sponsor: The employer who contributes funds and facilitates the participation in a 401k plan by its employees.
  3. Elective Deferral: A portion of earned income that an employee chooses to defer by transferring into a 401k and which does not contribute to taxable income in the year earned.
  4. Vesting: The process by which an employee accrues certain rights or privileges from his/her employer.

Further Reading

Lesson 12: ETFs

Mutual funds ETF Headingare great, but they have some drawbacks.  If you want to sell it, you have to wait to the end of the day. In addition mutual funds have some unavoidable costs and some limited functionality. In response to these shortcomings Exchange Traded Funds (ETFs) were created about 20 years ago and are one of the most recent and interesting financial innovations of the present day.

Key Points

  • An ETF is a type of hybrid investment company.
  • Creation is the process by which an ETF is created.
  • Redemption can be thought of as the reversal process of creation.
  • ETFs possess cost and functionality benefits compared to mutual funds.

What is an ETF?

An Exchange Traded Fund is a special type of hybrid investment company that creates marketable shares that trade on an exchange based on the value of the asset base it tracks.  The investor receives profits on the assets owned (interest if bonds are tracked or dividends if stocks) on a pro rata share basis.  The easiest way to describe an ETF is to think of it simply as a mutual fund with some increased functions (if a mutual fund is a knife, an ETF is a Swiss army knife).   One of the most crucial differences between an ETF and a mutual fund relates to the method of trading.

As you may remember a mutual fund is priced once a day at the end of trading. Thus buy and sell orders are processed at the price (Net Asset Value) at the end of the day for mutual funds. This is not the case for ETF shares. You can trade ETF shares at any point during the day on an exchange.  To understand what makes an ETF valuable and why it has key benefits over a mutual fund, we first must see how these funds are constructed.

How is an ETF Constructed?

Two crucial processes in ETF functionality are construction and redemption. Let’s begin by analyzing construction, which as the name suggests is how an ETF is created.

Let’s assume that I want to create an ETF (Colby Duhon Superfund).  Thus the Colby Duhon Superfund is the sponsor of the ETF. My first decision is what asset do I want to track.  Tracking means I will possess this asset whose value can fluctuate.  My choices include indexes like the S&P 500, bonds, gold, etc.  For the sake of this example let’s assume the Superfund will track the S&P 500.  The problem is the Superfund does not have enough capital (money) to purchase all the stocks traded in the S&P 500. This creates the role of the Authorized Participant.

The Authorized Participant (AP) is a large market maker or financial institution with sufficient buying power to provide the ETF with the asset it desires. Basically the Authorized Participant is the rich relative who has the buying power to purchase the assets the sponsor wants to package up as a unit.  It is worth noting that in some cases the sponsor and AP can be the same entity.  For the sake of the Superfund example we will assume this is not the case.

Now that the AP knows that the Superfund wants to track the S&P 500, it will go out into the market and buy the shares that comprise the S&P 500 in the proportion that the shares make up the index.  Once the AP has the shares assembled, it now has a basket of securities.  The AP will then trade this basket of securities to the sponsor (Superfund) and in exchange receive a creation unit which usually represents 50,000 shares of the ETF.  The AP then sells the shares of the creation unit in the open market.  When you buy a share of an ETF, you are buying a piece of this creation unit.

Old Guy in Chair
“Back in my day we didn’t have cool widgets.” Image courtesy of bbc.com

An easy way to think about this is continuing with the rich relative metaphor. You (the sponsor) want to create a cool widget that would sell well but you need some parts to make it. You contact your rich uncle (AP) and ask him to buy all the parts in the market.  The rich uncle buys the parts (stocks) and gives them to you. You assemble the new widgets using the parts and in exchange for the parts give your uncle the widgets (creation unit). Your uncle now has cool widgets to sell while you keep the parts.

As a final note in our example we created an ETF that tracked the S&P 500. We could create an ETF that tracks other assets such as bonds or gold. In any case the process is similar with the AP purchasing the assets (bonds or gold) and the sponsor providing the creation unit to the AP to sell.

