Types Of Mutual Funds

A mutual fund is quite simply an investment company where thousands of small individual investors can pool their resources and own a share of a diversified, professionally-managed investment portfolio that might otherwise be beyond their means.  Strictly speaking, there are two fundamental types of mutual funds:  open-ended mutual funds and closed-ended mutual funds.  That said, it is sometimes useful further divide these fundamental types of mutual funds into more descriptive categories.

Types Of Mutual Funds

Open-Ended Mutual Funds

Open-ended mutual funds are what most people think of when they think of mutual funds, much more-so than the other types of mutual funds..  Their distinguishing characteristic is that they have no set limit on the number of shares outstanding.  When you buy an open-ended mutual fund, new fund shares are created by the fund company on your behalf.  Similarly, when you sell shares the money goes back to the fund company and you are paid out of the community pot.

Open-ended mutual funds can only be traded once per day, after the market has closed for the day.  When you make a buy or sell order, you won’t actually know what price you will get until an hour or so after the market closes.  The transaction price is always the closing Net Asset Value (NAV) of the fund for the day i.e. the weighted average cost of the underlying securities.

There are two primary subtypes of open-ended mutual funds:  index funds and actively-managed funds.

• Index Funds are passively-managed, meaning they simply track an un-managed basket of stocks meant to represent a particular market segment.  Index funds exist to track the entire U.S. Stock Market (VTSMX) and entire WORLD market (VTWSX) all the way down to narrow market segments such as Real Estate Investment Trusts.  Since index funds simply attempt to track the market and not beat it, overhead costs are extraordinarily (they don’t need to employee expensive analysts or hot-shot fund managers).  Vanguard index funds are generally the largest, least-expensive index funds around, although smaller competitors have been steadily gaining ground (Dimensional Fund Advisors is one such competitor).
• Actively-Managed Funds are managed by a manager who actively attempts to earn above-average investment returns by making strategic buy and sell decisions.  Since this type of investing strategy is very labor-intensive, overhead costs are generally quite high.  There are company analysts, economists, researchers, and fund managers to hire.  Hence, actively-managed funds start out at an immediate disadvantage since the manager has to outperform the index by the amount of its hefty expense ratio just to break even.  One additional unwanted by-product of this strategy is more-frequent realization of capital gains, leading to higher tax obligations. For these reasons and more, I favor index funds.

Closed-Ended Mutual Funds

Closed-ended mutual funds are among the rarest types of mutual funds these days.  Once quite prevalent, they have mostly been relegated to a niche market for sophisticated players.  Unlike open-ended funds, closed-ended funds have a set number of shares outstanding and their market price at any given point in time has as much to do with supply and demand for these shares as with the underlying holdings.  It is not uncommon for closed-ended funds to trade at prices significantly higher or lower (usually lower) and the value of their underlying assets.

Closed-ended funds can be bought and sold throughout the day and are almost always actively-managed.  Since their prices sometimes differ dramatically from NAV, the occasional great deal can be found in this segment of the market.  Usually, however, investors are better off with an open-ended fund.

Exchange Traded Funds (ETFs)

Exchange traded funds (ETFs) are basically modern closed-ended funds in that the have a fixed number of shares outstanding and are traded throughout the day;  however, most ETFs are index funds under the hood (although actively-managed ETFs are on the horizon).  Because they don’t have to deal with investor redemptions and other such issues, ETFs are generally more tax-efficient than comparable open-ended index funds (with a few exceptions).  They also generally sport lower expense ratios, which is a significant advantage.