What do open-end funds, closed-end funds and exchange-traded funds all have in common?
Investors can use all three options as an easy and low-cost way to establish a diversified portfolio that reflects a particular investment objective.
But each of these fund types is structured differently.
What are open-end mutual funds?
Open-end mutual fund shares are bought and sold on demand at their net asset value, or NAV. The NAV, which is based on the value of the fund’s underlying securities, is generally calculated at the close of every trading day. Investors buy shares directly from a fund.
What are closed-end funds?
Closed-end funds, which are lesser known but more than a century old, have a fixed number of shares and are traded among investors on an exchange. Like stocks, their share prices are determined according to supply and demand, and they often trade at a wide discount or premium to their NAVs. According to the Investment Company Institute, more than 90 percent of closed-end funds calculate the value of their portfolios every day.
What are exchange-traded funds?
Exchange-traded funds, or ETFs, also trade like stocks on an exchange, but their market prices hew more closely to their NAV than closed-end funds. Under normal market conditions, premiums and discounts usually stay within 1 percent of NAV, with the exception of some smaller ETFs that trade infrequently. Investors can trade intraday.
Both open-end and closed-end funds have been around for many decades. Closed-end funds, which are the oldest, date back to the late 19th century. ETFs launched about 25 years ago and are becoming more popular. Inflows for ETFs hit $464 billion in 2017, according to data from State Street Global Advisors.
Still, mutual funds remain the most popular in terms of total assets because of their prominence in workplace retirement plans, such as 401(k)s. Closed-end funds have the smallest market share: Their total assets increased to $275 billion in 2017, according to an Investment Company Institute report.
Just because open-end funds are the most popular does not always mean they are the best option or that other fund types should be ignored. In fact, financial advisers have been favoring ETFs to their clients.
Closed-end funds have their fans as well. Households with close-end funds tend to be more affluent, per Investment Company Institute.
Before investors choose between these funds, they should understand the unique characteristics of each fund type and consider their own risk tolerances.
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Indexed vs. active management
ETF fans point to their lower cost as a clear advantage over mutual funds.
But, the costs of the funds reflect the differences in how they are managed.
Actively managed funds, where managers actively trade securities to maximize returns, are more expensive than funds that track a particular index, such as the Standard & Poor’s 500 index.
Index funds can have fees below one-tenth of 1 percent, whether they are mutual funds or ETFs. The higher price of actively managed funds, which can have fees that top 1 percent, is a consequence of the high cost of overhead, such as supporting a research staff who are trying to beat the market.
“Obviously, there is a cost to all of that,” says Greg McBride, CFA, chief financial analyst for Bankrate.com.
Unlike other funds, closed-end funds often trade at enormous premiums — trading at a share price higher than the NAV — or discounts, trading at a share price lower than the NAV.
While buying at a discount could seem like a deal, it could also point to the fund’s poor performance or another problem. So, investors are encouraged to do their homework and research a closed-end fund’s historical performance. Most importantly, the discount shouldn’t be the deciding factor.
“The bigger question is whether closed-end funds are right for you,” says McBride. “You are building a portfolio.”
While closed-end funds are viewed as useful for generating income, their quirks can scare investors away. Closed-end funds’ can use leverage investing, which helps them make more money in good times, but they can lose a lot of money in bad times as well.
“It can require a strong stomach because of leverage,” says Cara Esser, CFA, a senior investment research analyst in Mesirow Financial’s retirement planning and advisory group.
While ETFs and open-end funds can also use leverage, Esser says it’s more prevalent in closed-end funds.
And remember, a fund’s high dividend yield reflects the high risk behind the fund. Taking on the risk could potentially lead to greater returns. But, it could also lead to grief.
“Be cautious about yield chasing,” says Esser.