ETF Creation Diagram
ETF Creation Process

 

Redemption

Redemption can be thought of as the opposite of creation. In creation the AP gave the basket of assets to the sponsor and received the creation unit of shares. In redemption the AP returns the creation unit to the sponsor and receives the basic of assets back.

As I said before an ETF has many similarities to a mutual fund. So if presented with a mutual fund that tracks a market index and an ETF that does the same why would I choose the ETF? 1. Cost benefits 2. Functionality benefits.

Cost Benefit of ETF vs. Mutual Funds

  1. Cheaper operational fees: Due to the unique structure of the ETF, the ETF fund charges lower operational costs compared to that of a mutual fund. The difference lies in the presence of the AP when investing in an ETF. Due to this “middle man” the investing process is greatly simplified for the ETF fund and investor and this simplification translates into cost savings for the investor. For a direct comparison the average U.S. Equity Fund charges 1.46% in annual expenses where the average ETF Equity Fund charges 0.53%.1
  2. Favorable tax treatment: Most ETFs incur very few capital gains tax due to their unique creation process. ETFs and mutual funds are required to distribute capital gains to their investors, which will be subject to capital gain tax. Ouch. An ETF is able to avoid this problem by having a very low turnover ratio and avoiding the presence of a sale in the redemption process. The avoidance of a sale matters because if the ETF had to sell the shares it had to raise cash, this would be taxed. However a quick review of the redemption process reveals that when the ETF needs to raise more cash it does not “sell” the assets, but trades them to the AP for the equivalent creation unit. This structure enables ETFs to avoid unfavorable taxes.

Functionality Benefits of ETF vs. Mutual Funds

  1. Intraday Trading: As previously mentioned one of the crucial differences between an ETF and mutual fund is the ETF’s ability to trade intraday. Not having to wait till the end of the trading day could make a huge difference on your strategy in addition to being a nice convenience feature.
  2. The presence of options and other features: Though I haven’t discussed them yet, an ETF gets added functionality from the ability to purchase options on them. Options briefly are a form of derivative security that enables you the investor to buy or sell an underlying security for a set price.  What is necessary to understand is based on the presence of these, ETFs obtain a dimension of functionality unmatched by mutual funds.

 

Definitions

  1. Exchange Traded Fund (ETF): A special type of hybrid investment company that creates marketable shares that trade on an exchange based on the value of the asset base it tracks.
  2. Creation: The process of creating an ETF or more specifically creating a creation unit whose shares will be traded on the open market.
  3. Creation unit: A block of shares (usually 50,000 shares) created by the ETF and whose individual shares are sold on the market.
  4. Redemption: The process of trading a creation unit for the underlying assets it represents.
  5. Sponsor: An entity that wishes to create an ETF.
  6. Authorized Participant (AP): A market maker or large financial institution that possesses the capital needed to purchase the underlying assets a sponsor wishes to transform into an ETF.

 

Further Reading

Lesson 11: Mutual Funds

Mutual fundsThere are a lot of investments out there. There are corporate bonds, municipal bonds, small-cap stocks, mid-cap stocks, large-cap stocks, growth stocks, value stocks, the list goes on and on.  How can an investor diversify when bonds par at $1,000 and stock prices can easily be in excess of $100? If there were some way that many individual investors could pool their money together to own investments, they could all reap the benefits of investing without any one investor taking on a significant amount of risk.  This is why mutual funds exist.

Key Points

  • A mutual fund is a type of investment company.
  • Net asset value (NAV) is an important metric when looking at funds.
  • Advantages of investing in a mutual fund include professional management, diversification, and low investment for entry.
  • Disadvantages of investing in a mutual fund include additional costs, risk, and taxes.

What is an Investment Company?

A mutual fund is a type of investment company.  This begs the question “What is an investment company?”  Put simply an investment company is any company that issues securities and is in the business of investing in securities. How it basically works is that an individual investor buys shares of the investment company or more accurately shares of a fund the investment company controls. With the money procured from individual investors the investment company purchases securities as dictated by the goal of the fund and pays out the returns to the investors.

