When you think of investing, you may be more familiar with stocks and bonds. Another type of investment vehicle that you may not be as familiar with is derivatives. While all investing in the stock market comes with inherent risk, some types of investments tend to be riskier than others. Derivatives fall into that camp.
What is a derivative?
Derivatives are a contract that has a value that’s derived from an underlying asset or index – hence the name “derivative.” One example of a type of derivative are options because its value changes in relation to the price movement of the underlying stock.
There are two types of derivatives: over-the-counter derivatives, which are negotiated privately, as well as standardized derivatives that can be traded on a standardized exchange. Over-the-counter derivatives, also known as OTC derivatives, are well-known to have caused the Great Recession by creating heightened demand for underlying assets like mortgages.
The start of the derivatives market began in 1865 when farmers and grain sellers came together to hedge risk against the corn market. These derivatives were used as part of hedging and speculating to lower risk, which can cause inflated prices that are subject to manipulation and fraud. These types of derivatives have been referred to as futures contracts, which we’ll cover later.
“Derivatives are unlike securities in that they are more of a bet than an investment. Most common derivative contracts have an expiration date, which means a limited time for them to achieve a profit,” explains Asher Rogovy, an SEC registered investment advisor and chief investment officer at Magnifina.
“Securities, on the other hand, are either perpetual or repayable, so investors can simply hold them for the long-term. The key benefit of derivatives over securities is leverage. If a trader has conviction about a price move within a certain time frame, they can gain a much higher profit by trading derivatives instead of the underlying security. Of course, with this higher profit potential, comes higher risk.”
Types of derivative contracts
Derivatives can be complicated as there are various different types of derivative contracts. Some common types of derivatives include:
Options – this type of derivative allows the investor the option to buy or sell a security at a set price with a specific timeframe. If you purchase a “call option” you get the right to purchase shares at a later date. A “put option” offers you the ability to sell shares at a later date.
Swaps – The United States Security Exchange Commission (SEC) states that “Swaps are financial contracts in which two counterparties agree to exchange or “swap” payments with each other as a result of such things as changes in a stock price, interest rate, or commodity price.”
Futures – this is an arrangement where an investor can purchase or sell a set amount of a specific commodity at a set price at a future date. Future contracts are available to trade on an standardized exchange and are settled each day and can be purchased or sold off at any time.
Forwards – forward contracts are very similar to futures contracts in that it is an arrangement to buy or sell a commodity at a set price, at a set time in the future. But it’s important to note that forward contracts are not traded on an exchange.
Derivative contracts can be traded either over-the-counter (OTC) or on exchanges such as the Chicago Mercantile Exchange Group (CME Group) or the Korea Exchange.
How do derivatives work?
Derivatives can be used in a variety of ways to hedge against risk or used as speculative tools. As a financial instrument, the value of derivative transactions are at the mercy of market conditions such as credit, equity, and interest rates.
According to the San José State University Department of Economics, derivatives and swaps play an important role in the economy by transferring risk. The risk is transferred to other parties who are willing to take it on for a fee. In this way, derivatives are similar to the insurance industry where you hedge against risks such as the price of a stock dropping. But instead of it being called “insuring” it’s known as hedging.
You can hedge against risk with derivative contracts by purchasing a contract that has a value that will help offset any other losses you may have in other positions. Through hedging, investors strive to lower their risk of loss by having positions in the market that are opposite in order to minimize risk. Derivative contracts are arrangements between two entities – often referred to as a “counterparty” – that work together to reduce risk on their overall investment and the underlying asset.
Derivatives can also be used as a leveraging tool. In investing, leverage is when an investor maximizes the use of money that is borrowed to try and maximize profit. While this strategy can boost profits, it can also increase risk as well.
Speculation is a strategy where investors buy a type of asset like derivatives and speculate that the price will shift in the future. Given its name, this is more speculation than hard data. The investor using this strategy hopes to maximize profits but like the term suggests, it’s all speculative and can be very risky.
Pros and cons of derivatives
If you’re thinking of investing in derivatives, review the pros and cons first before getting started. This type of investment can have more moving parts and considerations as there is a counterparty and is based on underlying assets.
Lower exposure to risk by purchasing assets in a different position to minimize loss
Can be very risky for everyday investors
Get access to new markets
Derivatives are more complicated and can be difficult to understand
Use leverage to maximize profits
Potential for counterparty default
The financial takeaway
Derivatives are another investment tool that’s used to minimize risk while maximizing profits. It’s a complex financial vehicle that deals with assets that can shift in value but also provide opportunities to hedge against risk and use leverage to gain profits. It’s important to note that derivatives can be fraught with risk and the potential for fraud.
“Derivatives aren’t for beginner or casual investors. Because they are essentially bets, Wall Street does a very good job of making sure they are accurately priced,” notes Rogovy. “Because derivatives tend to expire, there’s less margin for error. With securities, some bad trades may be salvaged by holding for the long-term. Inexperienced traders are notorious for losing significant amounts of capital on risky stock option bets.”
