Mutual funds have existed in the U.S. since 1924. But it’s been in the last two decades that the industry has undergone its greatest growth as retirement-minded baby boomers developed their voracious appetite for these investing vehicles.
Today more than 8,200 mutual funds are open to investors and traders in U.S. Each can be categorized according to investing style, types of securities held in its portfolio, operating structure, sales fees, operating expenses, turnover rate, the presence or absence of trading penalties and other factors.
So to help make sense of this smorgasbord, here’s an overview of the types of stock mutual funds that you may encounter.
Open-end and closed-end funds
An open-end fund continually issues fresh shares to buyers and redeems shares of sellers. You can buy your open-end fund shares directly from the fund company, eliminating the need to go through a broker and incurring a commission. Some fund families also participate in “supermarkets” which allow you to buy funds outside the family itself, keeping your holdings under a single account, simplifying your bookkeeping and tax preparation, and again, avoiding commissions.
Investors or traders in open-end funds buy their shares at Net Asset Value. The NAV is the mutual fund equivalent of a stock’s share price. At the end of the market day, each fund recomputes its NAV by summing the value of all assets held in the fund, net of liabilities, then dividing by the number of fund shares.
If you buy or sell an open-end fund during the trading session, you will get the NAV based on that day’s price (assuming no loads or redemption fees, which we will discuss shortly).
Funds finalize their NAVs and close for orders at the different times. Some stock funds, for instance, require that you enter your order by 3:00 p.m. ET to get that day’s closing NAV, which will be based on the stock market close an hour later at 4 p.m. ET. Other funds allow you to get the day’s NAV on orders entered as late as 5 p.m. ET.
This is of little or no significance to long-term investors. But it obviously rules out open-end mutual funds as a vehicle for traders who aim to take advantage short-term price moves and market movements. If you fall in this category, exchange-traded funds (ETFs) or closed-end funds may offer a better alternative.
As of January 2000, the Investment Company Institute, a mutual fund trade association, tracked 7,800 open-end mutual funds in the U.S.
A closed-end fund has a lot in common with an open-end fund. Each owns a basket of securities, typically stocks and/or bonds, thus reducing risk through diversification. Each has a professional manager who picks, buys and sells the holdings. Each is offered an investment company, most of which offer a number of different funds.
Unlike its open-end cousin, a closed-end fund only offers a fixed number of shares to investors. They decide in advance how many shares to sell, capitalize in an initial public offering, then close their doors to newcomers.
Shares then trade on exchanges just like shares of stock. So unless you get in on the IPO, you don’t buy closed-end fund shares through the fund’s investment company. Nor do you redeem shares through the fund. Instead, you transact shares through the secondary market. There were about 500 closed-end funds at the end of 1998.
Some traders and active investors trade closed-end funds, since they can attempt to take advantage of intraday price moves in these instruments.
However, closed-end funds pose an added complication. Over the long run, a closed-end fund’s quoted share price should correlate directly with the net value of its underlying assets. But practice, closed-end funds will often trade at a discount or a premium to NAV. If this poses a problem, you should consider exchange-traded funds as your fund vehicle for investment or trading.
“Closed-end funds have historically had a problem in that their price can trade at a premium or a discount to the value of the underlying securities,” said Jim Novakoff, an expert on ETFs and partner of Levitt, Novakoff, a Boca Raton, Fla.-based investment firm. “This creates additional investment uncertainty and limits the use of closed-end funds. ETFs trade much closer to the value of the underlying securities because they have a built-in arbitrage mechanism. The creators of the ETF specifically designed them to overcome the pricing problems with closed-end funds.”
Load and No Load
A load is simply a sales fee charged you for purchasing a fund. It can range from less than 1% of purchase price to higher. Front-loaded funds levy their loads at the time of purchase. Back-loaded funds collect their fees upon redemption. A no-load fund does not charge a fee for the purchase or sale of shares.
There’s no free lunch, of course. Load or no load, funds can charge multiple fees to recoup their costs and pay for their services.
Funds that impose 12b-1 fees to recover marketing and distribution costs deduct them from fund assets on a yearly basis. The Securities and Exchange Commission caps the 12b-1 at 1% of fund assets. Management fees are calculated as a percentage of assets, and they often tend to decline as a fund assets grow.
What matters to you is the total effect of all fees. For that, consult the fund’s annual expense ratio. The ratio does not factor in loads. The number should decline as a fund’s net assets grow, enabling the fund to spread costs over a wider asset base.
Strategies and objectives Investment objectives vary too greatly to be covered in their entirety here. What follows is a broad description. When considering any fund, you should explore its stated objective in its prospectus.
Actively managed funds are run by managers who seek out stocks they believe offer the opportunity to beat the return of the market.
Passive funds are the closest thing to a fund operated on autopilot. Rather than a fund manager making human judgments about which stocks to buy, hold or sell, the passive fund invests according to a mechanical system.
The best-known passive funds are stock index funds, which target various equity indexes. An example would be the Vanguard 500 Fund, which tracks the S&P 500 Index. Since stock selection is largely automated, index funds often entail much lower expenses than actively managed funds.
Growth funds invest in companies whose earnings are growing faster than most of their peers. These stocks often trade at high Price-to-Earnings ratios and other fundamental ratios.
Value funds buy shares in companies whose stocks have taken a beating in the market and, in the view of the stock picker, are trading at a discount to the value of their businesses.
Blend funds, true to their name, blend both growth and value stocks.
Most growth and value funds are under active management, but passive examples exist as well. Actively managed growth funds include ^PBHGX^ and Invesco Dynamics (FIDYX). Examples of actively managed value funds include Van Kampen American Value (MSAVX) and Vontobel U.S. Value (VUSVX). Passive examples include Vanguard Index Growth (VIGRX), which tracks growth stocks in the S&P 500, and Vanguard Index Value (VIVAX), which tracks value stocks in the S&P.
Growth and income funds hold shares in large, established companies that pay dividends (income) and are believed to promise share price appreciation. In the 1990s, General Electric (GE) was the classic growth-and-income stock. Sector funds focus their assets in a single sector or industry. As a result, these funds are not regarded as diversified. If a fund’s sector falls on hard economic times, its share values almost invariably follow suit as well. If the industry heats up, so does the sector fund investing in that area. International funds invest in foreign markets. Some are free-ranging, investing in companies all over the globe. Others target specific regions such as Europe, the Pacific Rim and Latin America. Some focus further into individual countries.
You also can find funds that focus on U.S.-based multinational companies that derive a major share of their sales and profits from overseas. Fund manager L. Roy Papp runs two such funds: Papp America Abroad (PAAFX) and Papp America-Pacific Rim (PAPRX).
Many funds will actively target companies of certain sizes, as defined by a company’s market capitalization. A company’s market cap is simply the value of all its outstanding stock. It’s calculated by multiplying a company’s total shares outstanding by their share price.
In 2000, many observers considered large-cap stocks to represent companies with market caps exceeding $5 billion. Mid-cap companies fell in the range of $1 billion to $5 billion. Below that level, come small-cap stocks.
While most attention typically is focused on stock funds, there is one fixed-income vehicle all fund investors should know about: money market funds. Money market funds are like bank accounts. Although not insured by the FDIC, these funds invest in safe, short-term interest-bearing instruments. No money market fund has ever defaulted.
Money market funds provide you a place to safely park your assets in cash. You may be an active investor or trader, lying in wait until you judge conditions ripe to move your assets en masse into your chosen index or sector fund. Or you may be a buy-and-hold investor with a big chunk of change that you plan to dollar-average into a diversified fund on an automated basis from your money market fund.