An investment company is usually one of four primary types. There are open-end funds (mutual funds). close-end funds (CEFs), and Unit Investment Trusts (UITs). The fourth and fastest growing type of investment company called an Exchange Traded Fund (ETF) will be discussed next lesson once we have a clearer picture of how these different types of funds function.  It should also be noted that “investment company” and “fund” tend to be interchangeable terms.

 

L11.1 Graph of Investment Companies
Types of Investment Companies

 

Net Asset Value

Before we dive into the differences there is a key metric that is very relevant to both closed and open end funds is known as net asset value (or NAV). The most comparable but not perfect comparison is to think of the NAV of a fund as the stock price of a stock. The net asset value is calculated by the following

Net asset value (NAV) = (Total Assets in Fund – Total Liabilities)/ Total Fund Shares Outstanding

Let’s assume that in the CD Super Awesome Fund had $100 billion in assets, $20 billion in liabilities and 10 billion in shares outstanding. The NAV would be calculated as follows:

NAV = ($100 – $20)/ 10 = $80/10 = $8/share

Why does this number matter? It plays a significant role in the share value of open-end funds (mutual funds) which we discuss later.

 

What is a Mutual Fund (Open-End Fund)?

An open-end fund is an investment company which issues new shares to anyone willing to buy and will redeem (buy back) any shares from those wishing to sell back. The money received from investors is then used by the managers of the mutual fund to buy securities for the mutual fund.  It helps to think of a mutual fund as just another public company that sells and can buy back stock from investors.

What price is charged to investors or does the mutual fund have to pay to redeem shares? Remember the Net Asset Value (NAV)? The Net Asset Value represents the share price of the mutual fund.  So let’s return to the CD Super Awesome fund.  If I were an investor wanting to buy 100 shares of the fund I would pay $800 at the share price established above.  Likewise if I wanted to sell 100 shares back to the fund I would receive $800 for my shares.

100 shares of CD * $8/share = $800

A very notable difference between the common stock we discussed earlier and a mutual fund share is that while a share of common stock is priced constantly throughout the day a mutual fund’s NAV is calculated once at the end of the trading day. So you want to sell or buy a share at 10:00 A.M.? Too bad. You have to wait till after trade closes and the new NAV (share price) has been established.  Thus based on whether the mutual fund’s assets have increased or decreased in value will determine whether the NAV has increased or decreased.

 

What is a Close-End Fund (CEF)?

A closed-end fund is an investment company that issues a fixed number of fund shares in an initial public offering and uses these funds to invest in securities according to the purpose of the fund.  These fund shares are then traded on exchanges similar to common stock.

What is the main difference between close-end and open-end funds (mutual funds)? The biggest difference is the process in which the shares of the close-end fund are traded.  If you remember in a mutual fund the fund stood ready to buy or sell as many shares as needed. In a close-end fund the number of shares is fixed.

What effect does this fixed number of shares have on the price of the shares of the fund? These shares are now sold and bought by investors during the day on major security exchanges at values independent of the fund’s NAV. The NAV is now driven by market forces of supply and demand. This means at any time a share of a close-end fund can trade at a discount (less than) or a premium (greater than) the fund’s NAV.  Close-end fund have become less popular with the emergence of Exchange-Traded Funds but still exist.

 

Advantages of Investing in a Mutual Fund

  • Management by Professionals: The decisions of what investments in a mutual fund is not made by you. Instead a professional money manager is charged with investing in certain securities according to the goal and type of the mutual fund. This way while you can focus on doing your job the money manager is meanwhile researching opportunities to make your money work for you.
  • Diversification: If you remember our risk vs. return lessons, one of the main strategies to reduce risk is to diversify (hold securities whose performances are independent of each other). By having over a billion dollars worth of assets a mutual fund can hold hundreds to thousands of
  • Low Investment for Entry: Many mutual funds have a minimum deposit of $3,000 to participate but some can be low as $1,000. Without a mutual fund it would be nearly impossible to achieve the same level of diversification with the same level of funds.

