Open-End Index Mutual Funds

On 11/07/2010, in Mutual Funds, by Jordan Wilson
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Many investors passively invest using open-end index mutual and exchange traded funds.

Some investors lump the two instruments together when discussing passive holdings. And there are a lot of similarities when assessing for investment potential.

But there are also material differences between the two, so I shall discuss them separately.

Today we will take a very brief look at open-end index mutual funds.

An Index Fund is Still a Mutual Fund

An index mutual fund, or “tracker” fund, is exactly like any other open-end mutual fund.

There are mutual funds that invest in U.S. large capitalization stocks, Russian bonds, Canadian mining companies, etc. Pretty much any type of investments one can configure.

An index fund simply invests in a designated benchmark index for a specific investment style.

For example, the BlackRock Bond Index fund is an intermediate term bond fund that attempts to match the total return of the Barclays Capital U.S. Aggregate Bond index. The Dreyfus International Stock Index fund attempts to match the returns of the MSCI Europe, Australasia, Far East (Free) index (EAFE). And the Northern Global Real Estate Index fund seeks to duplicate the performance of the holdings in the FTSE(R) EPRA(R)/NAREIT(R) Global Real Estate index.

We have spent a fair amount of time discussing open-end mutual funds. If you want an in-depth analysis, please take a look at Mutual Funds in my category listing on the right.

I will briefly go through some of the key points and try to cross-reference to any specific posts for greater detail.

Open-End

Open-end funds are purchased and sold through each fund’s company.

Unlike most investments, you do not acquire open-end mutual funds on a stock exchange. However, often you can buy and sell open-end funds through your brokerage account as many brokerage houses will act as intermediaries between you and the mutual fund company.

Transaction Costs

A goal of passive management is cost minimization.

This should be followed in respect of any mutual fund transaction costs.

In most cases, avoid mutual funds with loads. This is especially true for index funds. Paying a sales charge for an index fund is not justifiable in my opinion.

Be careful with any brokerage commissions you are charged when trading through your account. If you invest directly through the mutual fund company, you should not be subject to commissions on trades.

Some brokerage houses offer commission-free mutual funds. Consider these as well when looking at index fund offerings.

Annual Costs

Look for index funds with low operating costs, as indicated by their management expense ratios (MER) and total expense ratios (TER).

Passively managed index mutual funds should have little to no management fees attached. Do not pay for a service that you are not buying.

While there will be administrative and other operating expenses associated with any mutual fund, focus on those with low TERs.

Match the Market Return

When assessing funds for investment, always compare a fund’s returns against its benchmark and its peers. Remember that performance is a relative concept and you need to analyze investments in proper context.

Find funds with minimal tracking errors, that match the benchmark index return as closely as possible.

Risks of Open-End Mutual Funds

Because the contractual relationship is between you and the fund company, make certain you minimize the counterparty risk.

You can only sell your shares back to the fund company. So you need to be sure that the fund company will be in existence and able to repurchase your shares when you want to sell them. Note that counterparty risk may also be known as default or credit risk.

Also, be aware of liquidity risk.

Normally fund companies calculate a fund’s per share net-asset value (NAV) daily using closing market prices for fund holdings. And most fund companies let investors buy or sell fund shares on a daily basis at a fund’s NAV. However, some funds may not perform net-asset valuations on a daily basis nor allow for acquisition or divestment of fund shares daily.

Make sure you know the frequency in which you may buy or sell shares. The less opportunity that you have, the greater the liquidity risk.

When investing in multiple index funds, watch your diversification.

Depending on the indices you choose to invest in, there may be an overlap of securities. This may create an over-concentration of certain investments and actually reduce your diversification. Always monitor the key holdings in each fund you invest in.

Finally, watch for window dressing and/or style drift issues to ensure that you are actually investing in the index you believe yourself to be.

Next up we will start to look at the other popular passive investment, exchange traded funds.

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