An Introduction to Funds
Introduction to Funds
Most investors that are new to the stock market are under the impression that there is only one type of fund that is managed - broadly known as Mutual funds. Actually, there are three types of Funds that are managed. Also, many of these new investors are under the impression that the fund does all the work. While this is true with regards to the buying and selling of the stocks the fund holds, the investor still needs to select which fund to buy and also decide if and when to sell their share of the fund.
The three types of funds the investor can buy are as follows:
Types of Funds:
- Mutual Funds: Also known as Open-end Funds, are the fund type that most investors that are new to the stock market will be familiar with. In fact, if no other reference is made to the fund type, then the reference is to a Mutual Fund. The investor can buy shares in a Mutual Fund directly from the fund provider.
- Closed-end Funds: These are similar to Mutual Funds except that the fund is listed on the stock exchange and investors actually buy shares in a Closed-end fund just like buying shares in any other stock listed on the stock exchange. That is, the stock investor buys the shares on the stock market from another investor who is selling their shares in the fund.
- Exchange Traded Funds: These are frequently referred to as ETFs and are similar to Closed-end funds in that they are also listed on a stock exchange, however ETFs are usually only passively managed and their portfolios generally consist of stocks that make up an index, and as such are primarily used to mirror an indices performance.
All funds utilize a pooled source of capital that is provided by investors and the fund manager allocates that money by purchasing stocks for the portfolio in accordance with the funds prospectus. This pooled source of capital is split up into units referred to as shares.
With a Fund, the term share refers to the investors share of the fund, whereas with a listed company a share refers to a share of the company. Thus with a fund, the investor buys a share of the fund, not a share of the company that owns the fund.
The traditional mutual funds and the Closed-end funds both have a portfolio of stocks and a fund manager who actively managers the fund. The fund manager's role includes monitoring the financial state of the companies in the portfolio and selling stocks that no longer meets the funds criteria.
ETFs are very similar to Mutual funds and Closed-end funds, but primarily have a portfolio that is designed to track an index. An ETF is normally only passively managed with the portfolio only amended when the underlying index it is tracking is amended. Both Mutual funds and Closed-end funds also have passively managed funds that track an index.
Shares in a mutual fund are bought directly from the fund provider and the investor does not need to have a stock brokerage account. Shares in mutual funds can also be bought through financial advisors and some stock brokers.
Closed-end funds and ETFs are listed on a stock exchange and their shares are bought and sold through a stock broker. When buying a Closed-end fund or ETF, the investor needs to have a stock brokerage account. The investor is simple buying someone else's share of the fund from the stock market and the fund is included in their stock brokerage account just like any other stock.
All fund types charge annual fees for their service and Mutual funds generally also charge entry and exit fees. Mutual funds may incur higher operating costs than Closed-end funds, as the investor can sell their fund shares back to the mutual fund at any time.
All fund types charge annual fees and
some also charge entry and exit fees
Closed-end funds generally have higher operating costs than ETFs. This is primarily due to Closed-end funds being actively managed, whereas ETFs only need to purchase shares to start their portfolio with the ongoing management only requiring a portfolio rebalance if the underlying index it tracks alters, thus the operating costs and hence the annual fees for ETFs are lower than that of Closed-end funds.
Closed-end funds and ETFs do not charge entry and exit fees, however normal stock trading brokerage is payable, but this is generally lower than the mutual funds entry and exit fees when an online broker is used (especially if a direct access broker is used).
Mutual funds tend to be popular with investors that do not wish to be actively involved with the stock market and not requiring a stock brokerage account makes it very easy for them to participate in the stock market.
In contrast, both Closed-end funds and ETFs tend to be popular with stock investors who are actively involved and have a good understanding of the stock market. They use these fund types in a similar manner to investing directly in stocks, using various strategies to capitalize on the prevailing market conditions.
This is what most beginner investors call a fund
Mutual Funds are the most popular fund type with investors and their popularity continues to increase. They tend to be aggressively marketed to investors with limited or no experience with the stock market or any other financial markets. Most investors who are not involved with the stock market will tend to invest in a mutual fund.
Mutual Funds are convenient for investors as they provide exposure to a diverse portfolio with a limited amount of capital. While the funds conduct large transactions with their block trades, the funds investor only requires a few thousand or even a couple of hundred dollars to participate.
Table 1. below shows a selection of stock index mutual funds with varying minimum investment amounts required to get started.
Table 1. Stock Index Mutual Funds
When an investor buys a Mutual Fund they are actually buying a share of the Fund. Mutual funds are sort of like stocks which have many shares on issue.
