We all know what a mutual fund is ‚Äď an arrangement in which investors get together, throw a bunch of money into a pot, and hire a professional money manager to buy and sell securities with the money, hoping to make a profit. The manager earns a percentage of the pot for his time and trouble.
Well,¬† it turns out that there‚Äôs a couple of ways to structure a mutual fund¬†‚Äď and the two most common are open-end and closed-end funds. On top of that is an opaque veil of commissions and fees, which¬†money managers and investment advisors slap on the customer – but that is a different topic altogether (to learn about the difference between commission based advisors and fee-only advisors,¬†read this article.)
Most of us are familiar with the open-end fund architecture. Here‚Äôs how it works: If you want to buy additional fund shares, you send your money into the fund company. The fund company adds your money to the pot, and issues additional shares. The pot gets bigger, and no one else in the fund loses any fund shares. Likewise, when you want to sell your shares, you send your request in to the fund company itself. They typically sell enough securities to raise the cash to send you. (It‚Äôs theoretically possible for them to just send you the securities. This is called an ‚Äėin-kind‚Äô distribution. But this is very rare in practice.)
Most people accept the arrangement without a second thought. But suppose the fund specialized in a very narrow or comparatively illiquid market. Can you see the problem with this?
If the fund got hit with a lot of redemption requests (or even one large one), they‚Äôd have to sell a lot of shares quickly to raise cash. This can depress the price of the security even as you‚Äôre selling ‚Äď and reduce returns for everyone else. Otherwise, the fund will have to hold a portion of the portfolio in cash to meet redemptions. Again, this ‚Äúcash drag‚ÄĚ can hurt returns, since cash doesn’t earn very much. Most managers would rather be invested in something else, most of the time.
That‚Äôs where closed-end funds come in. If you own a closed-end fund, you don‚Äôt typically buy shares directly from the investment company, nor redeem shares from the company. Instead, you buy them from other investors over the stock exchanges ‚Äď just like shares of stock! This helps the manager ‚Äď and other shareholders ‚Äď because they don‚Äôt have to worry about keeping cash around to meet redemptions, and they don‚Äôt have to worry about their own trading activity in response to purchases or redemptions distorting share prices. This makes closed-end funds a very useful tool when it comes to investing in smaller or more specialized markets.
There‚Äôs one other neat feature to closed-end funds ‚Äď it‚Äôs not the stock prices that set the daily price‚Ä¶ at least, not directly. Instead, shares are worth whatever other investors are willing to pay for them! Frequently, this means that closed-end shares can be bought for less than their underlying securities are worth if you sold them separately. When this happens, we say the fund is selling at a ‚Äúdiscount to NAV,‚ÄĚ or a ‚Äúdiscount to net asset value.‚ÄĚ
Again, this is important ‚Äď especially for investors looking for income. Why? Because even though the closed-end fund shares sell at a discount to NAV, it doesn’t change the interest or dividend payments coming in. Closed-end funds are therefore great tools for some income-oriented investors. There are no guarantees, though. Just because a fund is trading at a discount to NAV doesn’t mean it‚Äôs guaranteed to go up. Discounts could narrow or widen, and fund shares can get cheaper or more expensive.
Exchange Traded Funds
These funds, also called ‚ÄúETFs,‚ÄĚ are essentially index funds packaged like closed-end funds. They have the same structure, basically, as a closed-end fund. But instead of having a manager actively buying and selling stocks and bonds for the portfolio (and collecting a fat percentage!) The ETF portfolio follows an index. That is, it just owns a bunch of preselected securities designed to represent the investment characteristics of the market ‚Äď whatever that market is. It could be Canadian stocks. It could be U.S. bonds. It could be European equities. It could be oil companies. Whatever it is, you can get ETFs that track nearly anything. Still, keep in mind, nothing can replace good due diligence and research – there are a lot of thinly-traded ETF’s out there, which can turn out to be very illiquid and costly for an investor.
Who They‚Äôre For?
I¬†like to use ETFs for long-term holdings because of their low costs and the ease with which you can build a very diversified portfolio. They‚Äôre terrifically flexible ‚Äď and you can buy options on them, too. Which gives you a lot more flexibility as an investor, because you can set limit orders to protect your position, or short-sell them to benefit from a potential market decline.
Both ETFs and closed-end funds are fantastic, too, for wedging into very specialized markets or illiquid markets, while still maintaining some diversity. Examples include emerging markets, gold and precious metals, and funds that concentrate in specific countries, like Singapore.
I¬†also like them for people who tend to buy and hold for long periods of time, and for those who are attracted to dividend income investing in general, when you can buy shares at a significant discount to NAV.