University of Illinois financial planner: Many ways to own investments

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URBANA, Ill. — Most discussions about investing focus on stocks and bonds, but how to own them also needs to be part of the discussion.

“You can own individual stocks or bonds, buy shares of a mutual fund that holds stocks or bonds (or both), or buy shares of an Exchange Traded Fund,” according to Karen Chan, certified financial planner and consumer economics educator with University of Illinois Extension.

She explained, “When you buy or sell an individual stock or bond, you enter an order with a broker. You can use a market order, and your trade will execute at whatever the price is at that moment, or use a limit order, specifying the price at which you will buy or sell.”

Types

In mutual funds, Chan said your money is pooled with other investors and invested by the fund. The most familiar type of mutual fund is the open-end fund. When you buy or sell shares, you are buying them from or selling them to the fund itself.

“You can place an order to buy or sell shares of a mutual fund at any time, but the order will be executed at the end of the trading day when the fund has calculated its Net Asset Value,” she said. “You won’t know the exact price until after it executes. If the mutual fund sells an investment in the fund at a profit, it will report that gain to you and to the IRS on a Form 1099, even though you didn’t sell anything.”

Open-end mutual funds can be actively or passively managed. With active management, the manager chooses which investments to buy, hold or sell. Index funds use passive management; the fund tracks an index of stocks or bonds such as the Standard and Poor’s 500 or the MSCI World Index. The fund owns the same investments included in the index; there is no active buying or selling within the fund.

“You may pay a commission, or load, to purchase or sell shares of a mutual fund,” Chan said. “There are also no-load funds for which there are no purchase or sales fees. Your broker might charge a small fee if you hold the mutual fund in your brokerage account instead of buying directly from the mutual fund. There are also annual costs for owning a mutual fund, reflected in the annual expense ratio,” she said.

Although less common, there are also closed-end mutual funds. These funds trade throughout the day, and you are buying from or selling to other investors.

“The price can be affected by demand for shares of the fund, and you could get significantly more or less than the actual value of the investments inside the fund,” Chan said.

Exchange traded funds (ETF) are the newest kind of mutual funds. They trade throughout the day like stocks and closed-end funds, but the price is usually very close to the NAV.

“Using a broker, you buy and sell shares from the fund,” Chan said. “Large blocks of shares are created or liquidated as needed to keep the price close to NAV. You will pay a commission to the broker to purchase or sell shares of an ETF, but ETFs usually have lower annual expense ratios than open-end mutual funds.”

Advice

Chan suggested that when buying or selling large numbers of shares, the lower expense ratio of an ETF could more than make up for the brokerage commission. “If you make frequent small purchases, open-end mutual funds will likely cost less.”

Before buying any type of investment, Chan advises that individuals understand the investment and make sure that it fits your needs. When investing in mutual funds, ask questions such as:

• What types of stocks, bonds or other investments does the fund hold? How does that fit with other investments I already own?

• What is the fund’s objective? Does it match my investment goals?

• What are the costs of buying and owning the fund? How often will I buy shares? Will an open-end fund or ETF be the most cost-efficient?

• What are the risks? How long do I expect to own this fund?

• For actively managed funds: How long has the current manager led the fund?

“Answers for many of these questions can be found in the fund’s prospectus, which is an official document you can find on the fund’s website or request to be mailed to you,” Chan said.

For more information, read the Plan Well, Retire Well blog at www.extension.illinois.edu/go/retirewell.

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