Extra Innings 2: Asset Management

What have we learned so far?

• Diversify
• Hold the market portfolio
  • What comprises the market portfolio?
    • Stocks
    • Bonds
    • Real Estate
  • How can we invest in a large number of securities?
    • Buy individual securities
      • Costly
      • Rebalancing Issues
    • Invest in managed portfolios
      • Mutual Funds
      • Exchange Traded Funds (ETFs)
• What is in your portfolio currently?
  • Financial Assets
  • Human Capital: present value of your future earnings
    • Large part of your personal portfolio
    • Has systematic and unsystematic risk components

Mutual Funds

• Pooled funds which are managed by professional
• Active vs. Passive Management
• Index Funds
• Global vs. International Funds
• Fees
  • Expense Ratios (1–1000 bps; 77 bps on average)
  • Front- and Back-end loads
  • Other Fees

ETFs

• Portfolio held in trust with shares of trust sold
• Typically subject to per trade cost
• Also have expense ratios (10–125 bps; 65 bps on average)

Differences

• Liquidity
  • Mutual funds trade once per day at net asset value (NAV)
  • ETFs trade throughout the day on the open market
    • Subject to spreads
    • Subject to price impact
• Taxation
  • Mutual fund redemptions create turnover which create capital gains
  • ETFs redemptions are in-kind and don’t trigger a tax event

Taxable vs. Tax-Advantaged Accounts

• Rule of Thumb - IRS wants to tax every dollar once
• Taxable Accounts
  • Principal is after-tax
  • Capital gains are taxed at capital gains rate
  • Dividends are taxed as ordinary income
• IRA/401-k
  • Contributions are tax-deductible (reduce tax liability now, but taxed at withdrawal)
  • Capital gains and dividends are sheltered
• Roth IRA/401-k
  • Contributions are after-tax
  • Capital gains and dividends are sheltered
• When would one type of account be preferred over another?