Both traditional
open-end mutual funds and ETFs fall within this product
category, as do unit investment trusts (UITs), which are the
predecessors to ETFs. Closed-end funds also operate under
regulations of the Investment Company Act of 1940.
Open-End Mutual Funds are investment vehicles that
pool together money from many investors.
Structure – Portfolio managers/teams deploy the combined
investor assets to buy securities for that mutual fund’s
underlying portfolio. Mutual funds typically trade once per
day and continuously offer shares for sale directly to investors
(even if investors purchase a fund through a financial
intermediary such as a broker/dealer’s registered representative
or a financial planner) in exchange for their investment dollars.
The fund’s advisor agrees to redeem those shares for cash at
their then current value, when an investor requests it.
Types – There are many different styles of mutual funds that
invest in different securities, sectors of the stock, bonds, real
estate and commodities markets and have different investment
objectives. Mutual funds can be passively managed (they
track to a particular underlying index) or can be actively
managed (portfolio managers/teams are allowed to buy and
sell securities without following an index).
Earnings – During the year, the mutual fund collects dividends
from underlying stocks. However, the portfolio manager
does not pass these dividends to the shareholders as they
come in. Instead, the mutual fund pays out the dividends
monthly, quarterly, semi-annually or annually, depending on
a fund’s type. Capital gains that the fund may generate with
each sale of individual portfolio securities are usually paid
to investors annually. Shareholders can choose whether to
reinvest the dividends and capital gains back to the fund or
have them paid out.
Taxation – Dividend income can be qualified or non-qualified.
Qualified income is taxed at the current 15% maximum
federal tax rate. (Due to the tax code expiring, this rate may
change after December 31, 2010.) In order to meet the criteria
for the qualified income, the dividends must come from a
domestic corporation or qualified foreign corporation and
certain holding period requirements must be met by the
funds and the shareholder. Non-qualified dividend income
is taxed at an ordinary income tax rate. The mutual fund
company should distinguish between qualified and nonqualified
dividend income.
Benefits/Features – There are a wide variety of vehicles for
investors to choose from, and investors have easy access to
these investments.
Exchange Traded Funds (ETF) – are investment vehicles
that trade like stocks in the secondary market by way of
shares being bought and sold by investors (usually through a
financial intermediary) via a stock exchange.
Structure – As illustrated in the accompanying graphic,
ETFs begin and operate with Authorized Participants (APs),
who become part of the creation/redemption lifecycle of the
ETF. APs create a basket of securities to mirror the index the
ETF is tracking. ETF shares are then created in large blocks to
correspond to those underlying securities (creation units). APs
can then sell those ETF shares on the open market to investors.
Redemptions work in reverse. APs exchange large blocks of
shares of the ETF back to the ETF’s underlying trust in return
for obtaining specific securities of equal value. This ongoing
creation/redemption process utilizes "in-kind" exchanges,
which makes ETFs relatively tax efficient since there are no
cash transactions. ETFs do not sell or redeem shares for cash
directly with investors.
Let’s take a look at why price disparity may take place. ETFs
have a two-level structure: the underlying securities and the
actual ETF investment vehicle that trades on a stock exchange.
Because of this structure, and because of dynamic pricing of
the underlying securities, the per share value of the combined
underlying securities (the ETF’s net asset value) may slip out
of sync with the ETF’s exchange traded price.
One nuance unique to ETFs is that this price disparity offers
APs an arbitrage opportunity. This involves either creating or
redeeming ETF shares to profit from the price difference. This
perfectly legal arbitrage strategy tends to keep the ETF’s
market price closely aligned with the value of the underlying
securities.
Types – There are many different styles of ETFs that invest
in different securities, sectors, bonds, real estate, commodities
and currency markets. Most existing ETFs are passive in that
they track to either a well-known market or third-party
underlying index or an index proprietarily created by the ETF
sponsor. However, active ETFs have already been launched.
Leveraged ETFs and inverse ETFs¹ also exist to provide
specific enhanced or opposite returns linked to the indices
they track.
Earnings – During the year the ETF collects dividends from
underlying stocks. However, the portfolio manager does not
pass these dividends to the shareholders as they come in. If
applicable, ETFs pay out dividends quarterly. Frequency of
dividend payouts is a carryover from ETFs’ predecessors – Unit
Investment Trusts (UITs), whose dividend payments are paid
quarterly. ETF shareholders can choose to reinvest dividend
earnings and capital gains, which are paid annually, back to
the ETF or have it paid out.
Taxation – Dividend income can be either qualified or nonqualified.
Qualified income is taxed at the current 15%
maximum federal tax rate. (Due to the tax code expiring, this
rate may change after December 31, 2010.) In order to meet
criteria for qualified income, the dividends must come from a
domestic corporation or qualified foreign corporation and
certain holding period requirements must be met by the funds
and the shareholder. Non-qualified dividend income is taxed at
an ordinary income tax rate. The ETF sponsor should distinguish
between qualified and non-qualified dividend income.
Benefits/Features – Holdings are transparent, and ETFs are
usually tax efficient.
Unit Investment Trusts (UITs) – are registered investments
that buy and hold a fixed basket of securities throughout their
entire term and have a pre-set termination date.