Mutual Funds are bought by placing an order with the fund provider or their nominated representatives (which may be financial advisers or some stock brokers). The actual price paid per share is determined from the funds net assets value (NAV) which is calculated when the markets close each day. The NAV is simply the funds net assets (all the stocks it owns) divided by the number of fund shares issued. The actual price paid often includes a fee known as a sales load which covers the funds advertising and marketing costs (No-load funds do not charge a sales load).
Mutual funds are redeemable, which means the investor can sell their shares back to the fund. Similarly to buying fund shares, the price the investor receives for selling back their shares is based on the NAV plus any fees the fund imposes.
The fees charged by mutual funds tend to vary quite significantly and it is well worth the effort comparing the fees charged by the various funds that essentially have the same investing style and asset allocation. Even a small saving in fees can have a substantial effect on the net long term returns obtained.
The fees charged by mutual funds vary significantly
for the same fund style – it pays to shop around
There are over 10,000 mutual funds and a short list can be easily obtained using a mutual funds screener which allows the investor to select the criteria they require from a fund. Some investors will seek out funds that focus on small-cap growth stocks while another investor may be interested more in large-cap value stocks.
There are several types of mutual funds which can be broadly classified as follows.
Mutual funds classifications:
- Stock funds: These funds invest in stocks and use a variety of stock investing styles including growth, value and dividends (income). They may also specialize in certain industry groups such as technology or they may specialize in certain market caps such as small-cap stocks. Other funds will use combinations of investing styles, industries and/or market caps. The possible combinations are numerous. Some funds will invest to replicate the performance of a stock market index such as the DOW or the S&P 500.
- Bond funds: This type of fund invests in bonds such as treasury bonds, municipal bonds or corporate bonds and the returns obtained are primarily from the interest payments received from the bonds. They are less risky than stocks but in the long-term they under-perform stocks.
- Money market funds: These are funds that invest in short-term bonds such as treasury bills. They are considered a safe investment with returns that are usually less than that obtained from bond funds. They are a good alternative to a certificate of deposit (CD).
- Balanced funds: These funds invest in a combination of stocks and bonds/bills with the intention of providing the capital growth potential from stocks and the income stream from bonds and bills.
- Target date funds: They are also known Life cycle funds and are primarily intended as a retirement planning fund and frequently used with individual retirement accounts. The target date refers to the year the investor plans on retiring. These funds typically start off with a fairly high proportion of the portfolio invested in stocks and as time heads towards the target date, the proportion of stocks is gradually reduced and the portion of bonds and bills is increased.
- International funds: These funds invest in foreign countries and can use any combination of the above fund types. The returns obtained and the risk level of international funds is highly variable. Another issue is the currency exchange rate risk and whether the fund hedges against this risk.
An alternative to mutual funds and they can be bought from the stock exchange
The history of closed-end funds dates back to the late 1800s and was the first fund type formed. The idea was to allow the less wealthy investors of that time to participate in the growth of the US economy, as stock prices in those early days were expensive relative to the weekly wage or salary. In fact, the first mutual fund was formed some 30 years later.
A lot of the features and characteristics of closed-end funds are the same as for mutual funds. They both typically pay out most of the dividends received and distribute any capital gains made.
There are over 500 closed-end funds. While this is considerably less than the number of mutual funds, an advantage closed-end funds have over mutual funds is just that, they are closed. The mutual fund has the ongoing issue of having to provide new share units as demand for the fund picks up (which is usually in a bull market when stock prices are rising) and as such have to continually purchase stock at higher and higher prices. Conversely, in a bear market when stock prices are falling, mutual funds experience an increase in redemptions (investors selling their shares back to the fund) and thus the mutual fund must sell into a declining market. These can impact on the funds returns by the funds own investors effectively forcing the fund to buy and sell stock at less than ideal times.
Closed-end funds by their very nature of not providing new share units after its initial public offering or allowing redemptions of shares, means that the closed-end fund manager does not need not to buy and sell stock to satisfy the demand from their investors. Thus the closed-end fund manager is free to concentrate on managing the portfolio based on the stocks own merits.
Closed-end funds are popular with stock investors who invest in them and trade them just like stocks. Some investors use closed-end funds as a means of hedging a stock portfolio for the short-term by buying funds that increase in value as the market declines. Other stock investors prefer to have their funds included in the same account as their stocks.
Closed-end funds can be bought and sold
on the stock exchange just like stocks
While both mutual funds and closed-end funds are valued based on their funds net assets value (NAV), a closed-end fund trades on a stock exchange and the funds price is determined by the supply and demand characteristics in exactly the same way as stocks. Just like stocks which can trade at a premium or a discount to its valuation, so do closed-end funds. This means an investor looking to buy a closed-end fund has the opportunity to buy a fund at a discount and if so desired, may be able to sell the fund at a premium.
