Mutual funds, ETFs and other pooled investment products

What is a mutual fund?

A mutual fund is a pooled investment in which each investor has a pro-rata claim on the income and value of the fund. Individuals and institutions hand the selection and management of the portfolio to a professional. Advantages are low investment minimums, diversification, daily liquidity, and standardized performance and tax reporting.

The value of one share is the net asset value (NAV) per share, computed daily from the closing prices of the securities held.

$$NAV = \frac{A - L}{S}$$

Here $A$ is fund assets, $L$ fund liabilities and $S$ the shares outstanding.

How do open-end and closed-end funds work?

An open-end fund accepts new money and issues shares at the current NAV, and pays out redeeming investors at NAV, cancelling their shares. Its price therefore always equals NAV. The downside for the manager is that inflows must be invested and redemptions may force the sale of assets at a bad time, so open-end funds keep some cash.

A closed-end fund raises capital once and then has a fixed number of shares. Investors buy from and sell to each other, so the price depends on demand and can sit at a premium or discount to NAV. The manager never faces redemptions, but the fund cannot grow easily. Closed-end funds are a small share of fund assets.

Mutual fundpooled money, each investor a pro-rata claim at NAV

• Open-end Memorize issues and redeems shares at NAV
  • Price always equals NAV
  • Must hold cash for redemptions
• Closed-end Memorize fixed number of shares, traded on an exchange
  • Trades at a premium or discount to NAV
  • Manager never faces redemptions
• Sales charges Use it
  • Load fund fee to buy or sell
  • No-load fund no sales fee; annual fee only

$$N = \frac{I}{NAV}$$

$$D = \frac{NAV - P}{NAV}$$

A negative result means the price is above NAV, a premium.

Flip through the four states and compare how you buy, what price you get and when you can sell. Then try the NAV calculator with your own numbers.

Exam tip Open-end trades with the fund at NAV. Closed-end and ETFs trade with other investors.

What are load and no-load funds?

The difference is the sales charge. A load fund charges a percentage fee on buying and/or on redeeming, and usually sells through brokers who share the up-front fee. A no-load fund charges no sales fee, only an annual fee as a percentage of NAV. Load funds have become less important over time.

What kinds of mutual fund exist?

Funds are classified by what they hold.

Types of mutual fundclassified by asset type

• Money market Use it short-term, high-quality debt; stable value; not insured like a bank deposit
• Bond Use it by maturity, issuer, credit quality or tax status
• Stock (equity) Use it
  • Actively managed higher fees, more trading, more taxable gains
  • Index fund tracks an index; lower fees and turnover
• Hybrid / balanced Use it stocks and bonds; target-date funds shift the mix over time

• A money market fund holds short-term money market instruments such as treasury bills, certificates of deposit and commercial paper. It aims at security of principal, high liquidity and returns in line with money market rates. Many keep the share price constant at one unit of currency; others let it vary. It substitutes for a savings account, but it is not insured like a bank deposit.
• A bond mutual fund holds a portfolio of bonds, with maturities from about one year to 30 years or more. Categories include global, government, corporate, high yield, inflation protected and tax-free funds. The main difference from a money market fund is the maturity of the holdings.
• A stock mutual fund is either actively managed, with a manager picking shares to outperform, or an index fund that tracks an index. Active funds charge higher fees, trade more and, because funds often distribute realized gains, tend to produce more taxable gains.
• A hybrid fund (balanced fund) holds both stocks and bonds. Target-date (lifecycle) funds are hybrids that gradually shift from shares to bonds as the retirement date approaches.

How do ETFs, separately managed accounts, hedge funds and private equity compare?

Other pooled investment products

• Exchange-traded fund (ETF) Memorize trades all day on an exchange
• Separately managed account (SMA) Memorize investor owns the securities directly
• Hedge fund Use it leverage, shorting, derivatives; limited redemptions
• Private equity and venture capital funds Use it buy, improve and sell companies; 7 to 10 year life
  • Private equity mature companies
  • Venture capital start-ups

An exchange-traded fund (ETF) is an investment fund that trades on an exchange like a stock and is generally structured as an open-end fund. Because it trades intraday, an ETF can be bought and sold throughout the day, sold short or bought on margin. The market price stays close to NAV because authorized participants create and redeem ETF shares in large baskets, usually in kind (swapping securities for shares). Compared with mutual funds, ETFs usually have a lower minimum investment, pay dividends out rather than reinvesting them, and do not make capital gain distributions.

A separately managed account (SMA) is managed exclusively for one individual or institution, which owns the assets directly. It lets the manager tailor the strategy to the investor’s objectives, constraints, tax position and preferences (for example excluding certain industries). The main drawback is a much higher minimum investment, so large institutions are the main users.

A hedge fund is a private investment vehicle that typically uses leverage, derivatives and long and short strategies. Typical features are short selling, a search for absolute returns, leverage, low correlation with traditional assets and a two-part fee: an asset-based management fee (traditionally 2%) and an incentive fee (up to 20%). Hedge funds are not open to every investor. They typically require a high minimum and allow only periodic withdrawals or a long commitment.

A private equity fund buys, improves and sells portfolio companies; a venture capital fund does this for young companies. Most are limited partnerships between the manager (the general partner, GP) and investors (limited partners, LPs), with a life of roughly 7 to 10 years. Fees include a management fee of 1 to 3% a year on committed capital and carried interest, the GP’s share of profits (typically 20%). The exit comes by merger, acquisition or an initial public offering.

Go deeper Why closed-end discounts persist

Closed-end shares are priced by supply and demand, not by creation and redemption, so nothing forces the price back to NAV. Reasons for a discount include fees charged by the fund, holdings that are hard to value or sell, and tax effects. An ETF differs because authorized participants can exploit any gap by creating or redeeming shares, which keeps the price close to NAV.

Go deeper How ETF arbitrage works

If the ETF trades above the value of its holdings, an authorized participant buys the underlying securities, delivers them to the fund in exchange for new ETF shares and sells those shares at the higher price, which pushes the price down. If it trades below, the participant buys cheap ETF shares, redeems them for the underlying securities and sells those, which pushes the price up. The profit is small, and the effect is to keep price and NAV together.