Mutual funds, exchange-traded funds (ETFs) and closed-end funds (CEFs) - the purchase of any one represents the purchase of a ready-made portfolio of investments.
Mutual funds are “open,” meaning when you purchase the fund, more shares are created and selling reduces the number of available shares. There is no limit to the number of shares that can be offered for purchase. On the flip side, investor withdrawals can require assets within the portfolio be sold to pay investors.
The price per share of a mutual fund is directly related to the value of investments within the fund's portfolio. The value of the fund (its net asset value, or NAV) is determined after the close of the markets, when the portfolio's assets are appraised. The fund is bought or sold only after the close of the trading day when the fund's value is determined.
Purchasers buy into the fund through the mutual fund company. The fund company can establish a minimum purchase amount.
The portfolio can be passive (a fixed index) or managed where a fund manager buys and sells assets within the fund to implement a strategy.
Any taxable events within the fund like capital gains, dividends, or interest are passed on to investors. It is probable you will have to declare taxable income (unless the fund is purchased in a retirement account) even if the fund's share price decreases or you do not sell your shares.
ETFs are sold on the open market and not through a fund company; more similar to an individual stock on the market. The investor can buy and sell full shares anytime during the trading day. You buy as much or little as you want at the going market price, without a fund company requiring a minimum purchase amount.
The fund company has flexibility to increase or decrease the number of shares available to maintain a share price similar to the value of the fund's investments.
Most ETFs are fixed-index-style or passive (non-managed) portfolios. Passive portfolios tend to be very inexpensive because little management is involved since the fund just mimics an index like the S&P 500 index.
ETFs also tend to be tax-efficient because very little trading is going on within the fund. This is partially because passively managed funds do not require much trading of fund assets and partially due to the way ETFs are allowed to increase and decrease assets within the fund without having to buy or sell to meet investor demands. The result is a reduction in the amount of capital gains or trading costs passed on to investors.
CEFs are managed portfolios established by investment firms to meet an objective. CEFs are typically bought for the income they generate. The funds are bought and sold on the open market like an ETF.
The amount of shares available to the public are fixed. The available shares do not fluctuate based on the number of purchasers or the value of the investments in the portfolio. The result is a share price that moves based on market supply and demand and not the value of the assets within the fund.
The fund's share price could be different than the value of the fund's investments. If the share price is higher than the value of the assets, the fund is selling at a premium. If under, the fund is selling at a discount. Some buy a CEF at a discount hoping the share price will rise in the future - not a sure thing.
CEFs can borrow money from lenders to purchase more assets within the fund. This is called leverage. Leverage increases the instability of the fund's share price. The trade-off for increased price instability is enhanced income above mutual funds or ETFs.
If you purchase a CEF for its 15 cent per share per month dividend rate, you probably don't care whether the share price goes up or down as long as you receive your 15 cents a share each month ($1.80 a year).
The return is enhanced if the CEF is leveraged. Some CEFs provide managed distributions, which means if the fund advertises a 10 percent dividend rate, it will pay out 10 percent even if it has to pay back some principal (known as return of capital) to do it.
A CEF's expenses are higher than most mutual funds or ETFs because they are actively managed portfolios. Their expenses can be greater due to leverage issues, their distribution policy, unique assets in the portfolio, or the level of trading activity in their portfolio.
Note: This is not a comprehensive tutorial on the differences of these funds. It should be enough information to help you be aware of your fund options and inspire you to learn more.