Unlike mutual funds which are priced at the end of each trading day based on its NAV, closed-end funds can be bought and sold throughout the trading while the stock market is open. Therefore with a closed-end the investor knows the exact price that their order will be filled. With a mutual fund, orders are received during the day and the price is not determined until after the markets are closed (the price paid is based on the NAV at the market close).
The types of closed-end funds are essentially the same as for mutual funds. There are stock funds, bond funds, sector funds and international funds.
Table 1. below shows some of the popular Closed-end funds on the market (data based on Oct 20, 2017).
Table 1. Popular Closed-end Funds
Investors need to consider their brokerage costs which for some investors can be a high proportion of the purchase price if only one or two shares of a closed-end fund are bought. All else being equal, the decision as whether to buy a closed-end fund or a similar mutual fund involves the total fees payable.
These funds are popular with investors tracking an index
Exchange traded funds (ETFs) are the newest type of funds to emerge and there are over 700 ETFs. While ETFs have been around since the early 1990s, they have only become popular over the last decade with some of the heavily traded ETFs actually trading more volume than most stocks trade on a daily basis.
ETFs are extremely popular with stock investors who invest and trade them just like stocks. ETFs are similar to closed-end funds and they are both bought and sold on a stock exchange. While mutual funds and closed-end funds have a variety of funds dealing with different strategies, ETFs have portfolios that are primarily setup to track an index. The index tracked can be stocks, bonds, commodities or currencies. There is a newer type of ETF that actively manages the portfolio, but these are not currently popular with investors.
The main advantage ETFs have over closed-end and mutual index funds are their lower annual management fees, which can make a considerable difference to the net long-term returns.
As ETFs are basically index funds, there is no real difference between ETFs that track the same index, thus the ETF which provides the cheaper brokerage costs and annual management fee would be the wiser choice.
Table 1. below shows the two most popular ETFs on the market (data based on Oct 20, 2017).
Table 1. Stock Index ETF's
From Table 1. above, The SPY ETF is known in the market place as the Spider and the DIA ETF is known as the Diamonds. These two ETFs are so heavily traded that their daily trade volume is that of the Blue-chip stocks.
ETFs are actually a form of open-end fund like mutual funds. While ETFs trade on the stock market like closed-end funds do, ETF shares can be redeemed (sold back to the fund) for large quantities of shares (50,000 shares or more).
Since an ETF tracks an index, an investor can buy ETFs across various sectors or industries to build a diversified portfolio of ETFs as an alternative to simply buying a broad index fund that tracks the S&P 500 index.
Index funds are also a convenient way for stock investors to diversify their portfolio across different asset classes such as bonds. By purchasing an ETF that tracks a bond index, the stock investor effectively has the exposure to bonds without individually owing them and the bond ETF is included in their stock broker account.
ETFs are bought and sold on a stock exchange in exactly the same manner as stocks with the price determined by supply and demand for that fund. Investors need to consider their brokerage costs which for some investors can be a high proportion of the purchase price if the investor only buys a couple of shares in an ETF. All else being equal, the decision as whether to buy an ETF or a similar closed-end fund or mutual fund involves the total fees payable!
Understanding Mutual Fund fees
Know the fees that you will be charged - make better investment decisions
All mutual funds charge fees for their service and the fees charged vary considerably amongst mutual funds. The types of fees they charge are numerous and are often the source of confusion for beginner investors. Some fees are charged to buy a share of a mutual fund, other fees are charged on an ongoing basis and yet other fees may be charged for the investor to exit the fund.
Some funds will charge all of these fees while other funds may only charge some of the fees. The rates for the fees charged also vary considerably amongst mutual funds.
The types of fees that may be charged for buying a mutual fund share are as follows.
Upfront Entry Fees:
These are fees that may be charged when an investor buys a share in a mutual fund.
- Front-end Load: This fee which is also referred to as a Sales Charge is paid to a broker for selling the funds shares (like a brokerage cost for a stock purchase). This fee is an upfront fee and it can be high, but it is capped at 8.5% of the investment amount.
- Purchase Fee: This fee is an upfront fee and if charged, is paid to the mutual fund when the investor buys a share of the fund.
Deferred Exit Fees:
These are fees that may be charged when the investor sells their share back to the fund.
- Back-end Load: This fee is a deferred fee that may be charged when an investor sells their share of the fund. This fee is also known as a Deferred Sales Charge and is paid to the broker (like the brokerage cost for a stock sale).
- Redemption Fee: This fee is a deferred fee and if charged, is paid to the mutual fund when the investor sells their share back to the fund.