Looking to maximize your money and beat the cost of inflation? You want to invest in the stock market to get higher returns than your average savings account. But learning how to invest in stocks can be daunting for someone just getting started.
When you invest in stocks, you’re purchasing a share of a company. They’re basically a slice of ownership in a company that can yield returns if it’s successful. There are various ways to invest and leverage your money. But there’s a lot to know before you get started investing in stocks.
Step 1: Figure out your goals
It’s important to know what your fundamental goals are and why you want to start investing in the first place. Knowing this will help you to set clear goals to work toward. This is a crucial first step to take when you’re looking to create an investing strategy later on.
If you’re unsure of your goals, first review your financial situation, such as how much debt you have, your after-tax income, and expected retirement goal date. Knowing when you plan to retire can let you know your overall time horizon – or how much time you plan to hold onto your investments to reach your financial goal.
Based on that information, you can start figuring out your investing goals. Do you want to invest for the short or long term? Are you saving for a down payment on a house? Or are you trying to build your nest egg for retirement? All of these situations will affect how much – and how aggressively – to invest.
Finally, investing, like life, is inherently risky And you can lose money as easily as you can earn it. For your financial and mental wellbeing, you want to consider your appetite for risk. This is typically referred to as “risk tolerance” or how much risk you can reasonably take on given your financial situation and feelings about risk.
Step 2: Determine your budget
Once you’ve got some solid goals set, it’s time to review your budget. Here are some things to consider:
Your current after-tax income. Many people look at their pre-tax income, but you want to know how much money you’re working with after taxes which can help you create a realistic budget.
Your expenses. How much are your monthly expenses? How much do you have leftover each month? Is it possible to reduce or cut some expenses?
Overall debt. How much debt do you currently have? List out your monthly payments and compare that against what you’re making.
Net worth. Your net worth is your total assets minus your liabilities. This number can give you an idea of where you’re at financially and will allow you to get a “big-picture” snapshot of your financial health.
Financial goals. As we mentioned before, knowing your goals is important as it gives your money a purpose.
Risk tolerance. How much risk do you feel comfortable taking on? Calculating this will give you a clearer idea of what you can afford to lose.
Time horizon. How much time do you have before you want to reach your investing goals? This is key to mapping out your finances to ensure you’re keeping pace with when and how to invest without disrupting your budget or other goals not related to trading securities.
All of these are key ingredients that can help you determine your budget.
One last thing to consider: when you expect to retire. For example, if you have 30 years to save for retirement, you can use a retirement calculator to assess how much you might need and how much you should save each month. When setting a budget, make sure you can afford it and that it is helping you reach your goals.
Step 3: Get acquainted with various stocks and funds
Now it’s time to start doing research on what to invest in. There are different ways to invest in the stock market and there’s a lot to know so doing your research is well worth your time.
Stocks are a good option to consider if you want to invest in specific companies. Just keep in mind that you should look into the company itself and how it’s performing over time:
Stocks – A stock is a security that gives stockholders the opportunity to buy a fractional share of ownership in a particular company. There are many different types of stocks to choose from, such as blue-chip stocks, growth stocks, and penny stocks, so make sure you understand your options, what they offer, and what matches with your budget and investing goals.
“If you’re going to pick a stock, look at the [company’s] financial statements and select the stock based on the “bucket” you’re trying to fill in your portfolio. For example, are you looking for a dividend stock? Look at the dividend history. Are you looking for a growth stock? Look at the earnings per share: Is it showing consistent growth? [Consider] how these indicators measure against [its] peer group,” says Amy Irvine, a certified financial planner at Rooted Planning Group.
So you want to take steps to look at your income and expense balance sheets and make sure you’re hitting the right bucket – which refers to the grouping of related assets or categories – for your investing needs. For example, investing in small-cap, mid-cap, or large-cap stocks, are a way to invest in different-sized companies with varying market capitalizations and degrees of risk.
If you’re looking to go the DIY route or want the option to have your securities professionally managed, you can consider ETFs, mutual funds, or index funds:
Exchange-traded funds (ETFs) – ETFs are a type of exchange-traded investment product that must register with the SEC and allows investors to pool money and invest in stocks, bonds, or assets that are traded on the US stock exchange. There are two types of ETFs: Index-based ETFs and actively managed ETFs. Index-based ETFs track a particular securities index like the S&P 500 and invest in those securities contained within that index. Actively managed ETFs aren’t based on an index and instead aim to achieve an investment objective by investing in a portfolio of securities that will meet that goal and are managed by an advisor.
Mutual funds – this investment vehicle also allows investors to pool their money to invest in various assets, and are similar to some ETFs in that way. However, mutual funds are always actively managed by a fund manager. Most mutual funds fall into one of four main categories: bond funds, money market funds, stock funds, and target-date funds.
