June 11, 2021
You are probably very familiar with mutual funds. After all, there are thousands of mutual funds available to investors today and they have been around for a while.
In fact, they have been around much longer than any of us have been alive on this earth.
Lest we are not on the same page, let’s quickly talk about what they are.
A mutual fund is an arrangement where investment capital from multiple investors are pooled together and managed by an expert investor for collective profits.
Private investment clubs do something similar. But mutual funds are much larger in scope and handle a lot higher number of investors and total capital managed.
A brief history
Investopedia offers a glimpse of the history of mutual funds and we learn that the first such pooled resource investment idea can be traced to a Dutch investment trust created in 1774 by Adriaan van Ketwich.
The idea is not new.
The first modern-day mutual fund came into being in 1924 when Massachusetts Investors’ Trust was created and launched a pooled investment vehicle.
Even this idea is not that new.
But 1929 has a special place in mutual fund history as that was the birth year for the Wellington Fund, still in existence as the Vanguard Wellington Fund. It was the first fund to include both stocks and bonds in its portfolio.
Types of mutual funds
There are two types of mutual funds: open ended and closed ended.
You are probably familiar with the open ended kind as that is generally what is traditionally meant by the term. In this kind, funds can be added or withdrawn on any day without restrictions for the most part.
Sometimes a fund closes the (open ended) fund to new investors. But if you are already invested in it, there is usually no barrier to add more money to your account.
Likewise, you can always reduce your investment as you deem fit.
A closed ended fund (CEF), on the other hand, behaves like a company stock. A certain number of shares of the stock are issued by the company and then nothing more. When someone wants to invest in that company stock, they need to find a seller who will sell the number of shares of stock that needs to be bought.
A CEF behaves in a similar manner. The number of units of investment is fixed after the initial set up. These units are bought and sold on the stock exchange and buyers need sellers and sellers need buyers in order to have transactions.
Decimation of mutual funds
As the mutual funds came into society after stocks did, and mutual funds invested in stocks, the structure of mutual funds would naturally mimic that of corporate stocks.
Early mutual funds were mostly closed ended funds.
When the idea took hold and the mutual fund segment gathered momentum, a large number of CEFs were created and were thriving, often employing leveraging to improve returns. The Roaring Twenties saw to that.
Slowly but surely, open ended funds came into being as well, starting in the 1920s. As of 1929, 19 fledgling open ended mutual funds were competing against nearly 700 closed ended funds.
I think you can imagine what might have happened.
Yes, the infamous stock market crash of 1929 happened.
That wiped out highly leveraged CEFs. But the small open ended funds survived and the dynamic between them changed forever.
These days there are a lot more open ended mutual funds than their closed ended counterparts.
Okay, so what?
That is a topic for another day. We’ll look at the differences between them and think about why you might choose one over the other.
Adding spice to this discussion is the invention of yet another cadre of mutual funds: Exchange traded Funds, or ETFs. Yes, CEFs are traded on exchanges but the two are very different.
We’ll talk about that too!
Till then enjoy the warming weather!
P. Venkat Raman
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