Structure – Investors typically buy units of a UIT, then hold
those units until the UIT terminates, earning their portion of
dividends or interest along the way. But UIT sponsors usually
allow unitholders to buy or redeem units at any time prior to
termination through a continuous creation/redemption
process. At termination, investors can request the return of
their investment in cash, roll directly into a new UIT series,
if available, or request an in-kind redemption. UITs are not
managed on a day-to-day basis by a manager or team
because desired securities are bought and held throughout
the term of the UIT.
Types – UITs hold a predetermined selection of equity or
fixed-income securities, a basket of ETFs or closed-end funds
or a combination of securities. Maturity dates of two years or
longer are common.
Earnings – UITs usually do not allow for dividends or interest
to be automatically reinvested. Instead, income derived from
the security holdings are held in a separate income account
maintained by the sponsor until paid out, on a pro rata basis,
to unit holders. This payout is either monthly or quarterly.
Some sponsors allow cash income to be used to purchase
additional units of the UIT via a distinct purchase transaction.
Capital gains, if any, are paid at least annually and often
more frequently.
Taxation – Dividend income can be qualified and nonqualified.
Qualified income is taxed at the current 15%
maximum federal tax rate. (Due to the taxation code expiring,
this rate may change after December 31, 2010.) In order to meet
the criteria for qualified income, the dividends must come from a domestic corporation or qualified foreign corporation and
certain holding period requirements must be met by the funds
and the shareholder. Non-qualified dividend income is taxed
at an ordinary income tax rate. The sponsor should distinguish
between qualified and non-qualified dividend income.
Benefits/Features – Holdings are transparent. Also, UITs may
follow a niche or home-grown investment theme.
Closed-end Funds are registered products in which a
sponsor raises assets through an initial public offering
(similar to a stock’s IPO) by selling up to a maximum amount
of shares offered, using the proceeds raised to invest in a
portfolio of equity or fixed-income securities, then essentially
closing the portfolio to all cash flows.
Structure – Once the closed-end fund has locked the gates
of its portfolio, it begins trading on a stock exchange, just
like a stock. Investors can purchase or sell shares of a closedend
fund only by acquiring shares through a broker/dealer or
other financial intermediary via a stock exchange. Because
of their inherent two-level structure—underlying securities
and shares of closed-end funds—these registered products
tend to often trade at premiums or discounts. A closed-end
fund is trading at a premium when its exchange-traded share
price is higher than the net asset value of its underlying
portfolio. This typically occurs with a popular product or one
that has shown stellar performance. In this case, an investor
must “pay up” to acquire shares of the closed-end fund.
In contrast, a closed-end fund that is trading at a discount
will exhibit an exchanged traded price that is lower than its
underlying portfolio’s net asset value.
Types – Various closed-end funds exist and may invest in
domestic or foreign equity or fixed-income securities
including municipal bonds. Many single-country closed-end
funds are offered.
Earnings – Dividends and/or interest distributions pass
through to closed-end fund shareholders (including interval
fund shareholders) either monthly, quarterly, semi-annually
or annually.
Taxation – Dividend income can be qualified and nonqualified.
Qualified income is taxed at the current 15%
maximum federal tax rate. (Due to the tax code expiring,
this rate may change after December 31, 2010). In order to
meet the criteria for qualified income, the dividends must
come from a domestic corporation or qualified foreign
corporation and certain holding period requirements must
be met by the funds and the shareholder. Non-qualified
dividend income is taxed at an ordinary income tax rate. The
fund company should distinguish between qualified and nonqualified
dividend income.
Benefits/Features – The generally closed nature of closed-end funds—and to a
lesser degree, interval funds—allows them to invest in less
liquid investments because they don’t have to be ready to
redeem shares at any time. They sometimes use leverage in an
attempt to boost returns.
¹ Inverse and leveraged ETFs may not be suitable for all investors. The more an ETF invests in leveraged instruments, the more
the leverage will magnify any gains or losses on those investments. These funds are considered nondiversified and can invest a
greater portion of its assets in securities of individual issuers than a diversified fund. As a result, changes in the market value of a
single security could cause greater fluctuations in the value of fund shares than would occur in a more diversified fund.
This information is subject to change at any time and should not be construed as a recommendation of any specific security
or strategy.
This information does not constitute tax advice. Please consult your tax advisor and/or state and local tax offices for more
complete information.
Securities are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks,
including the possible loss of the principal amount invested.
RydexShares™ are distributed by Rydex Distributors, Inc., an affiliate of Rydex Investments.
Rydex Investments 9601 Blackwell Road Suite 500 Rockville, MD 20850
800.820.0888 Send us your comments
For more complete information regarding Rydex funds, call 800.820.0888 or click here for a prospectus. Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. The fund's prospectus contains this and other information about the fund. Read the prospectus carefully before you invest or send money.
Interval Funds
A hybrid, less common type of
closed-end fund (which is also a
registered investment product
under the Investment Company
Act of 1940) is an interval fund.
Interval funds do not trade via
an exchange in the secondary
marketplace. Only a fraction of
an interval fund’s shares may be
tendered for redemption during
each preset redemption interval,
as determined by the fund’s
sponsor (quarterly is typical).
Interval funds were created as
a potential solution to the deep
and persistent discounts some
closed-end funds encountered.
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