Vehicles of Investing: What Am I Buying? | Brandon Averill, Justin Dyer | AWM Insights #96
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Episode Summary
So now you are ready to invest and become an owner or lender, but what do you buy and how?
Stocks, bonds, mutual funds, ETFs, hedge funds, and private investments all make up the universe you have an opportunity to invest in. To keep it simple, buying stock is ownership and buying bonds is lending. Both mutual funds and ETFs can be very efficient vehicles to access public markets but understanding the details is an essential step.
Private investments like hedge funds, venture capital, and private equity can be a source of great returns but are also less transparent with much less information than the public markets.
Episode Highlights
(2:01) Stocks are ownership and bonds are lending.
2:30) Stocks are direct ownership. Think Apple, Microsoft, Tesla.
(3:34) Bonds are just loans. These loans can be to the US government, local government, or companies.
(3:55) Publicly traded companies (Apple, Microsoft) also issue bonds to then use that money to create more value or feed growth.
(4:40) There is a hidden cost: the spread between the bid and the ask price.
(5:25) Access to public markets is incredible and as simple as it has ever been for investors.
(6:05) Mutual funds, why they exist and what they offer.
(7:27) Single stock risk and why the diversified portfolio outperforms.
(8:30) Before diversified pooled investment vehicles, investors were overly concentrated in just a few stocks to the disaster of many during the Great Depression.
(9:01) Diversification and the closest thing to a free lunch in investing.
(9:08) Private markets have illiquidity issues and slower transaction time to complete a purchase or sale.
(9:46) Mutual funds are only priced once a day. At the end of the day they are traded or redeemed at their Net Asset Value or NAV.
(10:30) Exchange Traded Funds or ETFs are traded similar to a stock throughout the day.
(11:45) ETFs have gained in popularity but have been around for more than 30 years.
(12:30) The misconception of mutual funds due to some fund companies charging high fees in the past. Not all mutual funds are the same. They are just a vehicle.
(13:20) There are expensive ETFs and inexpensive ETFs just like the mutual fund universe.
(14:50) Derivatives. How ETFs use these to juice returns and the drawbacks.
(16:10) The movie to watch on derivatives is The Big Short.
(17:00) Hedge funds were originally started to hedge market downturns.
(18:05) Hedge funds have evolved into a bet on an active manager that they can beat the market. There are many strategies that now fall under hedge funds but very few do any hedging anymore.
(20:24) Private companies also sell ownership in stock or take money in the form of loans as bonds.
(21:33) Buying stock of private companies or lending them money is called direct.
(22:11) Buying into a private fund gives you the claim to ownership and the fund managers are responsible for finding worthy investments.
(24:55) NFTs and how you should think about these crypto and web 3.0 talk.
(26:30) Crypto is speculative because it is not ownership of a business or lending of money. This isn’t a bad thing, it just means it is speculative and buyers hopefully understand that.
(27:13) There is tremendous hype and it's hard to know what you actually own with NFTs.
(28:00) There is a disconnect between perception and where the NFT market is currently at.
(28:55) NFTs will be covered in depth next week.
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Brandon Averill: LinkedIn
+ Read the Transcript
Brandon Averill (00:00):
Hey, Justin, welcome back. Got a good topic to dig in today. We're going to get nuts and bolts a little bit and talk about... We've talked about investments, what those actually are, but well, let's get in today to, okay, great, I want to invest my money, what am I buying, I guess is the better way to put it. Hopefully we'll bring some clarity for everybody here, because the universe is awfully big. So I'll throw it over to you. I want you to start, maybe even just start at the basic level, when people think about investing, buying ownership, or buying, going out and lending your money, where do we start?
Justin Dyer (00:40):
Sure. So, I love our format so far this year. We're just slowly peeling the onion, as an old colleague always used to say. And the more we peel the onion or I peel the onion, I get to nerd out a little bit more. We'll try and keep it high level throughout these initial podcasts. But definitely want to, at the outset here, if you guys have call questions, topics you want to discuss, by all means let us know. I think we're going to tackle one we got some feedback on next week. So little teaser there. So owning versus lending is what we talked on last week, and then really we're talking about the vehicles in which you can take those two general paths with respect to investing.
