Open-End vs. Closed-End
Closed-end funds (CEFs) are investment companies that issue a fixed number of shares that trade intraday on stock exchanges at market prices. Since the market price is determined by investors, the price does not necessarily reflect the underlying value of the assets. CEFs trading below their net asset value (NAV) are said to be trading at a discount, while those trading above their NAV are considered to be trading at a premium.
Exchange-traded funds (ETFs) are a hybrid between open-end mutual funds and closed-end investment companies. While they are legally structured and classified as mutual funds, they trade on intraday stock exchanges like CEFs. ETFs may buy and sell shares in their fund – like a mutual fund – but they only trade in large block sizes with authorized participants.
There are many benefits and drawbacks to both open-end and closed-end investment companies. For most investors, open-end mutual funds provide the safest bet because mutual funds are obligated to repurchase shares at the NAV, so there’s less liquidity risk. ETFs have become increasingly popular because they can trade throughout the day with different tax implications. CEFs remain popular in some circles because they may provide great value.
Active vs. Passive
Passively managed funds seek to track the performance of a specific benchmark index. While investors can choose which index to focus on, the fund manager does not engage in any stock picking and simply seeks to mimic the index’s performance. A great example of a passively managed mutual fund is the Vanguard Total Stock Market Index Fund (VTSMX), which provides investors with broad exposure to small-, mid-, and large-cap growth and value stocks in the U.S.
Most academic research supports passively managed mutual funds as a superior option given their lower expense ratios. According to the Efficient Market Hypothesis (EMH), it’s impossible for a fund manager to beat the market over the long run because market efficiency causes share prices to always incorporate and reflect current information. There are very few funds and investors, such as Warren Buffett, that have a consistent track record of beating the market.
Taxable vs. Tax-Exempt
Mutual funds make two types of taxable distributions to their shareholders: ordinary dividends and capital gains. Ordinary dividends are generated from interest and dividends earned by securities in the portfolio and any net short-term capital gains realized after the fund’s expenses are covered. Capital gains arise from a fund’s sale of securities held in their portfolio for over a year and are taxed at a different rate in some cases.
Some mutual funds – such as municipal bond funds – are tax-exempt, which means that investors may not owe any tax on dividends. Even though the dividend is tax-exempt, investors must report the amounts on their income tax returns. Some of the income earned from these funds may also be subject to the federal alternative minimum tax (AMT), which is an important tax consideration for individuals that might be at risk.
The Bottom Line
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