 

Disadvantages of Investing in a Mutual Fund

  • Costs: By purchasing securities directly you avoid some of the fees present in using a mutual fund. These fees include sales-charges, 12b-1 fees, and management fees.
  • Risk: Unlike a savings account, there is the risk that the mutual fund’s assets could decrease in value and thus your return on the investment could be negative.
  • Taxes: Federal income taxes are due on both dividends and gains made by the fund and any profits made when the shares are sold. One exception is when the distributions are channeled into tax-deferred retirement accounts (IRAs)

Conclusion

One final note about mutual funds: there are a ton of these things. The broad three categories are stock, bond, or balanced funds which accordingly hold stock, bonds, or a mixture of the two.  Further classification includes capital appreciation stock funds, growth stock funds, international stock funds, sector funds, municipal bond funds, the list goes on and on.  Your goal and risk tolerance as an investor will dictate which type of fund best suits your needs.

L11.2 Mutual fund types
Mutual Fund Types and Relative Market Share. Image courtesy of teensguidetomoney.com

 

Definitions

  1. Investment company: A company that issues securities and is in the business of buying and selling securities as its primary activity.
  2. Open-end fund: An investment company who will issue new shares as required and whose share price is equal to the fund’s NAV.
  3. Close-end fund: An investment company that has a fixed number of outstanding shares whose value is commonly at a discount or premium to the fund’s NAV.
  4. Unit Investment Trust: An investment company that holds a very small number of securities that it does not actively sell and also has a limited life.
  5. Exchange Traded Fund: An investment company that does not issue securities directly to investors, but instead issue large shares known as “creation blocks”.
  6. Net Asset Value: A metric of an investment company that is equal to the sum of the fund’s assets minus its liabilities divided by shares outstanding.

 

Further Reading

 

 

Lesson 10: The Money Market

Stack of money
This is money. I am talking about the money market. You’re welcome.

The term money market is actually a great example of a misnomer. One might think that “money” in the form of currencies (Euros, U. S. dollars, Chinese Yen, etc.) are traded in this market.  This is incorrect. Instead the money market consists of highly liquid, short term debt investments.  The money market is the alternative to the capital markets which consist of longer term bonds and stocks.  An easy way to remember the difference is that if the asset is short term (it matures in one year), you are in the money market.  If the asset is long term (stocks, bonds, etc.) you are in the capital markets.

Financial Market Breakdown Chart
Here is a nifty breakdown to help remember.

Key Points

  • The money market is where short term debt instruments are traded.
  • Some of the key players in the money market include the U.S. Treasury, Federal Reserve, large companies, and individuals.
  • One of the main purposes of the money market is to house surplus funds and meet short term needs of funds.
  • Some of the securities traded in the money market include T-bills, commercial paper, federal funds, negotiable CDs, Eurodollars, and repurchase agreements.
  • The money market (mainly in the trading of T-bills) is where short term interest rates are determined.

What is the Money Market?

Say a company wants to build a new building or make a long term investment in a new product. A bond would be a perfect way for the company to raise a large amount of funds and pay it back over many years.  What if a company needs a smaller amount of cash for a quick payment (say to fill a small gap in the weekly payroll)? As the process for issuing bonds is very costly in terms of both dollar amount and time, it would be ineffective to issue bonds to address this small need of funds.  Thus in this case and others the money market instruments arose to fulfill the need of short term funds.

There are three common characteristics of money market instruments:

  1. Money market instruments mature in less than one year. Unlike bonds or stocks, money market instruments mature in less than one year than issue date whereas bonds mature in 5-10 years and stocks theoretically never mature.
  2. Money market instruments are highly liquid. The instruments in the money markets have high liquidity due to the large amount of participants and the large amount of funds that flow through the market.
  3. Money market instruments have low risk relative to the average risk of stocks and bonds. With their short maturities and high liquidity money market instruments in general possess very low risk when compared to their capital market counterparts.

Key Participants in the Money Market

The major participants in the money market include the U.S. Treasury, the U.S. Federal Reserve, large public companies, institutional investors, and individual investors.

  • U.S. Treasury: Remember those Treasury bonds that we mentioned in the bond market lesson? Well the U.S.
    Treasury Building
    This whimsical, fun looking building is the U.S. Treasury.