Index funds – this type of investment vehicle is a mutual fund that’s designed to track a particular index such as the S&P 500. Index funds invest in stocks or bonds of various companies that are listed on a particular index.
You want to get familiar with the various types of investing vehicles and understand the risks and rewards of each type of security. For example, stocks can be lucrative but also very risky. As we mentioned before, mutual funds are actively managed, whereas index-based ETFs and index funds are passively managed.
This is important to keep in mind because your costs and responsibilities vary depending on an active versus passive approach. Mutual funds are professionally managed and may have higher fees. With ETFs and index funds, you can purchase them yourself and may have lower fees. Having a diverse portfolio can help you prepare for the risk and not have all of your eggs in one basket.
“You can choose to invest in individual stocks, a stock mutual fund, or an ETF. ETFs are somewhat similar to mutual funds in that they invest in many stocks, but trade more similarly to an individual stock,” explains Kenny Senour, certified financial planner at Millennial Wealth Management. “For example, let’s say you open a brokerage account with $1,000. You can use that money to purchase a certain number of shares in ABC Company, the underlying price of which fluctuates while the stock market is open. Or you could choose to invest it in a stock mutual fund, which invests in many different stocks and is priced at the close of each market at the end of the day.”
Step 4: Define your investing strategy
The main things to consider when defining your investment strategy are your time horizon, your financial goals, risk tolerance, tax bracket, and your time constraints. Based on this information, there are two main approaches to investing.
Passive investing – an investing strategy that takes a buy-and-hold approach, passive investing is a way to DIY your investments for maximum efficiency over time. In other words, you can do it yourself instead of working with a professional. A buy-and-hold strategy focuses on buying investments and holding on to them as long as possible. Instead of trying to “time” the market, you focus on “time in the market.”
Active investing – an active approach to investing that requires buying and selling, based on market conditions. You can do this yourself or have a professional manager managing your investments. Active investing takes the opposite approach, hoping to maximize gains by buying and selling more frequently and at specific times.
Step 5: Choose your investing account
After choosing your investment strategy, you want to choose an investing account that can help you get started. Decide if you want to do it yourself or get a professional to help out.
If you want to be a passive investor and DIY, you can look into:
When considering active versus passive investing and if you should DIY it or get a professional, you want to consider several factors. Look at total fees, the time commitment involved and any account minimums as well.
The easiest way for many people to get started with investing is to utilize their employer-sponsored 401(k). Talk to your employer about getting started and see if they’ll match part of your contributions.
The key is to choose an investment account that fits with your budget and investment strategy, open an account, and then submit an initial deposit. Just know that when you submit money, it’s in a cash settlement account and not yet actively invested (I made this mistake when I first started investing!)
Step 6: Manage your portfolio
Now it’s time to start managing your portfolio. So that means buying stocks, ETFs, or index funds with their appropriate codes from your account. That is when your money is actually invested.
But it doesn’t stop there – you also want to continue to add to your portfolio so consider setting up auto-deposits each month. You can also re-invest any earnings or dividends to help build growth over time.
Diversify your portfolio by investing in different types of investment vehicles and industries. A buy-and-hold approach is typically better for beginner investors. It can be tempting to try out day trading, but that can be very risky.
Lastly, you’ll want to rebalance your portfolio at least once a year. As your portfolio grows and dips, your asset allocation – or how much you’ve invested in stocks, bonds, and cash – will have shifted. Rebalancing is basically resetting that to the proportion you want.
“Rebalancing is the practice of periodically selling and buying investments in your underlying portfolio to make sure certain target weights are stable over time. For example, let’s say you are an aggressive investor with 90% of your portfolio in stocks and 10% of your portfolio in bonds. Over time, as stocks and bonds perform differently, those weights will drift,” explains Senour.
“Without periodic rebalancing, your portfolio could become 95% stocks and 5% bonds which may not be in line with your intended financial goals for the account. There’s no “perfect” time frame for rebalancing as some financial professionals suggest doing so every quarter, but conventional wisdom says at a minimum rebalancing at least once per year can make sense.”
Continuing to invest money and rebalance your portfolio periodically will help you keep your investments in good shape.
The financial takeaway
Learning how to invest in stocks can be overwhelming, especially if you’re just getting started. Figuring out your goals and determining a budget are the first steps to take.
After that, get acquainted with various investment vehicles and choose the right ones for your financial goals and risk tolerance.
The key is to get started and be consistent. The best investment strategy is the one you’ll stick with. Just be aware all investing comes with risk and do your research on any related fees.
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Stock options can refer to two very different things. The first is an agreement that can give you the option to buy or sell stock. The second is a form of equity compensation that an employer may offer prospective and current employees.
Here’s what to know about stock options.
What are stock options?
A stock option is an agreement between two parties. When you purchase a stock option, you get the right – but not an obligation – to buy or sell a stock at a specific price within a certain period. If you’re the option seller, you’re required to fulfill the agreement based on the buyer’s decision.
