2.4: Open-end, Closed-end, and Exchange-Traded Funds (ETFs) (2024)

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There are three major types of mutual funds, open-end mutual funds, closed-end mutual funds, and Exchange-Traded Funds, commonly referred to as ETFs. Please don’t ask me why the name is capitalized but it is while the first two are not. Also, sometimes you will see Exchange-Traded Fund with a hyphen and sometimes you will see it without a hyphen. The investment world is full of these types of ambiguities. It is one of the reasons why the general public often throws up its hands and gives up trying to understand investments. That is why you need to study hard, Dear Rising Investment Gurus, to help your family, friends, and colleagues.

By far, the largest number of mutual funds are open-end mutual funds. When people refer to mutual funds without any qualifier, they are invariably referring to open-end mutual funds. An open-end mutual fund is a type of investment company in which investors buy shares from, and sell them back to, the mutual fund itself. There is no limit on the number of shares the fund can issue. Shares are issued and redeemed by the investment company at the request of investors. Investors can buy shares from (purchase) and sell shares to (redeem) the investment company at any time. As of December 2022, there were 8,763 open-end mutual funds totaling $22.110trillion dollars in assets. They make up approximately 72% of all mutual funds.

The second major fund category consists of closed-end mutual funds. A closed-end mutual fund is a type of investment company that operates with a fixed number of shares outstanding. Shares are issued by an investment company only when the fund is organized. After all original shares are sold you can only purchase shares from another investor. In this way, closed-end mutual funds are bought and sold like stocks and bonds on the open market. The investor will incur brokerage commissions. Closed-end mutual funds are a much smaller part of the mutual fund universe. As of December 2022, there were only 441 closed-end mutual funds holding only $252billion dollars in assets. That number represents only 3.6% of the available mutual funds. In recent years, both numbers have been steadily shrinking.

The current underlying worth of any mutual fund is represented by the Net Asset Value (NAV). At the end of every day that the stock market in the United States is open, all mutual funds are required to compute the Net Asset Value of a single share. The mutual fund staff sum the value of the securities in the mutual fund and subtracts any liabilities. The securities are quoted as of 4 pm New York time. The liabilities consist of pending redemptions to be sent to investors, pending purchases of new securities, and any other day-to-day costs of running the mutual fund. The liabilities are typically very low compared to the value of the securities. The result of the value of the securities minus the liabilities is then divided by the number of mutual fund shares. This is the Net Asset Value. This is the number you will see when you investigate your mutual fund. Although it is good to understand what the Net Asset Value represents, there is really no need to perform the calculation for yourself; each day, it is computed for you automatically and all you need to do is run to your nearest Internet-enabled device and ask for it.

Open-end mutual funds are bought or sold at Net Asset Value. Some open-end mutual funds may add a sales commission, also known as sales charge or sales load. If a sales commission is added, the resulting price is called the Maximum Offering Price (MOP) or just the Offering Price. The NAV or MOP is the price that the investor will pay when the fund is purchased. The NAV is the price the investor will receive when the fund is redeemed. Since closed-end mutual funds are bought and sold on the open market, their price usually either reflects a premium or discount to the Net Asset Value. They are very rarely priced at their Net Asset Value. Closed-end funds more often than not will sell at a discount to the Net Asset Value. The investor will pay the current market price when purchasing closed-end mutual funds and receive the current market price when redeeming closed-end mutual funds.

What are the advantages and disadvantages of open-end versus closed-end mutual funds? Open-end mutual funds are much more popular than closed-end mutual funds and therefore offer the investor a much wider range of options. With open-end mutual funds, there are no market forces so the investor does not pay any brokerage commissions and does not have to worry about any supply and demand market forces.