Some funds do not charge front-end and back-end loads. These funds are referred to as no-load funds and are more commonly found with passive funds such as index tracking funds which are have minimal portfolio monitoring requirements.
These are fees that may be charged annually by the mutual fund.
- Management Fees: This fee is paid to the fund to cover the costs of managing the investment portfolio and is paid out of the funds assets.
- Distribution "12b-1" Fees: This fee is paid to the fund to cover the costs of marketing and selling the funds shares. The fee is capped at 1% and is taken out of the funds assets.
- Account Fee: This fee may be charged by the fund to maintain the investor's account, especially for small investment amounts.
- Other Expenses: This is a miscellaneous fee that the fund may charge for costs that are not covered by any of the other fees.
The annual fees are grouped together and are referred to as the Total Annual Fund Operating Expenses. This figure is then divided by the fund's assets and is expressed as a percentage and is referred to as the Fund's Expense Ratio.
The expense ratio provides a convenient way of directly comparing the ongoing annual fees between various funds. However, the investor still needs to take into account the fund's entry and exit costs which vary considerably.
Mutual Fund Share Classes
Mutual fund companies may offer different share classes which have different fee structures.
Mutual Fund Share Classes:
- Class A shares: This class has a front-end load that is typically charged. The annual fees charged are generally the lowest with class A shares.
- Class B shares: This class has a back-end load which is generally only charged if the investor sells their shares within a specified time. The annual fees charged are usually higher than for class A shares.
- Class C shares: This may have either a front-end or back-end load but the load charge is generally lower. However, the annual fees are generally the highest.
Unlike stock purchases which are fairly straight forward with regards to their brokerage charges, mutual funds involve a variety of charges that vary considerably between mutual funds and also whether they are bought directly from the fund company or via a broker.
Active vs. Passive Managed Funds
Active funds charge more - but is the extra performance worth the extra cost?
Funds can be classified as either actively managed or passively managed. This applies to all of the fund types available such as Mutual funds, Closed-end funds and Exchange Traded funds (ETFs).
Funds that are actively managed utilize the services of an investment professional who manages the funds portfolio. The professional manager can be directly employed by the fund company and paid a salary or they may be engaged on a consulting basis and paid a fee for their services.
The role of the fund manager of an actively managed fund is to achieve returns that are superior to the returns available from a broad index. The active fund manager will conduct research into the fundamental potential of individual companies and will select the stocks that have the greatest potential for capital gains and/or dividend income.
The active fund manager will then monitor the financial performance of the companies selected and will also monitor their stock prices. The active fund manager will adjust the stock holdings in the portfolio as needed.
There are various investing styles that active fund managers may use and many funds are setup specifically to utilize one particular investing strategy. Examples are growth stock funds, value investing funds and combined stock bond funds such as target date retirement funds.
The performance of active funds is measured against a benchmark index such as the S&P 500 or the Dow Jones Wilshire 5000 index. The benchmark used may be more specific if the funds strategy is focused on a particular segment of the market such as the technology sector. In this case an appropriate technology index would be used as the benchmark rather than a broad based market index.
Funds that are passively managed also utilize the services of an investment professional who manages the funds portfolio. Passively managed funds are often based on an index and their purpose is to replicate the performance of that index.
The main difference between an actively managed fund and a passively managed fund is in the amount of work the fund manager needs to perform.
The stocks in an actively managed fund are selected based on their fundamental merits and their potential for capital gains and/or dividend income. The stocks for a passively managed fund are selected to represent the makeup of an index. For example, an passively managed fund that is designed to track the S&P 500 index, the fund manager might purchase 100 companies from the S&P 500 index having concluded that these stocks would be a good representation of the S&P 500 performance. These 100 stocks are included irrespective of the stock's fundamental merits or their potential for returns.
Actively managed funds select their stocks
based on fundamental analysis
An actively managed fund involves considerably more work as the fund manger needs to thoroughly analyze the fundamental merits of each prospective stock to be included into the portfolio. Whereas a passive fund manager only needs to select stocks for the portfolio that will replicate the performance of an index.
Passively managed funds select their stocks
based on the index being tracked
The ongoing management of an actively managed fund also involves considerably more work as each stock in the portfolio needs to be continually monitored and reassessed whenever new information becomes available, such as earnings reports which typically come every three months. Whereas a passive fund manager only needs to monitor the makeup of stocks in the index. Should a stock in the index be replaced with another stock, the passive fund manager merely needs to determine whether a stock in the portfolio should be replaced.
The extra work needed to actively manage a fund is reflected in the increased management costs, thus the setup costs and the ongoing annual costs of an actively managed fund are higher than that of a passively managed fund.