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.