There are many different ways to go about investing your money. Businesses often offer their employees retirement plans as one option. Another is to be your own financial advisor or seek out a professional as you dive into the stock market.
Regardless, each option should be explored thoroughly, and you should always keep diversity on the top of your mind for the best results. Haven’t you ever been told not to rush into things? Keep that thought as you build your portfolio and set foot on the road to financial growth.
Are you dreaming about mutual funds; adding them to your portfolio for future success? If so, what do you know about them? Let’s cover the basics first.
The Basics of a Mutual Fund
Mutual funds provide advantages to investors. They involve a mixture of investments from stocks and bonds to short-term debt and other types of alternative assets.
Need a visual? No problem. Close your eyes and think about a checkered cake with more than one ingredient or flavor to choose from. Delicious and savory to the taste! Mutual funds can give a similar reaction, maybe not to your taste buds but your financial plan.
What role do mutual funds play within the cake? The funds themselves serve as that protective layer of buttercream frosting on the outmost layer. As you purchase them and other investors, you each receive a slice of the cake. This is considered your share.
Types of Mutual Funds
Just like there are different flavors of cakes, there are different types of mutual funds. You can choose from:
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Closed-Ended Mutual Funds
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Open-Ended Mutual Funds
Our focus here will be on open-ended mutual funds, but it’s best to touch on closed-ended too.
Advantages of Mutual Funds
What does a mutual fund provide that other types of investments don’t? Mutual funds:
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Provide diversity. Within a mutual fund, there is exposure to an array of investments. This translates to different asset types and companies. Mutual funds do the work for you, keeping it as balanced as possible in order to meet the plan’s objective.
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Align with your investment objective. What is your end goal? To retire at your target retirement age, or maybe earlier? Buying a house?
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Carry lower costs than other investments. Since mutual funds are large and are trading frequently, it makes the transaction costs more affordable and manageable compared to those associated with an individually traded investment.
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Convert to cash quickly. They are liquid assets, redeemable at their current net asset value, with less applicable expenses (or transaction fees).
Open-Ended Mutual Funds - What Are They and How Do They Work?
Another way to think of open-ended is to think limitless. For example, an open-ended question encourages more than a one-word response. So when we talk about open-ended mutual funds, we are speaking of a fund available around the clock.
There is not a set limit to the number of shares that can be issued or redeemed, and there is no set maturity date. In fact, new shares are added, increasing the fund at purchase, and at the time of sale, those shares get retired.
Examples of open-ended mutual funds include:
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Traditional mutual funds
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Hedge funds
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Exchange-traded funds (ETFs)
Are Open-Ended Mutual Funds Managed Passively or Actively?
The answer here is both. It depends on the open-ended mutual fund you seek and your preference in how it is managed.
An actively managed fund means handing the investing decisions to a fund manager. This person is steadily watching the market's movement and ultimately is responsible for the performance of the fund. Both costs and risk are higher with an actively managed fund, though you may see greater returns on your investment because of it.
A passively managed fund rips out the manager and mirrors the market index. People who are risk-averse or are at peace with allowing their money to multiply gradually lean this way. Plus, passively managed funds are less expensive to manage.
Neither management style is good nor bad. The choice remains in your hands as the investor.
How Are Open-Ended Mutual Fund Shares Issued?
Unlike its sibling, the closed-ended mutual fund is purchased via the stock exchange; an open-ended mutual fund is obtained directly by the fund or fund manager.
Open-Ended Mutual Funds are issued based on the net asset value (NAV) per fund's share. This is the price the shares are either purchased at or sold for in the market.
Is your next question how the net asset value is calculated? If so, we have you covered. The formula takes the fund assets' total value (what is owned by the fund) and reduces it by the related liabilities (what is owed by the fund).
The NAV is subject to change on a daily basis. Why? Because the market value of the fund and its associated liabilities can fluctuate daily too.
Tax Implications With Open-Ended Mutual Funds
No one wants their investment to be in a loss position. But no one loves the idea of paying taxes either. The reality is you are taxed for capital gains. When a fund manager sells shares from the fund for a profit, that profit spreads to the investors, creating the capital gain.
Equity funds and debt funds have particular tax rules to follow. When 65% or more of the mutual fund assets are vested in equity, it is considered an equity fund.
When 65% or more of the mutual fund vests in debt, it is considered a debt fund. Each is taxed differently. You will receive a 1099-DIV for tax purposes when a capital gain occurs.
Pros and Cons Associated with Open-Ended Mutual Funds
There are always pros and cons with any decision you need to make in life. With open-ended mutual funds, advantages you can expect are as follows:
- Historical Data Is At Your Fingertips. Historical trends are a strong analytical tool to help make decisions for the future. Fund managers have access to these trends, which gives them the upper hand when making their investment decisions.
- Systematic Options Are Available. A systematic investment plan (SIP), systematic transfer plan (STP), and systematic withdrawal plan (SWP) provide options for the investor when adding to their investments or making a withdrawal.
- Now for the disadvantages:
- Carry Exit Loads. Exit loads are fees charged at the time of an investor redeeming their fund in full or partially within a specified period.
- Rapid Inflows and Outflows. When outflows occur, investors risk a significant loss that is difficult to overcome in a declining market. On the other hand, there is a risk of taxable capital gains passed on to investors in a booming market.
Open-Ended Mutual Funds Versus Closed-Ended Mutual Funds
A mutual fund is a mutual fund, right? Wrong. Although open-ended and closed-ended mutual fund appears the same from the surface, they act differently. Let’s learn a bit more about closed-ended mutual funds to understand how they contrast.
Closed-Ended Mutual Funds
When something is closed, it is simply not open. A transaction or process is stopped. Thus, a closed-ended mutual fund carries limitations allowing the investor to have a fixed number of shares. An example of a closed-ended mutual fund is a municipal bond fund.
Closed-ended mutual funds are considered the oldest type. They were introduced to the market in the late 19th century. They function similarly to that of stocks, trading during regular business hours and requiring an initial public offering (IPO) before making their debut on the market.
Most closed-ended mutual funds are actively managed, giving authority to a portfolio manager to perform the work on your behalf. The manager is responsible for buying and selling investments to keep your portfolio above the market index. Keep a close eye on those broker fees; they can accumulate fast!
The Bottom Line
Focus on the investment objective as you explore mutual funds, whether open-ended or closed-ended. Does it align with what you expect to achieve in your financial plan? If the answer is yes, you are on the right track with your strategy for growth.
Open-ended mutual funds are becoming more and more popular today. They are included in many 401(k) investment portfolios and more. They achieve the best results in the long term, so if you are hoping to turn over your money in the short term, these may not be the best route to follow on its own.
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Sources:
A Guide to Closed-End Funds | Investment Company Institute
Open-end Mutual Funds - Overview, Net Asset Value, Pros and Cons