“Stock options allow you to benefit from a change in a company’s stock in a heightened or leveraged manner,” explains Yves-Marc Courtines, a financial planner and principal of Boundless Advice LLC. “The gain may be from an increase or decrease in the stock’s price.”
Several key terms are important to discussing and understanding how options work:
Holders and writers: The option holder purchases the option, and the option writer sells the option.
Exercising an option: The holder exercises an option when they decide to buy or sell the stock.
Expiration date: The end of the potential purchase or sale period.
Premiums: The holder pays the writer a nonrefundable premium for the option. Its value can depend on the expiration date and underlying stock’s expected volatility.
Strike or exercise price: The price that the holder can buy or sell the stock at.
American-style options let the option holder (the buyer) exercise the option at any time before the expiration date. In contrast, you can only exercise European-style options on the expiration date.
Call options versus put options
There are also two types of options: puts and calls.
A call option means the holder can buy the stock at a specific price during a specific period.
A put option means the holder can sell the stock at a specific price during a specific period.
You can buy or sell either type of option.
Is buying stock options risky?
Investing always involves risk, and options trading can be much riskier than buying and holding a company’s stock.
“You can lose all the money you put in when you buy a stock,” says Theresa Morrison, a founding partner at Beckett Collective. “If you buy or sell an option and you don’t know what you’re doing, you could lose the money, your car, and your house.”
Investors can also use options to limit their potential losses. But you might not want to buy or sell options until you understand what you’re getting into.
An example of how stock options work
“If you want to dip your toe in, you could write a covered call,” says Morrison. “It means you own the stock and you write a call, meaning you sell a call.”
For example, you own 500 shares of company XYZ, which trades at $80 a share, and you sell five call option contracts – each contract is for 100 shares. You collect $1.20 in premiums per share and receive $600.
The holder has the right to purchase the 500 shares from you for $85 a share (the strike price) during the next six weeks.
The holder may let the option expire if the stock’s price never goes above $85. But, if it does, the holder can exercise the option, and you’ll lose out on potential gains. In either case, you get to keep the $600.
What are employee stock options?
Employee stock options are a type of employee equity compensation. Companies may offer options as part of a sign-on bonus or retention program.
To draw a comparison, Morrison says, “an employee stock option is always a call option because you have the right, but not the obligation, to buy the company’s shares at a fixed price during a certain period of time.”
Courtines points out that, unlike traded stock options, equity offers are granted rather than purchased. Still, there’s some risk involved. “What you’re giving up is a paycheck,” says Courtines. “Instead, you’re getting an option that could be worth more, but that could also expire worthless.”
You also may have to wait until an option vests before you can exercise it. For example, a portion of your option may vest each year during the first five years in a new job.
Common types of employee equity compensation
Companies can offer two types of stock options – incentive or nonqualified.
Incentive stock options (ISOs): An ISO can offer tax advantages because your profits could be subject to the capital gains tax rate. But they can also trigger the alternative minimum tax (AMT).
Nonqualified stock options (NSOs): Don’t receive a special tax treatment. Your employer may automatically withhold income and payroll taxes. And, you’ll pay ordinary income taxes on the difference between the current fair market value and your exercise price.
There are also other common types of equity compensation, but these aren’t technically options.
Restricted stock units (RSUs): Companies may offer RSUs that you’ll receive based on a vesting schedule or for meeting certain goals. “RSUs look more like a cash bonus,” says Courtines, “and they’ve become the dominant form of incentive compensation.”
Employee stock purchase plans (ESPPs): The company lets you buy its shares at a discount – often 5% to 15%.
What to ask if you’re offered or have equity compensation
Equity compensation programs are a popular way for companies to attract and retain employees. Here are a few suggestions and points to consider if you’re offered or receive equity compensation:
If you receive ISOs, Morrison suggests working with a professional to create an exercise strategy and five-year plan to account for the potential tax implications.
When you’re working at a private company, you may want to hire a financial advisor who can help you determine the value of the options or equity you’re offered.
If you receive RSUs in a private company, ask if they’re restricted by a liquidation event, such as an IPO or merger.
Make sure you accept the options or equity grant – it isn’t always automatic.
You may need to actively exercise your options, or they might expire.
Also, consider how the equity impacts your entire financial position. For example, you may want to immediately sell shares from RSUs and ESPSs and use the proceeds to diversify your portfolio. Otherwise, your income and a large portion of your portfolio may be dependent on the success of a single company.
The financial takeaway
Buying and selling options contracts can be risky and should be approached with caution. But experienced traders can use options in various ways, including to limit their potential losses.
Employee stock options are completely different from options trading, but they can also be complicated. While you don’t risk losing money, there’s a potential opportunity cost to accepting options rather than cash compensation. You’ll also want to carefully consider the tax implications of exercising your options.
We all know that a well-crafted resume is one important part in getting the attention of a hiring manager during the job-application process. It is, after all, a tool that outlines your relevant experiences and qualifications.
