Mutual Funds and ETFs

Investment Company Structure

The Investment Company Act of 1940 established three types of investment companies that pool investor money for professional management. Understanding their structural differences is crucial for the CFP exam.

Open-End Funds (Mutual Funds)

Open-end funds continuously issue and redeem shares directly with investors at Net Asset Value (NAV). There is no limit to the number of shares outstanding.

Key Characteristics:

• Shares are bought from and sold back to the fund company
• Priced once daily after 4:00 PM ET (forward pricing)
• Must maintain liquidity to meet redemptions
• Cannot trade at premiums or discounts to NAV

Closed-End Funds

Closed-end funds issue a fixed number of shares through an IPO, then trade on exchanges like stocks.

Key Characteristics:

• Fixed capitalization after initial offering
• Trade throughout the day on exchanges
• Can trade at premiums or discounts to NAV
• No continuous share issuance or redemption with fund

Unit Investment Trusts (UITs)

Unit Investment Trusts hold a fixed portfolio of securities until a specified termination date.

Key Characteristics:

• Passive management (no active trading within the trust)
• Self-liquidating at termination
• Investors hold units, not shares
• Fixed portfolio established at creation

---

Net Asset Value (NAV) Calculation

Net Asset Value (NAV) represents the per-share value of a mutual fund and is calculated using this formula:

NAV = (Total Assets - Total Liabilities) / Shares Outstanding

NAV Example

A mutual fund has:

• Total assets: $500 million
• Total liabilities: $5 million
• Shares outstanding: 20 million

NAV = ($500,000,000 - $5,000,000) / 20,000,000 = $24.75 per share

Forward Pricing Rule

All mutual fund transactions use forward pricing--investors receive the next calculated NAV after their order is placed, not the current NAV. Orders placed before 4:00 PM ET receive that day's NAV; orders after 4:00 PM ET receive the next business day's NAV.

---

Mutual Fund Share Classes

Mutual funds offer different share classes with varying fee structures. Understanding these differences is heavily tested on the CFP exam.

Class A Shares

Class A shares charge a front-end sales load (commission) when purchasing shares.

• Front-end load: Typically 3-6% of investment, reducing initial investment
• 12b-1 fees: Lower (typically 0.25% or less)
• Breakpoints: Volume discounts reduce loads for larger investments
• Best for: Long-term investors with larger initial investments

Example: A $10,000 investment with a 5% front-end load invests only $9,500 in the fund.

Class B Shares

Class B shares have no front-end load but charge a contingent deferred sales charge (CDSC) if sold within a specified period.

• Back-end load (CDSC): Typically 5-6% in year one, declining to 0% over 5-7 years
• 12b-1 fees: Higher (up to 1%)
• Conversion: Typically convert to Class A shares after 6-8 years
• Best for: Long-term investors who want full initial investment working
• Note: Many fund families have eliminated B shares

Class C Shares

Class C shares feature level loads--consistent annual fees without front-end or significant back-end charges.

• Front-end load: None or minimal (sometimes 1%)
• Back-end load: Usually 1% if sold within first year
• 12b-1 fees: Higher (typically 1%)
• No conversion: Remain C shares indefinitely
• Best for: Short-to-medium term investors (1-3 years)

---

Expense Ratios and 12b-1 Fees

Expense Ratio Components

The expense ratio represents the annual cost of owning a fund, expressed as a percentage of assets. It includes:

1. Management fees: Compensation for portfolio management
2. Administrative costs: Recordkeeping, legal, accounting
3. 12b-1 fees: Marketing and distribution expenses

Example: A fund with a 1.25% expense ratio charges $12.50 annually per $1,000 invested.

12b-1 Fees Explained

Named after SEC Rule 12b-1, these fees cover marketing, distribution, and shareholder services.

12b-1 Fee Limits:

• Maximum total: 1.00% of average net assets
• Maximum for marketing/distribution: 0.75%
• Maximum for shareholder services: 0.25%
• Funds charging more than 0.25% cannot call themselves "no-load"

Impact on Long-Term Returns

Higher expense ratios compound over time, significantly impacting returns:

The 1.30% difference in expense ratios costs nearly $90,000 over 20 years.

---

Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) are investment funds that trade on stock exchanges throughout the trading day, combining features of mutual funds and individual stocks.

ETF Characteristics

• Intraday trading: Buy and sell throughout the day at market prices
• Real-time pricing: Prices fluctuate based on supply and demand
• Lower expense ratios: Typically 0.03% to 0.50% for index ETFs
• No minimum investment: Purchase as little as one share
• Commission costs: May incur brokerage commissions (though many brokers offer commission-free ETF trading)

Popular ETF Examples

---

ETF Creation and Redemption Process

The unique creation/redemption mechanism is central to ETF operations and tax efficiency.

How It Works

1. Authorized Participants (APs): Large institutional investors authorized to create/redeem ETF shares directly with the fund
2. In-kind transfers: APs exchange baskets of underlying securities for ETF shares (creation) or ETF shares for underlying securities (redemption)
3. Arbitrage: APs profit by keeping ETF prices aligned with NAV

Creation Process

1. AP assembles a basket of securities matching the ETF's portfolio
2. AP delivers the basket to the ETF sponsor
3. ETF sponsor issues new ETF shares (typically in "creation units" of 25,000-50,000 shares)
4. AP sells ETF shares on the exchange

Redemption Process

1. AP buys large quantities of ETF shares on the exchange
2. AP delivers ETF shares to the sponsor
3. Sponsor delivers underlying securities to the AP
4. AP sells the securities in the market

---

ETF Tax Efficiency

ETFs are generally more tax-efficient than mutual funds due to the in-kind redemption mechanism.

Why ETFs Are More Tax Efficient

1. No forced sales: When investors redeem ETF shares, they sell to other investors on the exchange--the fund doesn't need to sell securities
2. In-kind redemptions: When APs redeem, they receive securities instead of cash, avoiding capital gains realization
3. Lower turnover: Most ETFs track indexes, resulting in fewer taxable transactions
4. Tax-lot management: The fund can deliver low-basis shares during redemptions, removing potential gains from the portfolio

Tax Efficiency Comparison (2024 Data)

Important Exceptions

• International/Emerging Market ETFs: Some markets restrict in-kind transfers, reducing tax efficiency
• Bond ETFs: May have more frequent rebalancing
• Leveraged/Inverse ETFs: Reset daily, can trigger significant distributions

---

Mutual Fund vs. ETF Comparison

When to Recommend Each

Mutual Funds may be better for:

• Automatic investment programs (dollar-cost averaging)
• Retirement accounts with no commissions
• Active management strategies
• Clients who prefer simplicity

ETFs may be better for:

• Tax-sensitive accounts
• Clients wanting intraday trading flexibility
• Cost-conscious investors
• Tactical asset allocation strategies