    Treasury also issues T-bills. We will discuss T-bill specifics later, but for now just now that the U.S. Treasury is the largest borrower of money market instruments which it uses to fund the federal debt.

  • Federal Reserve: The U.S. Federal Reserve (Fed) is the most influential player in the U.S. money market. It buys and sells vast amounts of T-bills to influence the money supply and short term interest rates in America.
  • Large Public Companies: Large companies participate in the money markets through buying and selling of securities.  One instrument associated with large companies in the money market is commercial paper which will be discussed later.
  • Institutional Investors: Due to their low risk many institutions (insurance companies, pension funds, etc.) will hold large amounts of money market instruments to generate investment returns while maintaining minimum risk.
  • Individual Investors: Primarily through the use of mutual funds (which we discuss in the next lesson) individual investors are able to participate in the buying and selling of the large dollar denomination securities in the money market.

Purpose of the Market

The primary purpose of the money markets is to provide a market that matches large amounts of excess funds from financial institutions to other firms and governments in need of short term funds.  Imagine a firm, let’s say Apple, has over $1 billion in excess cash.  What should Apple do with these funds? Furthermore let’s assume that the market for stocks and bonds has been volatile and therefore unusually risky lately.  One option is to buy money market instruments to generate higher return than the return that cash offers. (It is important to note that the return on cash is zero. Another way of thinking of this is cash in your wallet generates no return for you).  The money market allows Apple to invest in short term liquid securities that do not put Apple at significant risk and provides short term funds to other firms that need it.

Another way to think about the money market is imagine you as an individual have excess cash. One option you have is to go to a bank and put the money in a savings deposit.  The return on this account will be quite low. Now imagine there is a market where you can invest and get a slightly higher return with a corresponding slightly higher risk profile. You will provide the funds to institutions and businesses who have a short term need for funds and will compensate you with a higher rate for doing so.  This is the purpose of the money market.

Types of Money Market Instruments

  • T-bills: Treasury bills are issued by the U.S. Treasury Department and are used to finance the federal debt. The U.S. Treasury bill is arguably the most liquid and widely traded security in the world. As a result the interest rate offered on T-bills is used as a proxy for the short term risk-free rate.  T-bills do not pay interest and are instead sold at a discount and later matures at par value.  (Similar to the zero-coupon bonds discussed last chapter)
  • Federal Funds: Federal funds are short-term funds transferred between large financial institutions (usually larger commercial banks). Because banks must have minimum reserves relative to the amount of deposits they have, some banks need quick, overnight funds to avoid legal repercussions. As an investor you may hear the “federal funds rate” mentioned. This is the interest rate charged on these overnight bank loans.
  • Commercial Paper: Commercial paper are money market securities that are issued by corporations and mature in less than 270 days.  Commercial paper is offered directly from issuer to buyer and is used to fund the issuing companies’ activities.
  • Negotiable CDs: Negotiable certificates of deposit (CDs) are large, bank issued securities that range in value from $100,000- $10 million. Most individual investors will have little interaction with negotiable CDs, but it is worth noting that a negotiable CD is not the same instrument as the certificate of deposit that an individual can get at a consumer bank.
  • Repurchase agreements: Repurchase agreements (repos) occur when a firm sells Treasury securities and agrees to buy back the securities at a later date. In essence a repo is a short-term loan.  One firm sells the securities for quick funds and promises to rebuy the securities at a later date.  Repos are used by the Federal Reserve in conducting monetary policy.

The Risk Free Interest Rate

As mentioned above the T-bill is one of the most important securities within the financial markets.  The interest rate on the 3 month Treasury bill is commonly used as the “interest-free rate”. The interest free rate represents the return an investor should expect to earn on an investment with no risk. The T-bill is used for this theoretical rate because of its unparalleled liquidity and the ability of the U.S. Federal government to create more money to pay off the T-bill obligations as they come due.

 

Definitions

  1. Money market: The market for short term debt obligations used to facilitate short term borrowing and lending of excess funds.
  2. Interest free rate: The theoretical return an investor should earn on a security with zero risk. The interest rate on the 3-month Treasury bill is commonly used as a proxy for this theoretical rate.

Further Reading