Justin Dyer (01:23):
So start really at the top, which everyone's probably really familiar with is, at the very top you have stocks and bonds. Those are synonymous with what we really dug into last week, ownership, our stocks, lending our bonds. If you're buying a bond, effectively what you're doing is you're lending money to some kind of entity or institution or person in some cases to do something with it. If you're buying a stock that represents direct ownership, if you're doing it on a publicly traded exchange, you're buying a publicly traded company. So think about the big names that are always out there in the news, Apple, Microsoft, Ford, Tesla, these big company names that you hear most commonly are publicly traded stocks. If you're going to your brokerage account, we'll probably touch on actually how you can get access to these and some future episodes and pros and cons and how you trade them, et cetera.
Justin Dyer (02:29):
But if you're in your broker account and you're buying a share of Apple, you actually are buying a very small ownership in that company directly. Last week we talked about, what does ownership mean? You actually have a claim on future profits really at the end of the day is what you're looking at as a company owner. And again, really, this is the basic building block. On the bond side, won't get too granular here, but you can take different forms of loans. You can loan money to governments, so US treasuries, that is a bond. You can make loans, or you could go buy bonds for the state or the municipality which you live in. I'm in California right now, California issues a number of different municipal bonds, are what they're called. Companies at the same time, also issue bonds. So Apple has bonds that trade on the public markets, Microsoft does, pretty much any publicly traded company takes advantage of both issuing stock and issuing bonds to help fund their operations in one way, shape or form. They do an analysis to see what makes sense, which route to go, but that's what a stock and a bond is effectively.
Justin Dyer (03:45):
There are hidden costs to ownership of these vehicles. So when you go and you do try and trade one of these in your brokerage account, or even if you go to something like Yahoo finance and look up a quote, you can see that there's actually what's called a bid price and an ask price. And really the difference between those two is what's called the spread and there's a cost there. There's always is a difference. And really what those two numbers are saying is what people are willing to buy the stock for and what people are willing to sell the stock for. And generally speaking, what's quoted is the last price that a transaction actually happened. That's not guaranteed to be what you would get if you went in to go buy that, there might be some news item that hits the market right away and the price drops, and if you're buying it at that point in time, there are ways to protect against that, but not going too deep there. If you're entering an order right there, the price may fall and you might actually have a greater spread to your transaction, and that is effectively a cost to you.
Justin Dyer (04:52):
The great thing about the world in which we live in, is access is incredibly broad, incredibly easy. It's very straightforward to open up a brokerage account, to transfer money into it, and start investing in stocks and bonds and other vehicles, which we'll get into. So, real basic, stocks versus bonds, ownership versus lending, which we touched on. But the real cool thing about where we are today, and this isn't new but it's continued to evolve and really the innovation has sped up quite a bit is within co-mingled vehicles or pooled vehicles. The most common or kind of longest lasting pooled vehicle is on the mutual fund side of things. This dates back, I don't know the date exactly but I think the first mutual fund goes back to like the 1940s even, maybe even a little bit beyond that but-
Brandon Averill (05:50):
The 40 act. [crosstalk 00:05:51].
Justin Dyer (05:51):
40 act fund, yeah, there you go. You're right. So it's not a new innovation it's been around for quite some time, but the Genesis of it was, Hey, you know what? There's a benefit to being diversified in your investments. Let's pool our money together and quick teaser or reference back to this whole bid ask spread by pooling money together in a larger amount than you as an individual have, you actually get more efficient participation, more access or execution into the market that you're trying to participate in. So let's just say you want to buy the S&P 500, or some other list of stocks, pooling your money together probably gives you a little bit more efficient access to that, or it gives you more scale. So if you didn't have enough money to access all 500 stocks efficiently, by putting your money together with other individuals, you then have more money and you can actually go and get access to it.
