The following post is a contribution from Gary, a personal finance blogger who focuses on investing, saving, real estate, credit and debt, career and education advice, budgeting, and insurance at Gajizmo.com. Gary has worked at an internet company on their M&A team, as well as two private equity firms, and has a Real Estate Broker’s License.
Investment funds allow small and large investors to pool capital together and enjoy higher investment returns with lower risks than private brokerage accounts. Mutual funds offer many benefits, such as easy diversification of securities, professional management, lower trading fees and costs, and increased liquidity. However, investing in these funds requires research. The type of fund an investor chooses should fit his/her financial goals – capital growth vs. income – and investment philosophy, such as managed vs. passive, industry focus, growth vs. value vs. dividend stocks, types of securities purchased (stocks, bonds, REITs, commodities, etc.), and the size of companies in the portfolio.
The three main types of investment funds that companies offer are open-end funds, closed-end funds and unit investment trusts. While all of them manage money for individual investors, pension funds or employer-matched IRAs and 401(k)s, each has its own structure and characteristics.
The most common type of mutual fund investment companies, open-end funds can buy and sell an unlimited number of shares as investments. They can also issue an unlimited number of shares to investors and create a larger pool of capital, while buying back shares from investors who wish to cash out their investment. Most well know mutual fund companies are open-end funds like Fidelity, Vanguard, American Funds, American Century, TIAA-CREF, Franklin, Pioneer, AIM, Putnam and Eaton Vance.
Investors can only buy shares from the issuing company and must redeem and sell those shares back to the company when they want to recoup their investment. There is no secondary market for open-end funds. This structure of easily selling your investment position in a fund increases fluidity and liquidity for investors. A fund may become closed to new investors if it grows so large it cannot achieve its investment goals. Funds usually invest in specific industries like biotech, technology, energy, consumer staples, healthcare, etc., but if the investment focus is narrow, there may be an insufficient number of shares available for purchase and the fund will have to stop accepting new investors.
Charges and Types of Shares:
Within open-end funds, there are load and no-load funds. A load is a commission that is charged when shares are bought or sold. The majority of the commission is paid to the broker who makes the sale, and a percentage of the load is paid into the fund. How the investor pays the load depends on the type of shares purchased.
A Shares. With A shares, the investor pays the full cost of the load upfront when he buys the shares. Generally this is done by deducting the percentage load from the amount of money that is being invested (your capital allocation). If the load is 5% and the investment is $20,000, the fund will take an investment fee of $1,000 and the amount that will be applied to the purchase of shares is $19,000. If the NAV, or net asset value, of the mutual fund is $100 per share, your $20,000 investment, minus fees, will get you 190 shares.
B Shares. Investors who select B shares do not pay a load at the time the shares are purchased. Instead, the load is assessed when the shares are sold. The amount of the load is typically determined on a sliding scale with investors who sell their shares in the first year paying the highest percentage in load fees. The longer the investor holds his shares, the lower the percentage of the load and after a specified number of years, there is no fee for sales of shares. For example, for the first year, a fund may charge 6%; the second year, 5%; the third year, 4%, until the seventh year, when there is no load. B shares usually have higher annual costs for administration than A shares.
C Shares. C shares are like A and B shares combined – they have a smaller load at the time of purchase than A shares (usually 1% or 2%), but similar to B shares, there is also a load when C shares are redeemed and sold. Typically, C shares have the highest annual administrative fees and are best for investors who plan to hold the shares for at least two years.
Open-end funds have two prices, the NAV or net asset value, and the POP or public offering price. The NAV does not include the cost of loads. The POP is the price new investors must pay for shares and includes the cost of sales charges. The NAV is used for quoting the fund or per share price when researching a fund’s past performance. The price of open-end funds is updated at the close of each trading day.
Variable Annuities and Variable Life Insurance Polices:
Mutual fund investment companies contract with life insurance providers and variable annuity funds to provide investment shares that are the same as the publicly traded shares, but, under SEC regulations, must have separate names and CUSIP numbers (SEC tracking numbers). This can be confusing to investors who are looking for their favorite mutual fund in a variable investment vehicle. While the name of the fund may be different, the shares are exactly the same and have the same manager and objectives as the more familiarly named public fund.
Unlike open-end funds, closed-end funds issue a limited number of shares. Shares are issued in an IPO (initial public offering) and the shares are traded on the securities exchange in the same way as stocks. Since many closed-end funds are income-oriented, they may use leverage to pay higher yields and this makes closed-end funds a riskier investment than open ones. Management is also more active than open end funds and there are no loads or commissions. Investors pay a commission to a broker when buying or selling shares.
Exchange-Traded Funds (ETFs):
Exchange traded funds or ETFs are a particular type of closed-end fund that are not actively managed. These funds trade daily like stocks and other closed-end funds, but the fund investments usually remain static. This means that the securities within the fund’s portfolio do not change as they may with other types of funds. ETFs charge lower fees than other mutual funds because they are not actively managed and they have a range of investment objectives.
Unit Investment Trusts (UITs):
These investments have characteristics of both closed and open-ended funds. Like closed funds, the number of units is limited. Units are typically purchased from the issuer, but some secondary trading may be possible. Similar to ETFs, the portfolios are not actively managed; however, unlike ETFs, UITs hold their investments for a specified period of time that is decided by the trust that manages the fund. At the end of the period, the trust is dissolved and the funds are distributed among the investors. Returns on UITs are taxable and losses are deductible. The sales commission for purchasing UITs is generally between 1% and 5%.
Final Word on the Types of Investment Funds:
The right investment vehicle for an investor depends on his or her risk tolerance, objectives and the anticipated duration of the individual investment. Typically, closed-end funds, ETFs and UITs are best for short term investors who like trading, while open-end funds are better long term investments. The best investment strategy is to discuss options with a professional financial advisor before making a decision on the investments that best meet your needs. If you are interested in learning more about investment funds, check out the advantages and disadvantages of mutual funds and a comparison of the two largest fund companies, Fidelity Investments vs. Vanguard.
Editor’s Note – Thank you Gary for that very detailed contribution. Readers, which types of investment funds do you prefer to invest in? I’ve been a no-load mutual fund guy with Vanguard for a long time, but that doesn’t mean that there aren’t lots of other great options out there. Which ones do you like to use?
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