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Bond Fund Structures

Bond Funds

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Bond Fund structures are highly diverse and split into many differing types. Bond Funds come in almost as many structures as mutual funds. The construction of the security basket you are purchasing determines how vehicles are selected. It also determines how profits are delivered and the value of portfolios are generated.

Open End Funds

The first structural division is open end funds and close end funds. These specify how an investor enters and exits the portfolio, as well as its population limits. Open end funds have an unlimited amount of shares available for investors. You buy directly into the mutual fund, and the money for entry is sent to the fund itself. Each increase in buyers is used to increase the securities held. Managers sell stakes in the funds at their current net asset value, or NAV, which is the market value of fund’s assets minus its liabilities and divided by shares outstanding.

When you wish to cash out of the fund, you sell the shares back at net asset value at time of sale. The difference between the purchase and sale net asset value is your profit or loss.

Closed End Funds

Closed end funds function differently. These funds have a share count limitation and do not issue shares beyond that number. The price of the funds entry isn’t based on the net asset value. The shares of a closed end fund trade on an exchange like normal stocks. This means that share values can be overvalued or undervalued, and the net asset value differs from the entry fee. To enter or exit a closed end fund you purchase or sell shares on an exchange. Share price changes based on demand versus supply and are not tied to the net asset value of the fund. Since they must be transferred via exchange you can only trade shares during daily hours.

Actively Managed

The second fund division occurs between actively managed versus indexed, also known as passive, funds. Actively managed funds consist of a team of operators who manually select every investment, which are actively traded. Some investments are removed and others are placed in the fund. The fund’s performance is a representation of their ability to select investments. Their goal is to beat the average return you could easily acquire from an index of the same instruments. If they cannot beat the instrument’s market average, they’re underperforming against returns you can find elsewhere.

Passively Managed

Passively managed or index funds, do not have an active managerial team deciding to trade specific assets. They emulate an index by placing certain assets found within the market into their fund at the same ratio as the index being tracked. Asset percentages are periodically rebalanced to better emulate the market. The fund should theoretically return the market average for the index being tracked, but this doesn’t always occur.

Unit Investment Trusts

Unit Investment Trusts (UIT’s) are portfolios of fixed investments sold to investors. You purchase a share or set of shares, called units, from an investment bank at a small premium to the net asset value. That investment bank has purchased securities, in this case bonds, from the market and deposited them in the trust. Either monthly, quarterly, bi-annually, or annually, the UIT will send you profits earned by the trust itself. It’s important to note that the trust is fixed. In the case of bonds, when the bonds mature they will not be replaced. Eventually the entire selection of bonds will mature, and all interest and principle will be returned to the UIT’s shareholders. The unit investment trust isn’t managed beyond the initial selection of bonds in the portfolio. If you wish to exit the investment trust you resell your shares to the UIT’s managing bank at net asset value. They resell the shares to a new investor or may liquidate securities to compensate you.

Exchange Traded Funds

Exchange Traded Funds (ETFs) are traded on the exchanges almost exactly like stock shares. Investors trade them when markets are open, paying commissions when buying or selling. Exchange Traded Funds have extremely low expense ratios. ETF’s save money on various costs active funds need to pay for, such as advertising or management. The similarity to shares is high: ETF’s can actually be shorted or purchased on margin, which can’t be done with actual mutual funds. Additionally, shares are purchased and sold to other investors openly trading on the market. As long as the ETF has demand, it will also have liquidity. This means the exchange traded fund’s managers do not have to sell or restructure the fund to meet exit demands. No cash leaves the portfolio once it’s built. The structure of an ETF allows its price to remain close to the actual net asset value. It also reduces taxation issues. Typically, an exchange traded fund is an index fund, but they occasionally come in actively managed flavors. Actively managed funds will typically have slightly higher fees or operating costs.

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