Fund Form Should Match Function
Misunderstanding how a fund works is a recipe for unhappiness
Most NN readers know that investment funds vary widely in what and where they invest, like stocks or bonds, and how those securities are selected. But many are likely not aware of the varied legal forms the investment funds themselves can take, or what purpose each serves.
This NN will look at the five most prominent fund forms in terms of organization. While mutual funds hold more than five times the assets of the other four types combined, the total held in vehicles other than mutual funds is far from trivial at nearly four trillion dollars.
Diversification is a common trait of most funds and all fund types. It's largely why funds are structured as funds in the first place. But each kind of fund carries its own particular set of risks, as well as opportunities. We will attempt to shed light on why an investor might prefer one over another in this NN.
Mutual Fund (Open-Ended) - A basket of securities continuously offered by a company through which individuals can gain access to a professionally managed pool of money.
- Pros: Next day liquidity and generally low in cost. Literally thousands of choices.
- Cons: Tax inefficient. Daily liquidity forces managers to hold cash.
- Best Use: In a tax-sheltered account, unless used for current income. Auto-reinvestment. Buy and hold.
Exchange Traded Fund (ETF) - A basket of securities that tracks an index or follows a defined and set investing strategy. Trades like a single stock during the day at a single market price.
- Pros: Low cost and tax efficient. Daily liquidity. Nearly as many strategies as mutual funds.
- Cons: Less popular ETFs can experience large bid/ask spreads; Not actively managed so will never outperform designated index. Not well-suited for auto-reinvestment.
- Best Use: Within a taxable account comprised of other ETFs. Traders. Niche strategies.
Closed End Fund (CEF) - A managed basket of securities that trades like a stock with a single market price. A kind of hybrid between a mutual fund, ETF and a stock.
- Pros: Tradeable in secondary market, tax efficient, often available at a discount to underlying value after IPO.
- Cons: May trade perpetually at a discount to underlying value. Trading commissions. Often leveraged to increase yield which also increases risk/volatility.
- Best Use: As an income investment, mainly or only for investors that can withstand higher volatility.
Unit Investment Trust (UIT) - A fixed basket of securities initially made available in units, or shares, via an Initial Public Offering. Usually has a maturity date at which time the holdings are liquidated and cash is returned to shareholders.
- Pros: Designed for tax efficiency; Pre-defined maturity date provides clear and known exit strategy.
- Cons: Un-managed after IPO launch; Broker commissions apply to buys or sells; Lack of robust secondary market results in weak price discovery mechanism.
- Best Use: Easy way to buy into a diversified bond portfolio without much long-term principal risk for those who don’t mind waiting until maturity.
Interval Fund (IF) – A managed portfolio of mostly private and/or less liquid securities. Price set by the investment company based on the underlying securities. Does not trade actively on the secondary market.
- Pros: Provides ready access to the private security market for “average” investors. Often offers an attractive interest rate. May be auto-reinvested.
- Cons: Restricted liquidity. Costly to purchase through a commissioned broker. High expense ratios. Weak transparency. No tax advantages.
- Best Use: Either in taxable or non-taxable accounts, sometimes for income purposes. Offers access to illiquid investments but may require holding for extended periods.
As shown above, each fund type solves specific investment need(s). Any one of them could be a good choice in the right situation. It's important to
understand their nuances and trade-offs. As an example, ETFs appear to be best for an investor who wants to trade frequently. But if amounts traded are small, the cost of trading can overwhelm the liquidity benefit. As another example, interval funds may present an attractive combination of high yield and less volatile price movements. However their limited liquidity feature can be a noteworthy negative.
Ned’s Notes Takeaway: Choosing the correct fund type is nearly as important as deciding on a particular fund. However many investors skip this crucial step, consciously or unconsciously. The opportunities and limitations inherent to each fund type should be matched up with the investor's needs along with deciding in what and where the fund invests.
Addendum: Ned's Notes is a proprietary newsletter created by none other than Ned. Feel free to forward it to others as you like but its contents may not be used for commercial purposes without the express consent of the author.
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