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Many actively-managed funds have been criticized for failing to beat the market.
The Zions Direct investment center consists of 13 licensed representatives who together take thousands of phone calls every month from individual investors. While each of these calls is unique, each month lends itself to over-arching themes patched together by common concerns. This piece is intended to answer some of the more reoccurring questions my colleagues and I have heard over the previous month. In April, we had concerns regarding how interest rates affect the trading price of a preferred stock and also the difference between managed funds and index funds.
Question 1: How is the market price of preferred stock influenced by market rates?
A preferred stock is issued at a fixed face value, usually $25, which is also the redemption price if the issuing firm calls the stock. Prior to a potential call though, the price of the security will often fluctuate above and below the face value. A major influence on the price is the interest rate environment: as general market interest rates rise, the market price of the preferred stock can be expected to fall; and as general market interest rates drop, the market price of the stock can be expected to rise. This is known as interest rate risk.
As an example, let's assume a preferred stock is issued at $25 with an annual dividend yield of 4%. Based on the concept of interest rate risk, when the market interest rate rises to 5%, the price of the stock will drop to $24.75, compensating the buyer with an unrealized capital gain for accepting a lower dividend yield. However if the general market interest rate drops to 3%, the price will adjust to $25.25, forcing the buyer to pay more for a higher rate.
Of course, interest rates are not the only influence on the price. Another major consideration for preferred stockholders is the firm's ability to pay (credit risk). Investors should remember that preferred stock is an equity security and junior to all debt.
Question 2: What is the difference between an actively-managed fund and an index fund?
There are many decisions to be made when selecting a mutual fund, one of which may be selecting between an actively-managed fund and an index fund. In an actively-managed fund, a portfolio manager trades securities in efforts to beat a certain benchmark, such as the S&P. Conversely, an index fund buys shares of each stock in a certain benchmark, and allows the earnings of the fund to rise and fall with the market.
The advantage to owning a managed fund is the potential to beat the market. The fund manager actively seeks inefficiencies in the market and places trades he or she believes will be favorable to the fund. These managers must be paid for this service though, and therefore the expense ratios can be higher for managed funds. Many actively-managed funds have been criticized for failing to beat the market, and because of this, many investors select to invest in index funds. Index funds traditionally have low-expense ratios and in the long-term may produce enough of a return to satisfy many investors' required rates of return. Of course, every investor has different needs, and there are many aspects to consider when selecting funds such as your risk tolerance, liquidity needs and time horizon, among others.
Investment products and services offered through Zions Direct, member of FINRA/SIPC.
Investment Products: Not FDIC Insured • No Bank Guarantee • May Lose ValueSavannah Wade is a registered representative of Zions Direct. Zions Direct is a wholly owned non-bank subsidiary of Zions Bank