Mutual Funds, ETFs and Closed-End Funds: A Primer

April 3, 2017

There are over 9,500 mutual funds, 1,500 ETFs and 500 closed-ends funds available for U.S. investors to choose from.  These vehicles cut across numerous asset classes – equities, fixed income, commodities – and across both broad market exposure (ie S&P 500) to very narrow strategies (from Cyber Security to the Peru stock market.)  Many of these strategies are offered on both a passive or actively managed basis with a wide dispersion of fees and expenses between them.

 

The three most common fund structures are open end mutual funds, closed end funds (CEFs), and exchange traded funds (ETFs). There are other types, such as exchange traded notes (ETNs) and unit investment trusts (UITs) which do not have as many assets and we won’t discuss here.

 

Mutual funds are still the most popular investment vehicle and hold the most assets.  Investors, however, have moved a significant amount to assets from active mutual funds to lower cost ETFs in the past few years due to the majority of actively managed strategies failing to beat their respective benchmarks.

 

 

 

Mutual funds

 

Open end mutual funds are well known and have been around for quite some time (think Fidelity, Janus, and Franklin Templeton as examples.) These funds allow the investor to buy or sell (redeem) shares invested in a portfolio of securities at a fixed Net Asset Value (NAV) at the close of the US market at 4pm each day. The fund may issue new shares if there are more purchases than sales and may liquidate shares if there is more sale than purchases each day. Many custodians may require prior notice earlier but the fund company tallies up their redemptions and purchases at the end of the day, determine a price for the shares based on closing prices (less frequently traded instruments may be “priced” by an evaluator) and if necessary buy or sell securities during the same trading day as they get indications or the next day if more cash is necessary to meet redemptions. The requirement of meeting redemptions each day means a fund manager is likely to need to keep a cash cushion to meet redemptions.  This process also means a fund can have a lot of turnover merely to meet cash needs which makes managing a fund in a tax efficient manner difficult. There are both actively and indexed products available and underlying fees vary quite a bit depending on many factors.

 

If you trade infrequently, are a long term investor and believe in the efficiencies (and potential for alpha) in the underlying strategy, mutual funds may be the best option. This could be especially true if you are holding the positions in tax deferred accounts such as an IRA or 401k. Remember, mutual fund fees can be very low for passive index strategies or high for active strategies which can eat into returns.

 

ETFs

 

Exchange traded funds (ETFs) have only been around for about 25 years but have gathered a lot of assets, especially in the past few years. Originally these funds were meant to track broad indices but their popularity has led them to branch out into narrower investment niches. ETFs trade on exchanges continuously during the day, and have a creation and redemption process that attempts to keep the funds’ NAV at or close to the market price and to allow third parties that make markets to create and redeem units throughout the trading day if necessary. These third party traders try to match orders on the exchanges to meet buys and sells, or, if there is a mismatch between market prices and NAV, will either create units by delivering positions to a fund in exchange for new shares, or buying underlying assets from the fund and selling shares back to the fund to redeem shares. This process by “authorized participants” not only helps smooth the market but also allows the ETF to keep low cash levels to better track its index, and to operate in a more tax efficient manner.  Fees can vary depending on the product but are generally lower than mutual funds or closed end funds.

 

Closed-End Funds

 

Closed-end funds issue shares in the new issue market and have a fixed number of shares outstanding. Their prices versus the underlying value can often diverge as there is no formal mechanism for keeping the two prices in line.  As a result, CEFs can trade at large discounts to their underlying net asset value. The discounts and issuance of new CEFs can offer investors a way to invest into a fund at a discount with potential appreciation if only the fund trades up to their NAV at some point in the future.

 Frequently these funds offer higher distributions due to the use of leverage or the funds’ ability to pay managed distributions from sources other than income such as capital gains and return of capital. These factors make closed-end funds more complicated to evaluate but can often offer investors a unique way to access the markets.  Many of these strategies offer higher yields than other fund structures and so therefore can provide a steady cash flow for investors where appropriate.   It should also be noted that fund expenses on these types of funds can be above average given their use of leverage and active management.

 

Each of the fund structures just described, mutual funds, ETFs and CEFs, each have their pros and cons with many factors to consider including the type of investment account (taxable or retirement), tolerance for risk, views on the efficiency of the asset class, need for cash flow and time horizon.  Many investors would be best off choosing a mix of these vehicles depending on each person’s circumstances and the underlying investment strategy the vehicle invests in.  Ultimately, this is the role that portfolio construction plays in concert with the investor’s financial goals.

 

 

 

 

 

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