Types of Mutual Funds

Mutual funds are broadly classified as:

Open-ended Fund

An open ended mutual fund can allocate any number of shares to its shareholders. A shareholder can acquire shares of mutual fund only from the fund. A fund manager constantly looks at new opportunities to enhance the portfolio.

Shares of an open-ended fund can be bought any time in its lifetime after it is opened to the public. A few open-ended funds may close itself for the new investors or additional interments once it becomes too large to manage new investments. Sometimes when the market is at its peak and the fund manager cannot find anything attractive in the market to add to their portfolio.

A shareholder can only sell his/her share back to the mutual fund. An open-ended mutual fund has to always maintain a comfortable level of liquidity to pay the shareholders in case they redeem their shares. The fund manager has to be always aware of the market conditions otherwise in case of heavy selling the fund may not have enough liquidity to pay its investors. Once shares are redeemd they cease to exist.

Number of outstanding shares keeps changing with the number of shares redeemed and the number of new shares issued.

Closed-end Fund

A closed-end fund is a mutual fund that is traded as stocks in all major stock exchange. Shares of a closed-end fund are sold to the shareholders through initial public offering (IPO). Once the offering period is closed the shares can be bought from another shareholder in a stock exchange.

The main difference between an open-ended fund and a closed-end fund is that a closed-end fund is static. Number of shares of a closed-end fund remains unchanged. Closed-end funds are of various types: municipal bond funds, closed-end bond funds, general equity fund, growth fund, value fund, balanced fund etc.

Unlike an open-ended fund, a closed-end fund cannot shrink in terms of number of shares. The value of a closed-end fund can change. The assets of a closed-end fund and an open-ended fund are managed in the same way. A closed-end fund either sells at either a premium or a discount to the net asset value (NAV) of its portfolio.

I have never seen a definitive study of whether closed-end funds, as a group, do better or worse than open-ended funds. On casual inspection, neither kind has any particular advantage.


-- Peter Lynch (Beating the Street)

Exchange Traded Fund (ETF)

An Exchange Traded fund is a combination of open-ended and closed-end fund. An Exchange Traded Fund comes out with New Fund Offer for the investors. After the New Fund Offer is over, an Exchange Traded Fund has to be listed on an exchange. An investor can purchase units/shares from another investor who wants to sell it. An ETF appoints a Market Maker who makes sure that liquidity is maintained at all the time. If an investor wants to sell some units and there is no buyer in the market, then the Market Maker makes sure that shares are acquired and money is paid out to the investor at a rate that is currently prevailing in the market.

Just like a closed-end fund, an ETF can trade at a premium or at a discount.

Classification of Funds based on investment strategy

Money Market

Money Market funds invest in Commercial Paper, Treasury Bill, Certificate of Deposit and Commercial Bill. Through these investments they lend out money to the Government and Companies for a short term. Money Market funds are considered as safe because an investor can park money to earn a return without any risk of losing the principal. Money Market funds provide very low returns. Even though Money Market funds were always considered safe, during the 2008 economic crisis investors lost money as the NAV went down below $1. To avoid any such occurrences in the future, the U.S. Securities and Exchange Commission brought in a number of new rules (known as the Money Market reforms) to protect investor interest and provide sufficient safeguards to the fund company.

Equity

An equity fund mainly invests in the Stock Market. The fund manager acquires shares of companies through exchanges using the pooled money. Based on the investment theme of the mutual fund, the fund manager chooses from a basket of equities that suit the fund. To reduce the risk that is involved due to investment in the Stock Market the fund might allocate a certain percentage of its assets to be invested into the Debt Market.

Debt

Debt funds invest in debt tools like Treasury Bills, Government Securities, Bonds and Debentures. Their main aim is to appreciate capital by maintaining capital safety. The returns given by debt funds are low, but there is very low risk that the capital will go down.

Gold Fund

Gold funds invest in gold or in companies involved in the production of gold or adding value to gold. Performance of these funds do not entirely depend on the price of gold. Sometimes the performance of the fund may depend on the performance of the companies that it has invested in.

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