In the finance world, a prospectus is a document that serves a similar purpose for investors as a resume does for employers. It provides details about a company, it’s history, and what it’s offering to spark interest and help facilitate more informed decision-making.
The Security and Exchange Commission (SEC) requires companies aiming to offer an investment to the public to file a prospectus. This formal document details an overview of the company’s history and financials, what type of security is being offered and how many shares of it, among other things.
What is a prospectus?
A prospectus is a formal statement that describes the details of a new security being offered to the public. These documents are filed with the SEC for stocks, bonds, and mutual funds, and include key context and information that may help guide an investment decision.
Information on a prospectus may include:
Company history and information about its management team
Financial information, including audited financial statements
The security’s principal value and amount
Whether the offering is public or private
Number of shares offered
How investment proceeds will be used
Bank or financial institution doing the underwriting
A prospectus provides a level of transparency to the public by outlining the company’s background and goals for raising capital. One of the main purposes of a prospectus is to bring attention to a new company and initiate interest in a security with the hopes of raising capital once its securities are made available to buy.
It also details potential risks the company faces, including how long it’s been around, management experience and involvement level, and the market capitalization of the issuer.
Filing a prospectus protects the issuing company from claims that relevant information was not made clear or available. The consequences of including false information in a prospectus are severe: Those responsible for misleading information on a prospectus are subject to both civil and criminal penalties, including fines and potential imprisonment.
However, just because the information is there doesn’t mean investors don’t still have the responsibility to do thorough background research. Interested investors should still evaluate the issuing company’s financial documents to understand exactly how much risk they’re taking on and the likelihood that they’ll eventually be paid back.
Preliminary vs. final prospectus
A prospectus typically comes in two forms: a preliminary prospectus and a final prospectus. It takes time for a complete prospectus to be finalized, and a company typically releases a preliminary prospectus before a final one to gauge investor interest.
A preliminary prospectus is the first iteration of the document, and includes most of the same information that’s required on the final prospectus, except for the number of shares that will be issued and how much they’ll be issued for. This is because a preliminary prospective aims to assess market interest in a certain security, meaning it precedes its official market debut.
The final prospectus is typically filed after a company has issued an IPO, or officially gone public in the market. It includes all of the details of the offering, updated background information on the company, and the number and price of that security’s shares.
How to find and analyze a company’s prospectus
The easiest way to find a company’s prospectus is through EDGAR, a free online database maintained by the SEC. All foreign and domestic companies must file all important corporate information with EDGAR, which is short for Electronic Data Gathering, Analysis, and Retrieval system.
If you’re overwhelmed by the idea of reading a prospectus in its entirety and sifting through the jargon, fear not. because you may not need to read the whole thing to understand what you’re getting into.
However, going through this document can be beneficial, as a prospectus provides a portrait of the investment and a broader understanding of a company’s business objectives and goals. Note that it’s best to assess the document with a skeptical and inquisitive eye.
A financial advisor is the best person to help you cull the information you need as it relates to your investing goals.
The financial takeaway
A prospectus is a formal document that a company files with the SEC to describe a potential investment offering in detail. It includes information about the company’s background and financial position, as well as what investor money will go towards specifically.
A final prospectus is thorough and comprehensive, but should still be supplemented by your own research.
If you’ve avoided mutual funds because of high management fees or how frequently they can be traded, you might benefit from a closer look at the unit investment trust, or UIT.
Like mutual funds, UITs pool investor funds to purchase a series of assets, which are then bundled and offered up as a single unit – making them great for portfolio diversification.
Unlike mutual funds, UITs are designed to be bought and held until a specific maturity date, with extremely limited trading in the meantime. Because of this, the funds tend to be particularly popular with buy-and-hold investors where stability is more highly valued.
As of December 2020, the Investment Company Institute (ICI) reported that there were 4,310 outstanding UITs, representing $77.85 billion invested, so a booming industry awaits the interested investor.
What is a UIT?
A UIT is one of three basic types of investment companies. The other two types of investment companies are open-end funds and closed-end funds, which we’ll cover later.
UITs offer investors a fixed portfolio that can include stocks, bonds, or other securities in the form of redeemable units. They’re public investments that are bought and sold directly through the company issuing them, or through a broker working as an intermediary. Investors can redeem UITs after a set period of time passed, known as the maturity date.
How does a UIT work?
The goal of a UIT is that the passively held assets it contains will provide capital appreciation or dividend income throughout the life of the trust. And while that outcome isn’t guaranteed, UITs are regulated through the Securities and Exchange Commission (SEC), so concerned investors can breathe easier. Every UIT must register through the commission, which then enforces requirements about everything from where the fund can invest to under what circumstances trades can be made.
Money managers select assets for inclusion at the creation of the trust, aiming for securities they think will offer the most capital appreciation over time. They also set the maturity date for the fund, which can be anywhere between 15 months and 30 years. After that, the fund remains largely undisturbed until its maturity date.