Brandon Averill (06:53):
And I think, right, the big impetus around this was the realization and the data supports, that you're going to have higher risk adjusted returns, more representative returns, if you're not exposing yourself to single company growth. So back to the stocks that you just reviewed, we often as we're starting out investors or we're kids, we're given the assignment maybe even in school, pick the tenth stocks and we're going to play this game. And unfortunately it's a pretty silly exercise because nobody actually lets you just buy the diversified portfolio, which we know at least statistically outperforms over longer periods of time. But that was the purpose of these vehicles in large part, right? Justin was to bring more efficient access to a higher expected return kind of pool of assets as opposed to just exposing yourself to the five companies that you know because you're familiar with their product.
Justin Dyer (07:52):
Exactly. Well, and again, going back to when these vehicles were originally, or gained much more popularity, I believe there were co-mingled or pooled vehicles even back into the great depression. It was much more common for individuals to participate in a single stock or a handful of stocks and, Hey, guess from the 28, 29 period, all the way through World War II, it was a tough time in the market, and yes, to your point, Brandon people did realize that, Hey, don't put your eggs in one basket. Diversification is effectively the one true free lunch out there, if you will, if you want to call it that. And so yes, diversification has all sorts of other benefits that drove the innovation and adoption of these commingled vehicles. The other piece with respect to mutual funds and then we'll jump into exchange traded funds, which are very similar, but they have some nuances. The interesting thing about mutual funds is they don't trade throughout the day. So like a stock you can buy at any time during market hours, so market hours being 9:30 Eastern time up to 4:00 PM Eastern time, you can go in and buy and sell us a share of Apple at any point in time throughout that day.
Justin Dyer (09:13):
Mutual funds, you put in an order, you say, I want to buy $10,000 of this mutual fund, that actually doesn't happen until the close of the day. And so you get one price, it's called the net asset value, whether you're buying or selling, so it's an interesting distinction there. ETFs, exchange traded funds, a lot of innovations happening here and kind of much more of a new vehicle. I mean they've still been around for quite some time, multi decades in most cases, but there's been an infusion of new ETFs available really in the last 10 years, and you're even seeing an acceleration further over the last two, three years even. An exchange traded fund, it's a pooled vehicle just like a mutual fund is.
Justin Dyer (10:00):
For the sake of our conversation, we'll just summarize one of the key differences really is that it's traded throughout the day, as opposed to the very end of the day. It does bring up some additional benefits with respect to transaction cost as well, which we actually really like that aspect of it, whether it trades throughout the day versus the end of the day, for a long term investor, doesn't really matter all that much if you're buying something for the long term if you can buy it at 10:00 AM in the morning versus 4:00 PM in the afternoon, shouldn't really matter or be all that material to you. And that's kind of what our general take on it is.
Justin Dyer (10:46):
And really what's been changing with respect to ETFs from a reputational standpoint, is that traditionally they've always been these cheap index focused product. So like Vanguard or an S&P 500 ETF, iShares is a big ETF provider as well. The original ETF was launched, I think it's the original ETF, I shouldn't say that definitively, but State Street actually launched their spider, it's called S&P depository receipts is actually what that stands for, launched those, I want to say 30 years ago or so. And that was the first real popular large scale ETF, and iShares going back to there have really benefited BlackRock, which is the parent company that owns iShares and just recently BlackRock released their earnings, and largely because of iShares, their ETF business, they now sit over $10 trillion of assets under management which is an insanely large amount of money but really on the back and the success of their iShares business.
