Sampling 3 Flavors of Investment Funds

By Michael

What do open-end funds, closed-end funds and exchange-traded funds all have in common?

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They each offer investors an easy and low-cost way to pool their money to purchase a diversified portfolio that reflects a particular investment objective. And investors don't need to have a lot of money to gain entry.

But each of these fund types is structured differently:

  • Open-end mutual fund shares are bought and sold on demand at their net asset value, or NAV, which is based on the value of the fund's underlying securities and is generally calculated at the close of every trading day. Investors buy shares directly from a fund.
  • Closed-end funds 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 net asset value.
  • Exchange-traded funds also trade like stocks on an exchange, but their market prices hew more closely to their net asset value than closed-end funds. Premiums and discounts usually stay within 1% of NAV, with the exception of some smaller ETFs that trade infrequently.

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Both open-end and closed-end funds have been around for many decades. Closed-end funds are the oldest among these, introduced in the late 19th century. Exchange-traded funds, or ETFs, are a relatively recent innovation in the fund business and were launched about 20 years ago.

Mutual funds are notable for their widespread popularity. Currently, there are 7,136 open-end funds with total net assets of $9.04 trillion, according to Morningstar. Compared to that, the ETF market is tiny: nearly $1.29 trillion invested in 1,438 ETFs. But closed-end funds by far have the smallest market share, with 600 funds worth about $238 billion.

This doesn't mean that open-end funds are always the best option and other fund types should be ignored.

"One of the advantages to ETFs is that they are transparent, so you know what you are buying," says Michael Iachini, managing director of ETF Research at Charles Schwab Investment Advisory Inc.

And closed-end funds have their fans as well.

Before investors choose between these funds, they should understand the unique characteristics of each fund type.

Indexed vs. Active Management

ETF fans point to their lower cost as a clear advantage over mutual funds. But Jim Rowley, a senior investment analyst at Vanguard Investment Strategy Group, says that fund costs reflect the differences between actively managed funds, whose managers actively trade securities to maximize returns, and funds that track a particular index such as the Standard & Poor's 500 index. "Indexed products generally have lower expense ratios than actively traded funds, and you find that with both mutual funds and ETFs," Rowley says. "Actively traded ETFs and mutual funds can have fees well over 1%," he adds.

Index funds, on the other hand, can have fees as low as one-tenth of 1%, whether they are mutual funds or ETFs. The higher price of actively managed funds is a consequence of the high cost of management. "Active management is expensive and for good reason: They have research staff, operating costs, lots of software and data they need to buy, and that adds up," Iachini says.

Timothy Johnson, chief investment strategist at Lincoln Financial Network, suggests that investors take a close look at mutual funds if they invest small amounts at regular intervals, a practice known as "dollar cost averaging."

"You can trade smaller amounts with a mutual fund and without commissions, assuming it's a no-load fund," he says. (Some mutual funds do come with loads, or sales charges.) On the other hand, investors generally have to pay commissions with ETF purchases unless they're waived. ETFs make good purchases for investors with large sums to invest or investors searching for a very exotic asset class, he adds.

Johnson also recommends a mix of actively managed funds and index funds to clients. "We usually recommend a mix of indexed and actively traded products that fits their personality and risk tolerance," he says.

Closed-End Funds

Unlike other funds, closed-end funds often trade at enormous premiums or discounts -- some funds recently have been trading at a 50% premium.

While buying at a discount may seem like a bargain, Iachini at Schwab warns that "just because a fund is trading at a discount in the past doesn't mean that it will necessarily go up -- and sometimes funds trading at a premium might yield more." He recommends investors research a closed-end fund's historical performance carefully before buying.

The recent rally in some closed-end funds is a result of their high dividend yields. Roughly two-thirds of these funds invest in municipal and corporate bonds, and many of them use leverage. This helps boost yields to as high as 15%.

Johnson warns that these yields reflect the high risk behind these funds. "While everybody's afraid of getting a low yield, they need to think of what they are running from and running to. If something yields a whole lot more than something else, the market is telling you that there are risks," he says.

The funds' use of leverage helps them make more money in good times, but leverage cuts both ways. In bad times, they can lose a lot of money as well.

"During the financial crisis, some of these leveraged funds did not do well," Johnson says. "Investors should look past that yield -- that's the outside. Whenever I see people aggressively reaching for yield, it often leads to grief."

Copyright 2013, Bankrate Inc.