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Mutual Fund Investments
Many people invest substantial amounts of money in “mutual funds” and “family of funds” and “ETFs” without really understanding how the funds work. So, we present here a primer on Fund Investments to help our clients understand the differences. Such investment vehicles are categorized as Open-End Funds, Closed-End Funds, Hedge Funds, and Exchange-Traded Funds (ETF).
Most mutual funds in the marketplace are Open-End Funds, meaning that there are, generally, no restrictions on the number of shares which are issued or could be redeemed. Typically, the Fund will create or redeem new shares at the end of each trading day to reconcile the Net Asset Value (NAV) of the Fund. Net Asset Value equals the total assets of the Fund less total liabilities.
All investment companies run Open-End Funds and they are readily accessible to investors. In some Funds, the managers actively trade stocks and bonds from certain sectors of the economy or from a cross-section of sectors. In other Funds, referred to as passive funds, the managers allocate holdings to accurately track the makeup of a specific stock index, such as the S&P 500 or the Russell 2000.
Open-End Funds are the easiest to understand, and afford investors opportunities to diversify their investments among many companies and sectors. However, the management fees tend to be high (one percent or more of the fund value) and taxable gains mount up with the constant trading inside the Funds. This results in taxable capital gains for the investor every year.
However, transaction costs are minimal, so Open-End Mutual Funds are good vehicles for making many small deposits over time.
In a Closed-End Fund, the investment company issues a limited number of shares at the beginning, and will issue no more shares for the life of the Fund. Investors can buy and sell only those shares; after the initial sale, each share is available only on the secondary market from the shareholder. Like Open-End Funds, the managers can purchase stocks and bonds across many sectors. However, the price of a Closed-End Fund can deviate significantly from the Net Asset Value of the Fund; the price reflects the Net Asset Value plus (or minus) expectations of its future performance. If the price per unit is less than the Net Asset Value, the Fund is trading at a discount. If the price is more than the Net Asset Value, the Fund is trading at a premium.
Closed-End Funds tend to have a lower expense ratio than Open-End Funds. But, an investor must perform due diligence on Closed-End Funds to determine if the discount or premium on the price is reasonable. This can be difficult for most investors.
On the risky end of the spectrum are Hedge Funds, which are definitely not for the typical investor. These are mostly unregulated, very high risk vehicles which may be offered only to qualified investors with high annual income and liquid assets over $1 million Dollars. Hedge Funds may use investment vehicles featuring riskier strategies, such as short selling, leverage, options, derivatives, distressed securities, et al. Although the potential for unusually high reward exists, Hedge Funds are far too risky for most investors.
Exchange-Traded Funds (ETF) can hold a basket of assets, such as stocks, bonds, commodities, futures contracts, etc., similar to Open-End and Closed-End Funds. But, in an ETF, the fund manager can create or redeem new shares to keep the price close to Net Asset Value, and large institutional investors and market makers can assist in keeping the price stable by transferring amounts of the underlying asset in and out of the ETF. As a result, most ETFs are fairly accurate in representing the price movements of the underlying assets.
For many investors, an ETF provides the most cost-effective opportunity to invest in a particular sector (precious metals, foreign markets, a market index, small-cap companies, specific industries, etc.) rather than trying to build an individual portfolio containing all the investments represented by the ETF. In addition, expense ratios are very low in most ETFs.
ETFs are very flexible investment vehicles. One can easily trade ETFs on the exchanges, making them suitable for most investors. And, more experienced investors may short ETFs or buy and sell options on ETFs. However, unlike Open-End Funds, investments in ETFs usually are subject to trading commissions, so they are appropriate for occasional large investments rather than many small, regular deposits.
This paper was written by Richard J. Power, Attorney and Counselor at Law.
© PowerLaw, PLLC, Counselors at Law, 2010