One downside of open-end mutual funds is something that the investor has no control over. Invariably, if an open-end mutual fund becomes very successful, it will become very popular. Floods of new contributions will inundate the fund. At first, this may sound like a great boon to the company. However, too much money flowing into a mutual fund can create serious challenges for the mutual fund managers. They must put this money to use and that can be problematic. Will they choose to purchase more of the same securities that they already have in the portfolio? Will they decide to invest in new securities? Both have their pitfalls. Purchasing more of an existing security that is already in the mutual fund may bump the mutual fund up against the 5% rule discussed in the next section. It also could be difficult for the fund to purchase more shares without adversely affecting the price of the security, especially if the security is a smaller issue such as small company stock. Also, identifying, choosing, and monitoring new securities places more burden upon the mutual fund company. Too much diversification can be too much of a good thing. How many resources will the mutual fund company devote to the 250^th stock in their portfolio? For this reason, many open-end mutual funds will decide to close the fund. Other mutual funds handle this problem by adding more mutual fund managers, essentially creating multiple portfolios within the overall portfolio. Again, this is an issue that the mutual fund company must handle but it is important for us investors to be aware of.

In addition to the problem of a flood of contributions into the open-end mutual fund, if an open-end mutual fund experiences a flood of withdrawals from the fund, the exact same problem happens in reverse. Now, the mutual fund managers might be forced to sell securities to pay for redemptions. This may occur at precisely the worst time, namely when the market is experiencing a major downturn and ill-informed investors are running for the exits. Or it may occur when a very successful and popular money manager leaves a fund after many years. Too many contributions and too many withdrawals are both uncommon events but they are something that investors need to be aware of.

Closed-end mutual funds have the issue that the investor must pay a broker’s commission just as they would when they bought or sold a stock or a bond. (You may be saying to yourself, “My brokerage firm doesn’t charge commissions. I am not paying anything for my trades!” Ah, Dear Student, please know that you are being charged, one way or another. We will tackle the industry’s current sleight of hand in our next chapter.) Closed-end funds must be bought and sold in the marketplace so the forces of supply and demand are at work. Hence, there is sometimes a premium or, more often than not, a discount to the Net Asset Value. However, one advantage of closed-end funds is that it is much easier for the mutual fund investment advisors to manage the underlying assets. Recall that the number of shares is set when the closed-end mutual fund is established. The closed-end mutual fund managers do not have to worry about a flood of purchases or redemptions as do the open-end mutual fund managers.

A third type of mutual fund has emerged in the past few decades. Exchange-Traded Funds (ETFs) are hybrids of open-end and closed-end mutual funds. Exchange-Traded Funds are open-end mutual funds that have no limit to the number of shares. The mutual fund company issues new shares as needed. However, they trade on the stock exchanges like closed-end mutual funds. Therefore, the investor must purchase the fund using a brokerage account, incurring brokerage transaction fees as would a closed-end mutual fund. Competition and innovation have led some mutual fund companies to find a way to eliminate the brokerage transaction fees. Some mutual fund companies have opened their own brokerage firms and if you purchase their Exchange-Traded Funds through their brokerage firm, they waive the commission.

Exchange-Traded Funds were introduced in the early 1990’s. Starting in the 2000’s, their popularity began a meteoric rise, as shown in the table below. This has led many in the industry, especially the financial media talking heads doing their best to attract your attention by making profound revelations, to confidently predict that ETFs will supplant all other mutual funds. To steal from Mark Twain, the reports of the death of open-end and closed-end mutual funds are greatly exaggerated. Even given their spectacular growth, ETFs still only account for about 24.5% of the total number of mutual funds.

Source: Investment Company Institute, ici.org

There is some confusion surrounding the underlying investments in Exchange-Traded Funds that we will discuss when we discuss the various types of mutual fund strategies and objectives. Furthermore, because of the ability to buy and sell Exchange-Traded Funds throughout the trading day, many speculators and traders have begun to use ETFs as trading vehicles. Many in the industry including John “Jack” Bogle, founder of The Vanguard Group, have lamented the use of ETFs as trading vehicles as mutual funds were originally designed to be long-term investments.