Brandon Averill (11:52):
I'm glad you hit on the reputation there, Justin, because I think this is a really good point to make it because if we hear it all the time is, people have strong feelings about mutual funds or ETFs. And I think they come into it with that reputation of mind that mutual funds are expensive and oftentimes actively traded meaning that there is a manager there that's trying to read the tea leaves and make predictions. And I would say that might have historically been correct but what we've seen certainly over the last number of years is, that's completely changed. And I think same on the ETF side, I think one of the key takeaways we'll hit on at the end is the devils in the details and all of these I would say that's true. And it's no longer such a simple distinction. There are a lot of mutual funds out there that are managed fairly tax efficiently, they're super cheap, they're index-based, and they're really good vehicles for investors to have in their portfolio. And on the other side, ETFs, there are actively traded very expensive ETFs out there now.
Brandon Averill (13:08):
So really these are just wrappers and there are nuances, but they really are just vehicles. And I think blindly saying, "I'm going to go buy an ETF because it's cheap," you better look to see what the expense ratio is. I mean, we've seen a number of portfolios that people think that they're getting one thing and it's something completely else. So yeah, I just think it's really for people to know that and that you do need to look inside to see what you're actually buying, and that mutual funds aren't bad or good, ETFs aren't bad or good, you really just need to evaluate the individual characteristics of each of them to determine what fits in your portfolio more effectively.
Justin Dyer (13:53):
Yeah, that's a great point. And there is really a convergence between mutual funds and ETFs and the available strategies within each vehicle or within each type. But to your point, the devil really is in the details. You need to dig into it, speak with your advisor, really understand how it operates, what it does. This is getting a little bit into the derivatives side of things which, derivatives are another vehicle I'm jumping ahead a little bit, but it's another vehicle but you can actually have derivatives within a fund structure. And some people see a fund, ETF or mutual fund, that says S&P 2X return or something like that. And that fund is basically holding the S&P, but it's using these derivatives to turbocharge the exposure. And then the nuance there, and I'm totally not sticking with our plan to keep it high level, but I want to make this comment.
Justin Dyer (14:59):
The nuance there is, what actually generally happens in those vehicles is they reset the portfolio on a daily basis and the performance ends up being completely different than what people understand as just the simple marketing name of there's, oh, I'm going to get two times the S&P 500 return. And again, devil's into detail, sorry to go a little in the weeds there, but it's very true.
Brandon Averill (15:22):
I'll keep us off tangent. It's almost never the case too. You're always short that 2X, they very rarely get that right. And then B is, if anybody wants the cheat coded derivatives, and I know we're going to hit on this a little bit, but go queue up the big short, it's entertaining to watch and you can see the impact of derivatives when they spin out control.
Justin Dyer (15:46):
Right.
Brandon Averill (15:46):
So derivatives are just contracts and they can certainly introduce an element of risk, we saw that with Robinhood last year. Everybody thought they owned crypto and they quickly found out, oh, actually Robinhood you don't actually own the crypto. It was Robinhood, right? Yeah. You don't own the crypto. You own a derivative or a contract on the crypto. So anyways, we can get back to [inaudible 00:16:08] but-
Justin Dyer (16:08):
So one more pool vehicle that I think is pretty important to touch on, there's the private side of things as well, but one more pooled vehicle that really touches on more of the public side is the term hedge fund. Hedge funds also have been around for quite some time, I want to say very similar to mutual funds. Traditionally speaking, they were... What the term actually implies is, people out there wanted to hedge their risk, hedge their exposure to the broader equity markets, S&P 500 Dow Jones, industrial average, whatever the case may be. And so what they would do is they would put some sort of hedge in place, and I'm not going to go into what that might exactly mean, but just essentially think about, they wanted to protect some of their downside or protect some of their gains. And that really started the hedge fund industry. Fast forward to today, a hedge fund, the term hedge funds does not necessarily represent a single strategy whatsoever.
Justin Dyer (17:11):
Really the simple kind of definition or explanation I would give to that is, it's a commingled vehicle. It's a commingled fund. There are some that trade publicly with some restrictions, generally speaking, but they do trade on public markets where you can buy and sell them. But they're generally riskier and, or uncorrelated with the overall market. You're taking a lot of what's called manager risk so you're basically, instead of saying, "Hey, I want to participate in the growth and the power of markets overall and what they have done over the long term," you're saying, "No, I'm actually more putting my risk stacking my risk and hoping I'm being compensated for the risk, or the weight I'm putting in this manager skill to hopefully outperform." Data doesn't really support it, a little teaser there, and the data is kind of weak with respect to them. But they are out there, they've been around for some time. It's a very nebulous term and there's no one size fits all definition. You can see so many different strategies within that broad classification.