A prosperous UIT will earn its investors income in two different ways: in the form of quarterly or monthly dividends throughout the life of a fund, and as capital appreciation when the fund matures. Once your UIT expires, you have the option of taking delivery of the underlying assets into your own brokerage account, reupping into a similar or identical trust, or liquidating your holdings, which would give you the current cash value.
UITs vs. mutual funds
Mutual funds and UITs are similar in that they’re pooled funds overseen by a professional money manager, and are subject to SEC regulation. Here’s how the two assets diverge:
Mutual funds are actively managed and UITs are not: The ability to buy and sell assets within a mutual fund increases the potential for capital gains – and, of course, losses. Since UITs don’t actively trade, fees are lower, and as fixed income investments, their underlying securities do not change except in rare cases like bankruptcy or merger.
Mutual funds and UITs structure dividends differently: While mutual funds are designed to reinvest your dividends, UIT investors can miss out during market upswings, as the latter doesn’t allow for the purchase of additional shares.
UITs have a maturity date, while mutual funds do not: Much like bonds or CDs, UITs have defined lifespans and set metrics to hit before their expiration. This makes UITs, by their nature, a more long-term investment than mutual funds.
Mutual funds and UITs offer different ways to invest: If you have the cash to invest in a mutual fund, you can purchase shares on demand, as their quantity is limitless. But since UITs have a set limit or shares released upon its initial public offering (IPO), you have to invest within that window or be subject to the whims of the secondary market.
Each investment type has its own limits. But by and large, the reason you’d see a portfolio organized as a UIT instead of a mutual fund is to minimize both short-term and long-term expenses.
UITs come with much lower expense ratios and also come with favorable tax terms. Because of the way capital gains taxes are structured, it’s possible to lose money on a mutual fund and pay taxes on gains you never actually appreciated. For example, if the shares were sold right before you got your hands on them, you could find yourself with a shared tax liability for someone else’s capital gains.
But that won’t happen with a UIT. Because the securities are bundled when you place the order and not before, the original value – or cost basis, as it’s termed – is specific to you and can’t burn you down the road.
Who should buy UITs?
UITs have benefits to offer every investor, but they’re particularly compelling for those who aren’t interested in building a portfolio security by security, or who don’t want to pay the high expense ratios on actively managed mutual funds. Plus, the lower buy-ins on UITs make them more accessible for newer investors or those with less capital.
UITs are also quite popular with those at or close to retirement age because they tend to be more stable investment vehicles. While UITs might not have the growth potential of a different asset class, their buy-and-hold strategy is lighter on risk as well. From the very start, you’ll know exactly where you’re invested, how long that investment will last, and roughly how much income you can expect from your investment, all without having to wait to pore over a prospectus.
If you’re looking to join the ranks of UIT investors, these funds can be purchased directly from the issuer, or bought and sold on the stock exchange. Talk to your financial adviser about which UIT might be a match for you and your situation.
The financial takeaway
As an investment, UITs are a different option from mutual funds or closed-end funds that offer a winning combination of low costs, reliability, tax protection, and fairly predictable gains.
There are certain pitfalls, of course, like a lack of flexibility and a potential cap on earnings, since dividends can’t be reinvested. But if you’re nearing retirement or simply trying to stretch a dollar, UITs can prove to be a plum choice for the (semi) conservative investor looking to diversify their portfolio.
Imagine a relatively safe, long-term investment that generates income, allows you to save on taxes, and funds public projects crucial a community.
That’s essentially what happens when you invest in municipal bonds, which allow you to invest in the infrastructure of state and local communities while adding diversity and tax efficiency to your portfolio.
Here’s what you need to know about municipal bonds, from why they’re popular among tax-smart investors to how they can benefit your portfolio.
What are municipal bonds?
A municipal bond, or “muni” for short, is a type of bond issued by a state or municipality to help fund necessary public works projects.
Munis are popular with investors because of their tax advantages. Interest earned on municipal bonds is usually exempt from federal income tax. If you purchase a muni in the state you live, it could also be exempt from state and local taxes. Earning tax-free income is especially attractive to investors in higher tax brackets.
Investors also like the inherent safety of municipal bonds. In most cases, because you are investing in a bond used to help finance infrastructure backed by a local government, you can usually count on getting your principal back at maturity.
How do municipal bonds work?
At its most basic level, a bond is a loan made by an investor to a borrower. Whereas treasury bonds are issued by the US government and corporate bonds are issued by companies, municipal bonds are issued by local and state governments.
State and local governments issue municipal bonds to help pay for a wide range of projects including roads, schools and hospitals. Investors who purchase these bonds lend money to the municipality in return for regular interest payments (usually semiannual) for a set amount of time.
It’s important to pay special attention to the type of account you use to purchase these bonds. In a traditional IRA or 401(k) retirement account, earnings already grow tax-free. Most investors find holding munis in taxable brokerage accounts help make the most of munis’ tax-free status.
