Closed end funds

Closed end funds are, as discussed previously, mutual fund shares which trade on an exchange much like a stock.  Like open end funds, they are registered as investment companies under the Investment Company Act of 1940 and are highly regulated.  Unlike open end funds, which are priced at the end of the day and valued based upon the holdings in the fund, the market price of a closed end fund is determined by supply and demand for the fund on an exchange.

This results in a closed end fund having a market price which can at times vary significantly from its net asset value.  As discussed previously, this discrepancy can create an opportunity for an investor to buy fund shares at a discount to net asset value and sell fund shares at a premium to net asset value.

Closed end fund shares are issued once during an initial public offering, after which point shares can only be obtained by purchasing them from other shareholders.  This is on contrast to an open end fund, whose operators have the ability to create and redeem shares in reaction to capital flowing in and out of the fund.

Closed end funds tend to be capitalized in the $100 million to $1 billion range, which is much smaller than the typical open end fund, which oftentimes has a market capitalization exceeding $10 billion.  Closed end funds oftentimes employ leverage to boost returns, and frequently pay dividends and interest exceeding 6% per annum.

 

 

Large cap stocks

Large cap stocks represent publicly traded equity interest in the largest corporations in the economy, typically in the $10’s of billions and higher.  They tend to be well known companies and are usually household names.  Large cap stocks tend to be less volatile and risky than small cap stocks but typically offer less opportunity for growth and appreciation.

The shares of large cap companies tend to trade frequently and be more liquid than shares of small cap companies, which oftentimes do not trade as frequently and can be less liquid.

Large cap companies tend to be very established in their line(s) of business and highly diversified in their operations. Many large companies are known as “blue chip” companies due to their high level of quality.  The advantage which such companies have is that they tend to be less risky and more stable than smaller companies due to their breadth, size, and access to capital. The main disadvantage which these companies have is that they are unable to grow their revenues and earnings as rapidly as small companies.

As an investor, having a portfolio which is diversified across many different asset classes is a good strategy to manage the risk of your portfolio.  By combining large cap stocks with other asset classes such as small cap stocks, international stocks and bonds an investor can tailor their portfolio to their needs.

 

Risk tolerance and time horizon

An investment portfolio, and the underlying asset allocation which makes up the portfolio, is typically designed based upon attributes unique to the investor, such as risk tolerance and time horizon, as well as factors external to the investor.  Such external factors include market conditions, macro and micro economic factors, individual security analysis, as well as a large variety of other factors, the details of which will not be discussed here.  Here we will focus on two factors which are unique to each investor: the investor’s time horizon and the investor’s risk tolerance.  By varying the amounts of stocks, bonds and other asset classes based upon these two factors a portfolio can be designed and managed to meet an investor’s goals and objectives.

Time horizon

Investments with greater returns typically have greater risks, and investments with lower returns typically have lower risks.  An investor with a long time horizon can afford to suffer through market downturns; and for this reason could have a larger amount of risky, high return investments than an investor with a short time horizon.  An investor with a short time horizon should have a higher concentration of lower return, lower risk investments than an investor with a longer time horizon.

Risk tolerance

An investor with a high risk tolerance can afford to hold a larger concentration of high risk, high return investments than an investor with a low risk tolerance.  Such an investor will be less likely to become upset during a market decline and sell their investments.  This is a critical aspect of portfolio design and construction, particularly for individual investors.  An investor with a low risk tolerance would be more likely to become upset and sell risky investments during a market downturn, incurring a loss.  Such an investor should therefore hold a larger concentration of lower risk, lower return investments, as such investments will be less likely to decline in value by significant amounts.

Mutual funds

Mutual funds are diversified investment pools which are available to the general public, and are frequently used by investors to provide diversified exposure to securities as part of an overall asset allocation.  They are registered securities and are highly regulated.  They are frequently referred to as “investment companies”, and are structured in either an “open end ” or “closed end” format.  We will review the basics of open end funds and closed end funds here, and discuss some of their advantages and disadvantages as relates to issues such as liquidity and valuation.

Open end funds

Open end funds are mutual funds which can be redeemed or purchased by an investor on a daily basis, and can be done so at the market price, or “net asset value”, of the securities which are held by the fund.  The advantage of open end funds is that the investor does not run the risk of being unable to redeem his or her shares at the market price of the underlying securities in the fund.  The main disadvantage of open end funds relates to the fact that assets flow in and out of the fund on a daily basis, the net result of which can be a negative impact on fund performance.

Closed end funds

Closed end mutual funds trade on a securities exchange, similar to a stock.  The market price of the closed end fund will be determined by supply and demand of the fund on the exchange, and frequently will differ from the net asset value of the fund.  A shrewd and disciplined investor can purchase such shares at a discount from their net asset value, and sell them at a premium to their net asset value.  An advantage of closed end funds is that there are no daily inflows or outflows of fund assets, so the fund manager is able to manage the assets inside the funds in a long term manner.

529 Plans

529 plans are savings vehicles for the purpose of funding higher education expenses.  They have numerous tax advantages, including tax deferral and tax free withdrawals.  The withdrawals are typically tax free as long as they are used to fund qualified higher education expenses such as tuition, board, fees, books and other expenses at an eligible school.  Under certain circumstances, 529 plan contributions are eligible for a tax deduction at the state and local level.

With a 529 plan, the owner sets up an account for the benefit of a child, grandchild, or other family member (the beneficiary).  Unlike with custodial accounts, the owner retains control of the 529 plan account, even after the beneficiary reaches the age of majority.  The owner also has the ability to change the beneficiary of the account after establishing it.  For example, if a parent creates an account for the benefit of one child and that child later decides not to attend college, the beneficiary of the account can be changed to another child.

Keep in mind that 529 plan contributions are considered gifts and are thus subject to the gift tax rules.  For 2016, the gift tax exclusion is $14K per beneficiary.  Keep in mind that all gifts, not just 529 plan contributions, are subject to this limit.  There are rules unique to 529 plans which allow the gift tax exclusion for the next five years to be taken in the current year by making an election on your gift tax return.  Using this election you could make a contribution of $70K ($140K for a married couple) to a 529 plan for a single beneficiary in the current year.