Justin Dyer (18:27):
And again, it can be a publicly traded vehicle, meaning you can go buy it within an exchange, or it could be more of a private fund type structure, which is another aspect and we can touch on that. And Brandon, maybe you can jump into the private side of the marketplace.
Brandon Averill (18:44):
Yeah, I was going to say, that's a great transition because most of what we've been talking about, purchasing individual stocks, individual bonds, those can be done on the public and private, but we talked about them mostly in the public sphere. So public, again, meaning that access, we can all log on to a computer, we can get access to these different exchanges where these companies trade public-
Justin Dyer (19:09):
And highly regulated.
Brandon Averill (19:11):
Exactly. These co-mingle funds trade publicly and almost everybody has access to them. They're highly regulated. And this is where we've talked about in the past. We'll talk about a lot more in the future, on that public side, all information is available to everybody. There is no information advantage. If you want to seek out that information it is available, and what we know is that markets do reflect all available information and so there's very strong evidence of that. But kind of as we work down the structure standpoint and get beyond the commingled funds, all these types of vehicles exist in the private markets as well. But with the private markets, not nearly as regulated, although they're starting to try to do a little bit more of that, but this is really where private companies don't have to share their information with everybody. And so you can have the same relationships, you can go buy ownership or stock in privately traded companies. You can go lend money to privately traded companies as well. But the information flow, it's not as available.
Brandon Averill (20:28):
So it really is who you know, what your access is, how willing the company is to actually reveal that information to you. There are private investments we made that we have a lot of information on, and if other people called up the company, they're not going to give them that information. So theoretically, we might be able to arrive at a better price. There are companies that we don't have access to that information and other people do. They're going to know more about that. So as we move through, if you go buy the stock individually, you go lend the money individually that's what the private industry refers to as directs. Meaning that you're directly going to those companies and entering into an arrangement with them.
Brandon Averill (21:16):
And then there's the co-mingled side. And this is where it's pretty simply just access to funds. These are typically run by venture capital companies. So there'll be a general partner that's running these funds or private equity groups that are running these funds. So what a fund does is the same concept, it's going to then, you're giving your money to a manager that manager now is going to go out to the market and buy direct allocations to different companies or lend to different companies. And those get aggregated. And you as the investor now get broader diversification to a pool of investments as opposed to trying to figure out, Hey, this is the one direct opportunity that I want- [crosstalk 00:22:04].
Justin Dyer (22:04):
And I would say there's an important distinction too in size. So there was a headline today or yesterday, I can't remember when I saw it, about Blackstone big private equity group. They have a record war chest on hand and they're on the search for deals here. And that is, they have so much capital, they're not going to go put that into small startup companies. They play in a specific area of the market, private equity, maybe they're trying to buy out large companies that they feel like they can improve management on or something like that where, to your point on the venture capital side, or as you reference venture capital, they're a little bit more nimble writing smaller check sizes to these startups to get the business really off the ground, higher risk, higher return, but interesting tie back to kind of maybe some names you'll see in the news. Blackstone, big private equity group, Anderson Horowitz is a big venture capital firm, they were in the news 2-3 weeks ago with a big crypto fund, venture fund, that they're trying to raise, but these funds are generally on the venture side a lot smaller than they are on the private equity side, kind of for logical reasons.
Brandon Averill (23:20):
Yeah. And they certainly get a lot of the headlines, because it's again, going back to your comment, I mean the expected return for these vehicles better be high because you're taking a significant amount of risk they also generate a lot of the headlines. And I know we certainly, that'll be the next step is to get into. Well, the next step is, okay, we've kind of gone over some of these high level things, but how do we actually get access to them? Okay, we'll talk about how do you actually buy a stock on the public stock market? How do you buy a bond on the public bond market? If I did want to participate in private, how do I go about doing that? We'll get into all that in a future episode.
