Investing in mutual funds is a popular way to diversify your investment portfolio without the hassle of buying individual stocks, bonds, and securities. You’re probably familiar with open-end funds, but have you considered closed-end funds? Both options offer opportunities for investors, but there are some key differences you should know before making a decision.
What is an Open-end Fund?
Most mutual funds fall under the category of open-end funds. These funds continuously offer new shares for sale, creating new shares as investors buy and removing shares from circulation as investors sell. The number of shares a fund can issue is unlimited.
Open-end funds are priced based on their net asset value (NAV), which is the value of the fund’s assets minus its liabilities. For example, if a fund has $100 million worth of cash and securities in its portfolio and $10 million in liabilities, its NAV would be $90 million.
To determine the net asset value per share (NAVPS), divide the NAV by the number of shares outstanding. So, if a fund has a NAV of $90 million and 10 million shares in circulation, the NAVPS (or per share value) would be $9.
Open-end Fund: Pros & Cons
Pros of Open-end Funds
Open-end funds freely issue new shares to meet investor demand. They’re always open to receiving new investments and capital. These funds tend to offer less volatility and more predictable pricing compared to closed-end funds.
Cons of Open-end Funds
Open-end funds are priced once daily at the end of trading, so you may have to wait for your buy or sell order to fill and not get the same price you saw when you executed the transaction. Moreover, open-end funds must maintain cash reserves to cover redemptions, which means they can’t invest 100% of their assets. This results in some of your capital not being invested, resulting in lower potential returns.
What is a Closed-end Fund?
Closed-end funds differ from open-end funds in that they’re not open to new investments and capital. They raise capital and offer a fixed number of shares during an IPO period. After the IPO, shares of the fund trade on an exchange, similar to stocks and exchange-traded funds (ETFs).
Closed-end fund prices fluctuate throughout the trading session, often trading above (at a premium) or below (at a discount) their NAV.
Closed-end Fund: Pros & Cons
Pros of Closed-end Funds
Closed-end funds trade on exchanges, allowing you to buy and sell shares throughout the trading session. Share prices are determined by supply and demand, so it’s possible to buy the underlying assets at a discount. Closed-end funds offer higher potential returns than open-end funds because they can invest 100% of their assets and can invest in specialized, less liquid parts of the market.
Cons of Closed-end Funds
A closed-end fund’s liquidity depends on investor supply and demand, making it less liquid than an open-end fund. These funds also experience increased volatility as shares can trade above or below their NAV. Some closed-end funds use leverage, which can enhance returns but also increases risk and can amplify losses.
Open-end vs. Closed-end Funds: Key Differences
| Aspect | Open-end Funds | Closed-end Funds |
|---|---|---|
| Number of Shares Issued | Unlimited | Fixed |
| How the Fund Trades | Directly with the Investment Firm | On Exchanges like Stocks |
| How the Fund is Priced | Once Daily at NAV | Throughout the Trading Day at Market Price |
| Percentage of Funds Invested | Not All Assets are Invested | 100% of Assets are Invested |
When is an Open-end Fund the Wiser Choice?
Open-end funds are more common and are often found in employer-sponsored retirement plans such as 401(k)s. They’re a good choice for investors seeking less risk, predictable pricing, and returns. However, open-end funds don’t offer the same earnings potential as closed-end funds.
When is a Closed-end Fund the Wiser Choice?
Closed-end funds are ideal for investors comfortable with more risk in exchange for higher potential returns. They’re also suitable if you want to buy and sell funds on an exchange throughout the trading day to take advantage of price fluctuations. Closed-end funds can be particularly attractive when purchased at a discount, meaning they’re trading below their NAV.
Time Stamp: Compare the Costs and Fees Before Investing
When considering open-end and closed-end funds, it’s essential to factor in the associated costs and fees. Fees can eat into your earnings over time.
Open-end funds charge an annual expense ratio to cover management, administration, and distribution costs. Some funds also impose a sales charge or “load” when buying or redeeming shares.
Closed-end funds also charge an expense ratio, which may include an interest expense if it’s a debt-leveraged fund. Additionally, you may owe a broker commission and transaction fee when trading closed-end fund shares.
Consider working with a financial advisor to learn more about open-end and closed-end funds, their tax consequences, and help you select investments suitable for your financial goals and risk tolerance.
Frequently Asked Questions (FAQs)
What is an example of an open-end fund?
Most mutual funds are open-end funds. Examples of popular open-end funds include the Vanguard Total Stock Market Index Fund (VSMPX), Vanguard 500 Index Fund (VFIAX), and Fidelity 500 Index Fund (FXAIX).
What’s the difference between an open-end and closed-end fund?
The key difference between open-end and closed-end funds lies in how they trade. Open-end funds trade at the end of each trading day at their NAV, while closed-end funds trade like stocks on an exchange. Open-end funds continuously offer new shares to investors, while closed-end funds offer a fixed number of shares during an IPO period, which are then traded between investors on an exchange.
Can a closed-end fund be sold?
Yes, you can buy and sell shares of a closed-end fund throughout the trading day on a market exchange.
For more informative articles on personal finances, visit Personal Finances Blog.