The first generation of mutual funds began to impress their existence upon the public consciousness in the early 1970s. These open-ended vehicles became widely used by both individual and institutional investors to fund retirement plans, provide current income and diversify small portfolios. But the 1990s saw the advent of several new types of funds that were more streamlined, liquid and efficient than traditional open-ended funds. This article explores several reasons why the traditional open-ended mutual fund may be losing its relevance. (For related reading, also check out How To Pick A Good Mutual Fund.)
TUTORIAL: Mutual Fund Basics

Cost Disadvantages
Although the first generation of mutual funds has helped millions of Americans achieve their financial goals, they also have several substantial disadvantages, such as high costs and illiquidity. Many A-share mutual funds carry initial sales charges as high as 5.75% and charge annual 12b-1 fees as high as 1%. B-shares can have back-end sales charge schedules that gradually decline the longer you hold your shares and C shares typically do not have initial sales charges but can charge a back-end load if the shares are sold within a short time frame. The latter two share classes also typically have higher annual expenses than A shares. Obviously, this substantially reduces the return on capital to the investor, both in the short and the long term. (For more on fees, see The ABCs Of Mutual Fund Classes and Stop Paying High Mutual Fund Fees.)

John invests $100,000 in the A-share class of a growth fund. He pays an initial sales charge of 4.75%, thus reducing his initial principal to $95,250. The 12b-1 fees also reduce his average annual return of 8% per year to 7.25%. If John leaves his money in the fund for 20 years, the initial charge and lower annual return will reduce his overall savings by nearly $80,000.

Liquidity Disadvantages
Owners of open-ended mutual funds must also wait until the settlement date to get their money out of the fund. An investor who sells shares of a fund on Monday will not be able to take constructive receipt of the sale proceeds until Thursday of the same week, at the earliest. For investors who need to access their money quickly for any reason, this can be a real problem.

Forward Pricing
Mutual fund prices also lag the markets on a daily basis. Because the portfolio managers trade securities within the portfolio on a daily basis, it is impossible for open-ended funds to post an intraday share price. They must instead use forward pricing, which is based on the daily closing prices of all of the securities within the portfolio.

Performance Disadvantages
This is perhaps the greatest disadvantage posed by open-ended funds. Although many funds have posted impressive returns over five- and 10-year periods, the average annual returns of virtually all stock funds have lagged those of the market itself over longer periods of time. As of 2010, only one mutual fund that has existed since 1970 has beaten the 10-year rolling return of the S&P 500 Index every single year. The rest have underperformed the markets as a whole, which has led to the popularity of index funds that simply invest directly in the S&P 500 or other index. (For more on index funds and how to invest in them, read The Lowdown On Index Funds.)

Taxation Disadvantages
Although taxation of any type of investment that is not housed inside a Roth IRA is inevitable, the taxation of open-ended mutual funds is especially inevitable. Open-ended mutual funds almost always pass on a pro-rata share of capital gains (and losses) distributions to shareholders once each year, typically in November. This means that any shareholder who owns shares in a taxable account will have gains or losses to report every year. These gains or losses may adversely affect the amount of income that the investor had planned on reporting that year.

Alternatives to Open-Ended Funds
Over the past 20 years, a plethora of alternatives to open-ended funds have arisen. Although some of these vehicles have become more popular than others, they all offer diversification and some degree of professional management without many of the shortcomings of open-ended funds. A list of these includes:

  • Unit Investment Trusts (UITs)
    These instruments resemble mutual funds in that each unit of the trust represents a portion of each security that is held within the portfolio. However, they are more tax-efficient than actively managed funds, although they may post substantial gains or losses when the trust matures. (For more, see Investing In A Unit Investment Trust.)
  • Variable Annuity Subaccounts
    These are essentially clones of taxable retail funds, but must be treated and reported as separate securities for regulatory reasons. Variable subaccounts have most of the same disadvantages as open-ended funds except that they do not post capital gains distributions. (For more, check out Subaccounts: As Good As Their Clone Funds?)
  • Closed-End Mutual Funds
    These funds have a limited number of shares than can be issued to investors. Once all of the shares are sold, the fund is closed to new investors and the shares begin trading in the secondary market.
  • Exchange-Traded Funds (ETFs)
    Although this class of fund is still the new kid on the block, ETFs have quickly become very popular with serious investors for a number of reasons. As their name implies, these funds trade like stocks on the major exchanges and can be sold like any other security while the markets are open. They provide liquidity, diversity and some degree of professional management as well as tax efficiency in most cases. They can be ideal instruments for tax-loss harvesting. (For more on this topic, see ETFs Vs Index Funds: Quantifying The Differences.)

Bottom Line
Although there is still a huge market for open-ended mutual funds, their relative illiquidity, tax inefficiencies and subpar performance compared to their benchmark indexes over time have led to the creation of several more-efficient alternatives. Instruments such as ETFs and UITs are rapidly increasing in popularity and may eventually supplant their more traditional cousins.

Related Articles
  1. Mutual Funds & ETFs

    7 Best ETF Trading Strategies for Beginners

    Exchange-traded funds are ideal instruments for beginning traders and investors. Learn the seven best strategies for trading ETFs.
  2. Mutual Funds & ETFs

    ETF Analysis: SPDR Dow Jones International RelEst

    Learn how the SPDR Dow Jones International Real Estate exchange-traded fund (ETF) is managed and for whom the ETF is most appropriate.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares JPMorgan USD Emerg Markets Bond

    Learn about the iShares JPMorgan USD Emerging Markets Bond fund, which invests in bonds of sovereign and quasi-sovereign entities from emerging markets.
  4. Active Trading Fundamentals

    How Hedge Funds Front-Run Index Funds to Profit

    Understand what front running is, and learn how hedge funds use this investing strategy to profit from the anticipated stock buys of index funds.
  5. Mutual Funds & ETFs

    Top 5 Chinese Mutual Funds

    Learn about some of the most popular and best performing mutual funds that offer investors exposure to the important emerging market economy of China.
  6. Mutual Funds & ETFs

    ETN Analysis: Rogers Intl Commodity Energy Total Return

    Learn more about the Rogers International Commodity Total Return, which is an exchange-traded note that tracks a broad index of commodity futures.
  7. Mutual Funds & ETFs

    ETF Analysis: Schwab US Large-Cap

    Discover how the Schwab U.S. Large-Cap exchange-traded fund is managed, the index it tracks and the investors for which it is most appropriate.
  8. Investing Basics

    Explaining Unrealized Gain

    An unrealized gain occurs when the current price of a security exceeds the price an investor paid for the security.
  9. Investing Basics

    What is a Settlement Date?

    A settlement date is the day a security trade must be settled.
  10. Investing Basics

    Explaining Risk-Adjusted Return

    Risk-adjusted return is a measurement of risk for an investment or portfolio.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Derivative

    A security with a price that is dependent upon or derived from ...
  3. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  4. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  5. Series 6

    A securities license entitling the holder to register as a limited ...
  6. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  1. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  2. How are non-qualified variable annuities taxed?

    Non-qualified variable annuities are tax-deferred investment vehicles with a unique tax structure. After-tax money is deposited ... Read Full Answer >>
  3. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
  4. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  5. Can my IRA be used for college tuition?

    You can use your IRA to pay for college tuition even before you reach retirement age. In fact, your retirement savings can ... Read Full Answer >>
  6. Why are IRA, Roth IRAs and 401(k) contributions limited?

    Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!