Brandon Averill (24:05):
But we are definitely going to take a deviation next week, and I think we can riff on this a little bit too to tease that out. But I'll ask you Justin, we've heard blockchain and crypto and NFTs and this whole world going on, how does this play in? I mean, I think last week we pretty much put to bed the idea that these are investments because most of them we don't have any way of figuring out future cash flows and coming up with a price, but they are, I would say that's probably too simplistic of a look, to be honest. I'm just kind of curious from your perspective and I guess I'll cut to the chase. We're going to do an NFT episode next week because the flood of questions we've been getting and it was definitely requested by a good friend of ours. I'm sure he's listening right now, so it's coming. But how does it tie into just the market, Justin, and access to these things and what's the vehicle and maybe just give a two second highlight because we're going to get deep into it next week.
Justin Dyer (25:09):
Yeah. And I think I'd go back to really what we've hit on a couple times and I think is even the summary of this episode is that the devils really are in the details, especially with respect to let's call it web three, which is a still, I think still to be defined term. I mean people are using it really broadly speaking for NFTs, crypto, blockchain, defi, all these terms that are being thrown out or kind of being aggregated into this web three topic. But the devils truly are in the details. There's a lot of around cryptocurrency specifically and a lot of people that are taking advantage. I think the jury is definitely still out on what a cryptocurrency is. It's not an investment at this point and not saying that in a bad way, it's a speculative journey I guess if you will, that you're leaping into if you're participating in that.
Justin Dyer (26:11):
There's some arguments about what, let's say, Bitcoin is or isn't, and again, I think the jury's still completely out on that. Just a quick kind of teaser on that again, and I'm not giving you a short answer, but I'm trying to tease this stuff out where everyone said, oh, Bitcoin's going to be a great inflation hedge. Well guess what, that's argument's going to shot in its foot. Doesn't mean it will or won't in the future, but it certainly isn't right now. NFTs, I mean this one really is in the details and we will get into this. It's really hard to know what you actually own. There's a ton of, again, using the term hype, that's driving excitement, but I don't really think people understand the underlying technology quite well, understand the efficiency, understand the cost of this entire space.
Justin Dyer (27:06):
There's a lot of work to make it more efficient to make it better understandable. But boy, I did a deep dive on the technical front of it a week or so ago, and will tie into some of those topics when we dive into it ourselves. And there's a lot of work that needs to happen to, I think, catch reality up to what people think is actually truly going on and what people think they're getting and why they're spending in some cases, ridiculous amounts of money on pictures of gorillas.
Brandon Averill (27:42):
Well, I think the other thing is to be fair, and we'll get into this aspect too, is conceptually-
Justin Dyer (27:46):
Or apes, sorry.
Brandon Averill (27:46):
... there's some really, yeah, really cool potential applications of it too. It's a shift to creators actually getting compensated in the right way. And I think that's why this is getting traction. And so I think it will catch up. I think we can confidently say that, trying to predict which one and all that's going to be really difficult as with that, anything. But, well, we'll cut it off there, we'll jump into this next week. We got a lot of work to do to make sure that we can distill down at least our take into a nice little succinct episode and at least generate some insight for everybody that does take the time to listen.
Brandon Averill (28:35):
But we'll close out today. Hopefully this was helpful. Just given a landscape of how do you actually go or what do you actually go buy when you're ready to invest your money? And we'll take a deviation next week on NFTs, but then we'll jump back in with, okay, great, we know what to buy now, how do we actually go buy it? Where do we actually go buy it? But until then, head over to awminsights.com, couple downloadable resources as you all know. We would love to know your thoughts, you can drop us a note, give us feedback, that'd be great. But until next time, own your wealth, make an impact and always be a pro.