In rare cases, municipal bond interest may not be exempt from federal taxes if they are used to fund an activity not qualified for tax-exempt status under IRS rules, like paying pension fund liability. It is usually obvious to you, your broker or your advisor when a muni is not exempt from federal taxes.
Investors who buy and sell municipal bonds may be liable for capital gains tax on profits from those sales or for bonds purchased at a discount price. In addition, if you are subject to the alternative minimum tax, you may be required to pay some taxes on municipal bond interest.
Are municipal bonds safe investments?
Municipal bonds are considered relatively safe investments because they have lower default rates and higher credit ratings than corporate bonds. Plus, many munis are backed by insurance that guarantees payment in the event of a default.
That’s not to say munis are immune from default. For example, during the Puerto Rican debt crisis and the Detroit city bankruptcy, there were several muni bonds that could no longer make payments.
If municipal bonds pique your interest, it’s important to understand credit ratings. There are three major credit ratings agencies – Standard & Poor’s (S&P), Moody’s and Fitch – all of which rate the issuers of municipal bonds based on their ability to meet their financial obligations. This makes it easier for investors to evaluate risk.
Although many munis receive the highest ratings from the agencies, such as AA+ or Aa1, it’s important to remember that ratings can be downgraded during the life of the bond if a municipality’s financial situation changes.
Like all bonds, munis also carry interest rate risk. When interest rates fall, prices for existing bonds paying higher rates will rise. In turn, when interest rates rise, prices on existing bonds paying lower rates will decline. If you hold muni bonds to maturity, price risk is not a factor. You only experience the ups and downs if you are buying and selling muni bonds.
How much will I earn from municipal bonds?
In return for safety and the tax advantages, investment-grade municipal bonds often yield less than their taxable counterparts, such as corporate and government-issued bonds.
High-yield munis, or munis that come from less-creditworthy issuers, can have significantly higher yields than investment-grade munis ,but they come with more investment risk. Investors in high-tax brackets may find that the tax advantages of investing munis help bridge the gap between muni and taxable bond rates.
How to buy municipal bonds
In most cases, you buy and sell municipal bonds through a broker. There are three main ways you can invest in munis:
Individual bonds bought through a broker require you to do your own research and decide whether to buy new issues or bonds sold through the secondary market, where you can buy munis already issued to other investors. You’ll also need to investigate credit risk carefully, since your own portfolio of muni bonds will likely not be as diversified as a mutual fund or ETF.
Municipal bond mutual funds invest in a wide-range of muni bonds, offering investors the diversity they can’t get on their own, while still providing the federal tax advantages on income and in some cases some limited state and local tax breaks. If the upside is instant diversification and professional management, the downside is recurring management fees. You’ll also be subject to capital gains tax when you sell your shares.
Mutual bond ETFs are a good way to invest in a diverse array of municipal bonds. Like mutual funds, income is exempt from federal taxes and some interest earned may also be tax exempt at the state and local level, depending on where you live.
ETFs trade like stocks on the market with prices fluctuating throughout the day, so you may experience more volatility with an ETF than a mutual fund. Like mutual funds, you’ll be subject to capital gains tax when you sell your shares.
Whatever investment you choose, be sure to pay attention to the account you are using to purchase muni bonds. You likely don’t want them as part of your tax-deferred retirement accounts such as traditional IRAs or 401(k)s where you won’t get the full force of the tax exemptions. Better to put them in a taxable brokerage account.
The financial takeaway
Municipal bonds can offer a relatively safe, tax-advantaged way to diversify your fixed-income portfolio. While yields may not be as high as taxable bonds, the tax exemptions on interest earned can help even the playing field. Investors in high-tax brackets looking to diversify their taxable investment accounts may be best suited to municipal bond investing.
When it comes to investing in the legal marijuana industry, they dont call it the “green rush” for nothing.
Many analysts are projecting massive growth for the cannabis industry. New Frontier, a Washington DC-based cannabis research firm, expects total US legal cannabis sales to exceed $35 billion by 2025.
In light of such tremendous growth potential, many see marijuana as a golden investment opportunity – but not without risk. It’s important to remember that the use and sale of marijuana, despite state laws, is still illegal under federal law.
Here’s what you need to know about investing in the legal cannabis industry, including the risks and challenges, the biggest companies to watch, and why ETFs could be the safest way to add marijuana stocks to your portfolio.
Basics of the cannabis industry
With each election, more states are voting to legalize some form of marijuana use. A total of 36 states have legalized medical marijuana, with 15 states and Washington DC legalizing cannabis for recreational adult use.
Broadly speaking, there are two markets in the marijuana industry: recreational and medical. While each cater to different markets, both represent growth potential. Whereas medical marijuana stocks involve companies dedicated to the medicinal and therapeutic benefits of the drug, recreational cannabis companies cover products for personal enjoyment.
On the medical side, there’s also a growing market for CBD products. CBD, short for cannabidiol, is the legal, non-psychoactive compound found in cannabis plants that’s taken to ease chronic pain, anxiety, and other ailments.
