Mutal Funds, ETFs, Closed End Funds–What’s The Difference?
One key rule in investing is to not put all your eggs in one basket–or all your money in the stock of one company. No matter how great the company, no matter how long it has been in existence or how well known it is, it could fail–case in point: Sears. While Sears has not yet filed for bankruptcy (at the time of this writing), “word on the street” is that it is coming. Sears has been a retailing giant since the 1800’s and sent packages through the mail long before Amazon came into existence.
The problem with buying a large number of investments is that researching them and following them takes too much time, even if you have learned how to do it. Yes, there are investment geeks out there who love reading annual reports, who know what PEG, PE and EPS mean, and who revel in uncovering stocks no one else has heard of, but most of us would rather go to the beach, and outsource the job. Of course investment companies have seen the need and developed products to meet that need. Today we are going to take a look at three types of products you can buy that basically pool your money with that of other investors to buy shares in many companies.
Open-Ended Mutual Funds:
Open-ended mutual funds are still the most common type of pooled investment vehicle, but Exchange Traded Funds are making headway.
With an open-ended mutual fund, a custodial company develops a plan stating the types of things in which it will invest, as well as the long-term goals. This plan, which is described in a Prospectus gives investors some idea of what they are buying–is it stocks, or bonds? Big companies, or little? Is the goal current income or increasing share price? Are people picking the investments or is a computer matching an index?
An initial share value is established and as investors send in money, the fund managers invest it per the prospectus. If the initial share value is $10 and your money gets there the first day, you purchase one share for every $10 you invest. As the purchased investments appreciate (get more valuable) or decrease in value, each share price adjusts proportionately. Every day at the end of the day the NAV or Net Asset Value per share is computed.
With open-ended mutual funds, investors can buy more every day, and new shares are created, priced at the same NAV as the old ones are that day. As more money comes into the fund, the fund managers invest it. If more investors want to withdraw funds than contribute, then the fund managers have to sell assets, whether or not they think doing so at this time is wise. As money comes in, the managers have to invest it per the prospectus–for example, if the prospectus limits cash to 10% of the fund assets then once cash reserves exceed 10%, they have to be invested per the prospectus, regardless of whether the managers believe it is the ideal time to buy those investments.
Open-end mutual funds are the most common investment offered by 401(k) plans. There are thousands of funds with a variety of investing styles and goals. Mutual fund investments are made by dollar amount, not by share amount, and most fund companies require an initial minimum investment.
Exchange-Traded Funds:
Exchange Traded Funds are similar to open-ended mutual funds, except that while mutual funds are valued at the end of the day and everyone who buys and sells shares that day gets the same price, ETFs are valued minute by minute as the value of the owned stocks change. If you buy an ETF for $10 per share in the morning, I may be able to buy the same ETF for $9.00 per share in the afternoon–or it may cost me $11.00.
Because the price of the shares fluctuate throughout the day, ETFs are purchased by shares, not by dollar amounts, so you only need the cost of one share to start an investment. They also can be bought or sold almost instantaneously, depending on your broker, so if you want to time the market, or set stop-loss or limit orders you can. Some brokers charge a commission for buying or selling ETFs, though generally if you purchase directly from the managing company, there is no sales commission.
Closed-End Funds:
A closed end mutual fund is one in which a limited number of shares are sold. If someone who owns shares in a closed-end fund wants to sell them, they are sold on the stock exchange for whatever price can be obtained, which may be the same, more, or less than the proportionate value of the fund assets.
For example, FundA may be, for simplicity sake, invested 1/4 in ABC, 1/4 in DEF, 1/4 in GHI and 1/4 in JKL today. The NAV of the shares is $10.00, so each share of FundA represents $2.50 of each company. Tomorrow, there is really bad news about ABC and the price drops by 20%, and the other companies’ price remains the same. Now, the NAV of the shares of FundA is $9.50. If FundA was an open-ended mutual fund, and it received my order for shares tomorrow, I would pay $9.50 per share–and that’ s what you would receive if you wanted to sell. However, with a closed-end fund, if I wanted to buy shares in FundA, I would have to go to the stock exchange, and pay the going rate, just as if I was buying the underlying stocks. It is not uncommon for closed end funds to sell at a noticible discount or premium to the NAV. If more people want to buy FundA, then the price goes up; if “everyone” wants to sell, the price goes down–however, there are still the same number of shares of FundA in existence, and each share is still invested in ABC, DEF, GHI and JKL.
For fund managers, the advantage of closed-end funds is that they have a set amount of money with which to work. With open-ended funds, if there is a large in-pouring of assets, then fund managers may have trouble investing it in companies in which they believe and in accordance with the fund prospectus. Closed-end funds don’t have that problem. In the same way, if too many people want to withdraw money from open-ended funds, the managers can be forced to sell assets when the value is down. With closed-end funds, the investor might suffer a loss in that situation, but the fund as a whole would not.
Investors benefit because without having to manage funds coming into and out of the fund, the operating expenses of a closed-end fund are less than that of an opened ended one. Further, if you are looking for income, closed end funds tend to pay shareholders regularly–passing on both the dividends paid by the underlying stocks and the capital gains earned when stocks within the portfolio are sold.
I own a few shares in a closed-end fund–Liberty All Star Equity Fund (USA), which is a large cap fund. Its major holdings include Adobe, Visa, Amazon and Alphabet. You can read more about it here. Liberty tries to pay out 2.5% of the Net Asset Value of the fund each quarter to shareholders, which means it is good for those who want income. Today it is selling for 6.99% less than the NAV. On the other hand, a sister fund focused more on growth is currently trading at 6.6% more than the NAV.
I am due to collect a distribution of $0.17 per share. My shares cost an average of $6.29 each, and closed today at $6.25. The current Net Asset Value per share is $6.72
So, is buying this fund a guaranteed 10% return annually? No. If the fund does not have enough earnings to cover the distribution, it makes up the deficit by returning capital to the shareholders; in effect giving you some of your money back, which of course lowers the NAV (and probably the market price) of the shares. Still, if you want to know that on four days of the year, you will receive a check for more or less an amount of money, closed end funds may work for you.
Overall, USA’s annualized performance over the last ten years has been 8%, which is slightly less than the 9.62% return of Vanguard’s Total Stock Market Index Fund, and slightly more than the Lipper Large Cap Core Average, which the fund considers to be its benchmark.
Note: This article originally appeared at Racing Towards Retirement.
Category: ETFs
