If you’re an investor looking to build a well-diversified portfolio, you’re likely familiar with mutual funds. But do you know how they work, and do you know there are two different kinds? Mutual funds can be classified as closed-end or open-end, and while they have some similarities, they also have some major differences. But first, let’s take a moment to revisit what mutual funds even are.

What Are Mutual Funds?

Both closed-end and open-end mutual funds are investment companies that pool the monies from various investors in a fund established to accomplish a financial objective. The funds are then “managed” by a money manager in order to pursue this objective, which is delineated in the fund’s prospectus. These managers invest in a wide range of securities, including stocks, bonds, money market instruments, and even a combination of these. Delivery of profits are also the same in closed-end and open-end funds. Profits to shareholders can be in the form of income from potential dividend payments and capital gain distributions and capital gains realized from the sale of shares that experienced an increase in share value.

Characteristics of Closed-End Mutual Funds

Closed-end and open-end mutual funds also differ in many respects. Attributes of closed-end mutual funds include:

  • Fixed number of shares issued at Initial Public Offering (IPO)
  • Shares are bought from and sold to other investors in the open market
  • Shares of the fund may trade at a discount or premium based on the supply and demand for that particular issue
  • Additional profit potential from selling shares if the discount from NAV decreases, if the premium increases, or if the discount becomes a premium
  • Broker commissions on purchases and redemptions
  • Ability to buy on margin and sell short
  • Allowed to issue preferred shares and debt

Historically, the best time to purchase closed-end funds has been just after they are issued—although, there are no guarantees in investing. At the IPO, the fund’s shares are issued at their actual value. Shortly thereafter, the funds tend to drop under net asset value and sell at a discount. Exactly why these funds sell at a discount after the IPO continues to be one of finance’s greatest mysteries.

Characteristics of Open-End Mutual Funds

On the other hand, open-end funds (often simply referred to as “mutual funds”) have the following characteristics:

  • Open to new investors due to continuous issuance of shares
  • Shares are purchased directly from the fund’s underwriter
  • Shares of the fund sell at their NAV
  • Brokers may receive larger commissions with open-end funds than closed-end funds after their IPO

It is possible for an open-end fund to restrict the issuance of new shares at some unknown point in time. However, this does not cause the fund to become a closed-end fund.

Should I Invest in Closed-End Funds or Open-End Funds?

Investing in closed-end funds may be a bit confusing for inexperienced investors. Since these securities sell at discounts or premiums, it requires the ability to determine the intrinsic value of the underlying securities to conclude whether or not the investment makes sense. This adds an additional layer of risk and goes against the theory that markets are efficient.

If you are uncertain on which investment vehicle is best for you, consult your financial advisor.

 

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.

Richard J Feldman

Richard J Feldman

Senior Vice President, Financial Advisor

CFP®, Series 65 Advisory Registrations† Richard Feldman has over 15 years of experience in the financial services industry. He joined Wealth Enhancement Group in 2021 through the Investor Solutions acquisition. Richard brings a wealth of experience in advising clients on portfolio construction, risk management strategies, and retirement planning. His experience includes financial planning, trading, and client advice. He is a graduate from the University of Miami where he...Read More