Summary of video: What is an ETF? Part 2: Closed Ended Mutual Funds
Key points from this video:
You don’t need to learn about closed end funds, but his discussion might help you understand what it means that most mutual funds are open-ended. Closed-end funds are also similar to ETFs, so this may help you understand that. Don’t concern yourself with closed-end funds too much because there is no circumstance where this would be a better idea than low-cost index funds that are open-ended.
- In an open ended fund (the most common type of mutual fund), when an investor wants their money back they have to deal with the fund itself.
- In a closed ended fund, once the fund is created if someone wants to buy or sell a share, it happens in the secondary markets.
- In an open ended fund, there is an incentive to constantly market and grow the fund to get more as management fee.
- In a closed ended fund, once the fund is created they don’t have to market it anymore.
Transcript of video: What is an ETF? Part 2: Closed Ended Mutual Funds
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In the last video, we had Pete starting an open ended mutual fund that was managed by Pete Inc. Mutual funds normally have nice grand names. Maybe they call this the Saturn Fund, and if there is a Saturn Fund out there I just picked that name at random. I’m not implying that this is you or anything like that, or something like the Galileo Fund, anything like that. I”m sure there is probably is a Galileo Fund, so once again don’t sue me, I just made up that name on the fly, but it’s managed by Pete Incorporated. We called it an open ended fund because at any time one of the people who own a share, or a unit in the fund, can redeem it back from the fund that Pete or the management company would say, “Okay if you want … If you want, at the end of that video your $180 back we’ll buy that. We’ll give you $180, you give back the share, and then we cancel the share.” If anyone wants to add to the fund, if they want to invest, the corporation can create new shares and then issue it to people, and sell it to people, and then that their money will go into the common pool, and the management company would take fees off of it.
What is a closed end fund?
That probably had you asking, “Well if this is an open ended fund, what is a closed end fund? Or do they even exist?” They do. That’s what I’m going to talk about here, closed end funds. Closed end funds on some level are a little bit simpler, what happens in a closed end fund is that all of the investors are essentially … Or I guess you could say the share structure is locked in right from the beginning. If Pete wanted to start a closed end mutual fund he would once again register a corporation with the FCC, he would market it, he would tell everyone, “Hey I’m Pete, I’m an awesome investor, here’s my track record.” Then he would get a bunch of investors, so let’s say he is able to find 20 investors, and that’s all he’s able to find, so this is 20 right here, I’m not going to count. Let’s say there’s 20 slices right over, he has 20 people, so let’s say they each get $100, or they each give $100, so he is able to raise $2000. 20 times 100, so he is able to raise $2000.
Once that happens the fund is closed. Petes going to do his best to manage this, so Pete will manage this, and he will still take a management fee, maybe the same 1%, but what’s fundamentally different here … He doesn’t have to market the fund any more because he can no longer get new investors, this is actually the main difference. An open ended mutual fund, at any point in time, or I should say, at the end of trading, at the end of the day, they can lose investors or they can gain investors. It’s an incentive for an open ended fund to constantly market itself, because the manager wants to manage more money so that he gets more of a management fee.
A closed end fund they’ll market it right when they’re creating the fund, but once they create it, let’s say over here he just got his 20 investors, then it is closed. He can’t get anymore, he can’t create anymore shares, or cancel anymore shares. What can happen … You might say, “Well on the closed end fund how did these people, let’s say that you’re holding one of these shares. Let’s say you’re holding 1 share right over here. What happens if you want to … If you need to buy a house or you owe money to somebody, so you want to get the value of your share back?” The answer with a closed end fund is that you would then go sell your share to someone else. This right here you can trade it, you can trade it. You would trade it just like you would trade the stock of any company. In fact when you go and buy or sell a share of IBM most of the time you’re just buying or selling it from someone else, you’re not transacting with IBM the company, you trade it in the secondary market, you’re not dealing with the actual corporation. That’s where the investor gets their liquidity, when we say liquidity, it allows them to convert it into cash, because they can trade it.
The big difference: with an open ended fund, when an investor wants their money back they have to deal with the fund itself. The fund will buy back their share. If someone wants to invest in a fund, the fund will sell them the shares. They’re always dealing with the fund itself. In a closed end fund, once the fund is created its share pool is fixed, and if someone wants to buy or sell a share, it happens in the secondary markets. They’re buying and selling from each other, they’re not dealing with the actual fund manager. The disadvantage from the fund manager is that it’s much less flexible in terms of growing or shrinking the fund. The advantage is this fund manager doesn’t have to keep cash around in case the shareholders want to redeem. In the open ended fund, we saw that the manager has to keep some cash around in case one of the investors wants their money back. Here, the closed end fund, he knows that no one can get their money back, right? Here, he or she can invest as they see fit.
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Footnotes and Credits for video: What is an ETF?
The video is a different approach to learning what an ETF is. I like it because it introduces some key vocabulary and concepts in an easy-to-understand manner. It was produced by The Khan Academy and they own the copyright. Khan Academy is a non-profit educational organization created in 2006 by educator Salman Khan to provide “a free, world-class education for anyone, anywhere”. They have given me permission to embed this via YouTube on this educational website.