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Types of Mutual Funds: Open-Ended and Closed End Funds

The two most common types of mutual funds are open and closed ended, and they differ greatly in makeup and price advantage.

Basic Types of Mutual Funds

There are two basic types of mutual funds. “Open-ended” mutual funds are the most common type of mutual funds. Investors may purchase units from the fund sponsor or redeem units at the valuation promised in the fund documents, usually on a daily basis. “Closed-ended” mutual funds are traded as financial securities once they are issued and holders must sell their units on the stock market to receive their funds back.

Types of Mutual Funds: Closed vs. Open

Open Mutual Funds

Open mutual funds are established by a fund sponsor, usually a mutual fund company. The sponsor has promised in the documents of the fund that it will issue and refund units of the fund at the fund unit value. These types of mutual funds are valued by the fund company or an outside valuation agent. This means that the investments of the fund are valued at “fair market” value, which is the closing market value for listed public securities. Essentially, the fund company prices all of the fund’s holdings at the market close and adds up their value; it then subtracts amounts owing and adds amounts to be received by the fund before finally dividing this net amount by the number of units outstanding to “strike” the unit value for that day. Any participants withdrawing funds from the fund that day receive this unit value for their funds withdrawn. Any new purchases are made at the same unit value.

Closed Mutual Funds

Closed mutual funds are really financial securities that are traded on the stock market. A sponsor, a mutual fund company or investment dealer, will create a “trust fund” that raises funds through an underwriting to be invested in a specific fashion. These types of mutual funds retain an investment manager to manage the fund assets in the manner specified.

Once underwritten, closed mutual funds trade on stock exchanges like stocks or bonds. Their value is what investors will pay for them. Closed mutual funds usually trade at discounts to their underlying asset value. For example, if the price of the fund assets less liabilities divided by the outstanding units is $10, the fund might trade on the stock market at $9. This fund would be said to be trading at a “10% discount to its net asset value.” The reason for this discount is debated by academics, but is due in large part to the lack of liquidity of the fund units and the presence of the management fee.

Negative Value of Management Fees and Administration Costs

The holder of a closed-end mutual fund also has to consider the effect of the management fee and administration costs on the value of her fund holding. Since the closed-end fund documents allow these charges to be made against fund assets for the life of the fund, it presents an ongoing cost to the unitholder compared to holding the securities directly. If these fees amount to 3% per year, this means that there is a future stream of expenses built into the actual value of the fund units. These types of mutual funds will deduct these expenses from the fund income or sell holdings to pay the fees as contracted. In financial terms, these expenses or outlays are “negative cashflows” that have a “negative present value” accounting for the time value of money. As a rough cut, with a very long term to the life of the fund (a duration of over 10 years) and fees and expenses of 1% per year would indicate a 10% discount to asset value and a 3% fee would be 30%. This is one figure that underwriters don’t feature in their marketing literature for new issues of closed-ended funds

Liquidity and Redemptions

Open mutual funds keep some portion of their assets in short-term and money market securities to provide available funds for redemptions. A large portion of most open mutual funds is invested in highly “liquid securities,” which means that the fund can raise money by selling securities at prices very close to those used for valuations. Funds also have the ability to borrow money for short periods of time to fund redemptions. The documents of open mutual funds usually provide for the suspension of unit redemptions in “extraordinary conditions” such as major interruptions to the financial markets or total demands for redemptions forming a substantial portion of the fund assets in a short period of time.

Illiquid investments, those not actively traded on the public markets, are restricted by government regulators because they are difficult to dispose of in a short period of time. A fund holding an illiquid investment might not be able to sell it in a short period of time or would have to take a significant discount to the valuation level the fund was using.

Other Types of Investment Funds

There are many other investment funds that are quite similar to these types of mutual funds. These look and act like mutual funds but differ in their legal status and nature of their investments.

Exchange Traded Funds have offered strong competition to mutual funds in recent years, primarily because of lower costs to the investor. That is because they generally track an index, such as the S&P/TSX, S&P 500 or the Nasdaq as opposed to traditional mutual funds made up of a basket of equities or bonds (or both), which is actively managed.

“Pooled funds,” for large and sophisticated investors, are unit trusts like mutual funds but fall under prospectus exemptions from securities legislation. “Segregated funds” are really insurance contracts that depend on the value of a portfolio of investments and are legally “variable rate insurance annuity contracts.” “Labor Venture Funds” are pools of capital that take advantage of special tax incentives for labor unions to establish investment funds that invest in smaller and start-up businesses. “Royalty Trusts” are closed-ended unit trusts which take the income from a pool of income producing assets and pass this through to investors.