The growing acceptance of cannabis is not just happening in the US, but all over the world. Grandview Research projects that the global market size for the cannabis industry will reach $73.6 billion by 2027.
“Investors have the opportunity to get in on the ground floor of an emerging industry,” says Michael Shea, CFP at Applied Capital, adding that by getting in early, investors could “capture outsized returns as the industry grows and develops.”
Types of marijuana investments
Currently, the medical marijuana market offers strong short-term income potential. But the recreational side continues to attract investors as more states pass legislation.
There are four major categories of marijuana stocks related to different facets of the cannabis industry:
Growers: Companies that own marijuana farms and actively cultivate the plant.
Retailers: This includes dispensaries in states where residents can purchase marijuana and cannabis-related products such as edibles, oils, and more.
Manufacturers: Companies that provide ancillary support to the industry and are involved in cannabis extraction, product preparation, packaging, and labeling.
Drugmakers: Pharmaceutical companies that use biotech to create drugs derived from the cannabis plant.
It should be noted that some companies that are tangentially connected to the marijuana industry may still benefit from its growth. An example would be companies that develop hydroponic technologies, such as GrowGeneration (GRWG).
Risks of investing in marijuana
One of the biggest risks of marijuana investing is that it’s rising popularity makes it a prime target for scam artists. In fact, the SEC has issued a warning that lists several various marijuana-related fraudulent investment schemes including unlicensed sellers, unsolicited investment offers, and market manipulation.
Other risks of investing in marijuana to consider:
Business risk: As long as marijuana is federally illegal, it will continue to be difficult for marijuana companies to open US bank accounts. Sean van der Wal, Managing Partner at Drawing Capital, explains that this not only makes it more difficult to secure funding, but also means that “many marijuana producers rely on cash,” which “poses a significant risk from a liability and accounting perspective.”
Legislative risk: The industry’s growth is tied to legislation. Surprisingly, there’s even some risk involved with the legalization of marijuana. Kenny Polcari, founder and Managing Partner of Kace Capital Advisors, says future taxation is a big question mark. “Right now you can buy marijuana and pay no sales tax.” But “taxes will increase the price of marijuana for the end user.” And, if too high, those added costs could push some consumers away.
Valuation risk: Many of the companies that are involved in producing or selling marijuana are young. What should their valuations be? It’s hard to tell. Polcari warns that “if valuations end up too high as the excitement builds, the potential exists that the market will correct and prices will decline.”
Demand risk: As more companies enter the market, supply could outpace demand for cannabis products. Van der Wal also says that “enthusiasts may be compelled to produce their own product in small batches for personal consumption” as legalization spreads. This could especially be true if high excise taxes are applied to marijuana sales. And, in these ways, he says “analysts may overstate the total addressable market.”
Volatility risk: Marijuana stock prices often swing wildly up and down in short periods of time. This is less likely to be a concern if you plan to hold onto your investments for 10-30 years or more. But if you have a shorter investment horizon, you may want to stay away from volatile investments like marijuana stocks.
How to invest in marijuana
Much like investing in any stock, you’ll need a broker to invest in marijuana. You’ll also want to do your due diligence before choosing investments, which means taking the time to research each company and staying up to date with the latest regulations.
There are two main types of marijuana investments: individual stocks and marijuana ETFs. ETFs allow you to spread your investment among companies across the entire marijuana industry.
If you’re a trader looking to take advantage of short-term price shifts, Polcari says that individual stocks may be the way to go. Otherwise, he prefers ETFs since they don’t require you to pick and choose and run the risk of picking the wrong company.
Some ETFs seek to provide investment results that correspond to an underlying index while others are actively managed. The advantage of index ETFs is that they tend to have lower expense ratios. But actively managed funds may be able respond faster to marijuana stock news – both positive and negative.
The list below of popular marijuana ETFs includes a mixture of actively managed and index options:
Because US marijuana companies are engaged in activities that are illegal on the federal level, there aren’t many publicly-listed US cannabis stocks on major exchanges. By contrast, Canadian cannabis companies – where recreational use of cannabis was legalized in 2018 – are able to list on major stock US exchanges like the Nasdaq and the New York Stock Exchange.
The distinction is important to know because US cannabis companies looking to raise capital are forced to list on the secondary market, or trade over-the-counter (OTC). OTC stocks can be dangerous as they lack public financial records and are often more susceptible to price manipulation.
The good news is that the number of publicly-listed marijuana stocks is growing. As you’re evaluating your options, the first thing to consider is the company’s market cap. The larger the market cap, the better the chance that the company will have the financial stability to survive over the long haul.
Here’s a list marijuana stocks that have a market cap of at least $1 billion:
Marijuana investing isn’t for everyone, especially for retail investors who prefer to minimize risk. But investors with a higher risk tolerance may find that the growth promise of marijuana stocks and ETFs make them a worthy addition to their portfolios.