Mutual funds are investment vehicles managed by an investment management company which pool funds from its participants called unitholders and invest them according to a specific investment style to earn return for the unitholders and allow diversification opportunities.
A mutual fund is created by forming a legal entity which collects cash from investors and issues them shares called units in proportion of their investment. The fund has a portfolio manager (called fund manager) which invests the cash raised in stocks, bonds, money market or in a combination of all the above asset classes depending on the mutual fund investment mandate.
Open-end fund vs closed-end fund
There are two main mutual fund structures: open-end fund vs closed-end fund. The open-end fund can issue new units and buy back existing ones at the current net asset value per share, but a closed-fund doesn’t. The number of units in case of the closed-end fund stays the same throughout the life of the fund. The following table summarizes the difference between open-end and closed-end funds:
|Structure||Open-end fund||Closed-end fund|
|Issue and redemption of units||Issues new units and redeem existing units at the current net asset value per unit.||The number of units is determined at the start of the fund and there is no new issue or redemption.|
|Existence of secondary market||The units are purchased from and sold to the mutual fund.||The units are bought and sold in a secondary market to other investors.|
|NAV||The units are traded at the net asset value per share.||The units can trade at a discount or premium to the net asset value per share.|
|Advantages||Due to the flexible structure, the fund is able to attract more investors.||The fund manager has more flexibility in choosing investments thereby potentially earning higher return.|
|Disadvantages||The fund might be required to liquidate investments prematurely in order to redeem units which hurt the fund’s total return.||Due to unitholders inability to redeem their units by selling them to the mutual fund, the fund’s growth is restricted.|
No-load funds vs load-funds
All mutual funds charge an annual management fee from its investors which is subtracted in the calculation of the net asset value per share. There are some funds called load funds which charge a fee at the time of issue of new units or redemption of units in addition to the management fee. The mutual funds which do not charge any fee at the time of issuance or redemption of units are called no-load funds. Some funds may charge the additional fee only if investors redeem their units early say before 2 years, etc.
The load funds are further classified into front-load funds and back-load funds. The front-load mutual fund is a fund which charges a fee at the time of issuance of new units. For example, if a fund carries 3% front-load fee, $100 of your investment will get you a $97 equity in the mutual fund. On the other hand, back-load fund charges a fee at the time of redemption of units.
Written by Obaidullah Jan, ACA, CFA and last modified on