“Mutual Fund” – a pooled investment structure, with professional management and typically holding a diversified portfolio allowing multiple share holders to own a slice of such a portfolio easily.
But we often hear people talking about mutual funds and comparing them to Exchange Traded Funds (ETFs) and Closed-ended funds (CEFs).
First, note that ETFs and CEFs are also mutual funds. We often use the term “mutual fund” as a short-hand specifically to refer to traditional open-ended mutual funds (the kind where you buy shares by sending money to the fund and at the end of the day the fund issues shares directly to you, or vice versa).
An “open ended” mutual fund is simply a fund where the manager/sponsor can create or destroy shares as needed to either allow new participants to buy in or to cash out existing participants. Sometimes such funds are closed to new shareholders for various reasons (often because they’ve grown too fast or too much and all the money is becoming difficult for the manager to put to work without affecting the other shareholders or the market in which they trade). When one buys into or sells out of a traditional open-ended mutual fund, one’s shares are typically created or redeemed at the end of the day, and for exactly the proportional value of the Net Asset Value (NAV) (the proportional share of the aggregate shared portfolio) that those shares represent.
So, generally, if you see the term “mutual fund” in isolation, it’s referring to traditional open-ended mutual funds.
ETFs and Closed End Funds are also mutual funds, but the process by which shares are created or redeemed differs from the open-ended funds.
CEFs usually have a fixed number of shares created when they are started and they simply trade in secondary markets on stock exchanges. CEFs have some advantages and disadvantages. Because there is a fixed number of shares and the manager doesn’t have to deal with redemptions or new cash infusions, a CEF may more safely hold illiquid securities. CEFs often also are able to engage in leverage – borrowing money in order to amplify the behavior of the overall portfolio. Leverage, of course, is a two-edged sword – it amplifies both ups and downs. Because CEFs are particularly well-suited to illiquid securities – and offer access to leverage – there are many CEFs which specialize in municipal bonds.
ETFs also trade on stock exchanges, but unlike CEFs, ETFs also have a process whereby new shares are constantly being created or redeemed. Most retail investors buy ETF shares from other shareholders via trades on a stock exchange. But there are special market participants (called “Authorized Participants” — typically large banks) who actually create or destroy those shares in exchanges (of cash and/or securities) with the ETF. The process of creating or destroying shares in that way may allow an ETF to push some holdings with capital gains out to those special participants — thus minimizing how often they have to push capital gains out to ordinary shareholders. This may add a layer of potential tax efficiency to the ETFs.
Because CEFs and ETFs trade on stock exchanges, it’s possible that the price for which they trade may not match exactly the value of the share of the underlying portfolio. For CEFs, this difference — called a discount or premium — may be quite substantial and can be extremely persistent. For ETFs, it’s usually small and short-lived, as those special market participants see any variance between trading share price (market price of shares) and underlying portfolio values (NAV — see above) as an opportunity to arbitrage out that premium/discount.
In all cases – ETFs, CEFs, and traditional open-ended mutual funds, if the fund is an index fund which tries to track an index it may or may not track it precisely. Most CEFs are actively managed. Most ETFs track indexes (though more new actively managed ETFs have been coming to market recently), and traditional open-ended funds may be index funds, index-like passive funds, or actively managed.
For an S&P500 index fund, it’s likely that the fund will track the index pretty closely (minus expenses) — it’s relatively easy to simple (for a fund company) to buy those 500 stocks in the right proportions and just sit on them because the S&P500 is market-cap weighted, 500 stocks isn’t that many (for a fund), and those 500 are amongst the largest, most liquid, easily traded stocks in the world.
Most other indexes are much harder to track, and some are extremely difficult to track — not everything in the index may actually *trade* (this is especially true of bond funds), or the index may hold way more things then they can reasonably buy (say, a total market fund) — or the composition of (or proportion of things in) the index may vary more constantly (especially an issue for indexes which are not simple market-cap-weighted ones).
On top of that tracking error — an index fund will also not match the index itself because there are things like paying the managers, administrative overhead, trading costs, etc. etc.
All three types of funds have advantages and disadvantages, and some are better suited to either certain asset classes or types of accounts or circumstances than the others.