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Making Sense Out of the Structure of Mutual Funds

The Key to the Structure of Mutual Funds

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Technically, mutual funds are “open-end” funds -- one of four basic types of an investment company. Closed-end funds, exchange-traded funds and unit investment trusts are the three other types.

In order to understand the structure of mutual funds, it is helpful to compare them to other “40 Act Funds” -- industry jargon for investment companies registered under the Investment Company Act of 1940.

Open-End Funds and the Structure of Mutual Funds

You can think of a mutual fund as having an open-end structure because the cash flow door -- both into and out of the fund -- is always open. In other words, the portfolio manager continues to invest new cash from investors, and the fund company continues to offer new shares of the fund to new investors.

So, when you invest in a mutual fund, money is directed to the mutual fund, shares are created and issued to you (to be held in an account at a brokerage firm, bank or at the fund company). This process is different from investing in a stock. When you invest in a stock, you are buying or selling shares on an exchange or over-the-counter (unless it is an initial public offering or a secondary offering) – new shares are not be created.

Closed-End Funds and the Structure of Mutual Funds

Closed-end funds are often confused with, and mistakenly called, mutual funds. They are similar to open-end funds in that their assets are invested in a wide range of securities. A major difference is that closed-end funds behave more like a stock -- the market value is driven by supply and demand for the shares. On the other hand, an open-end mutual fund continually issues new shares to investors and does not trade on an exchange.

ETFs and the Structure of Mutual Funds

ETF is short for "Exchange-Traded Fund." An ETF holds a basket of securities and trades on a stock exchange. The market value of an ETF changes throughout the day based on the supply and demand for each individual ETF. The net asset value (value of the securities within the fund) of an ETF may differ from the market value (price that an investor purchases/sells the ETF) due to the supply and demand effect.

UITs and the Structure of Mutual Funds

UITs can be thought of as a hybrid investment; sharing some of the qualities of mutual funds and some of the qualities of closed-end funds.

UITs are similar to mutual funds in that an investor can redeem shares (versus trading on a stock exchange) from the UIT sponsor. But unlike mutual funds, UIT sponsors might also maintain a secondary market in the UIT. In other words the UIT sponsor might facilitate buys and sells between investors in order to avoid depletion of the UITs assets.

UITs, like closed-end funds, issue a set number of shares. These shares are called “units.” Unlike closed-end funds (and open-end funds), the securities within a UIT portfolio are not actively-traded.

A UIT portfolio is established at the inception date and holds the original securities until termination of the UIT. At the termination date the UIT shareholders either receive the proceeds of their investment or they can reinvest in the next UIT series (if available).

Structure of Mutual Funds -- Advantages and Disadvantages

According to the Investment Company Institute, the US investment company industry stands at $10.3 trillion dollars (as of December 31, 2008). While there are advantages and disadvantages for each of the four types of investment companies, it appears that investors believe the advantages of mutual funds outweigh the disadvantages of mutual funds -- and outweigh the advantages of other investment companies.

Open-end mutual funds continue to hold and gather the vast majority of investment dollars. According to the Investment Company Institute, as of December 31, 2008, $9.6 trillion of the $10.3 trillion investment company industry is held in mutual funds.

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