Mutual funds can be a good way to invest if you want to diversify your portfolio without buying individual stocks or bonds. Aside from knowing which share class you’re investing in, you also need to know whether you’re buying an open-end or closed-end fund. This primer can help you understand the difference when deciding which mutual funds to buy.
What Are Open-End Funds and How Do They Work?
When you buy a mutual fund, you’re buying shares in that fund. An open-end fund has no limit on the number of shares it can issue. So, when you purchase your shares, more shares are created. If you sell your shares, the open-end fund buys them back.
Open-end fund shares are purchased at what’s known as their Net Asset Value or NAV. This number reflects the total market value of the assets held in the fund at the end of each trading day, less liabilities and divided by the total number of outstanding fund shares.
Market value of the fund’s underlying assets is calculated daily at the end of trading. So, if the fund includes a mix of stocks and bonds, then the final closing price of the individual stock and bond holdings can be used to tally up the fund’s market value. This means the fund’s NAV can change daily as stock market prices fluctuate during trading hours. Essentially, NAV reflects how a fund performs on any given day.
Examples of open-end funds include traditional mutual funds, hedge funds and exchange-traded funds (ETFs), which are funds that trade on an exchange like a stock. You can buy and sell these kinds of funds in an employer-sponsored retirement plan, such as a 401(k), in an individual retirement account or through a taxable brokerage account.
Closed-End Funds Explained
Closed-end funds take a different approach. Instead of having an unlimited number of shares, these funds have a fixed number of shares to trade. If shares in the fund are sold, no new ones are issued.
These types of funds are associated with the launch of an IPO, or initial public offering, when a company is opening up its shares for purchase to investors for the first time. A closed-end fund can be useful for generating income in a portfolio if the fund’s price increases after its IPO.
Aside from having a limited number of shares available for trading, closed-end funds differentiate from open-end funds in how they’re valued. Rather than trading at NAV, the share price for closed-end funds is tied to how supply and demand move throughout the trading day.
This means that funds can be priced above or below their true value, depending on the balance between supply and demand. Low supply and high demand can result in a closed-end fund trading at a premium, compared to its NAV. On the other hand, high supply and low demand for a fund could push the per-share price down.
Access to closed-end funds comes through brokers; you won’t find them in your employer’s retirement plan. You can buy and sell shares through a brokerage, which typically means paying a commission fee for each trade.
Open-End Funds: Pros and Cons
Open-end funds have a few things working in their favor from an investor’s perspective. One of the biggest advantages is accessibility since you have more opportunity to invest in these funds, either inside or outside of a tax-advantaged account.
Like closed-end funds, open-end funds are professionally managed. The burden of choosing the right investment to hold in the fund is placed on the fund manager. All you have to do is decide which fund to invest in, making diversification a much simpler task.
These funds also have an advantage when it comes to trading price since NAV is recalculated daily. This can make it easier to trade in or out of the fund with some predictability in pricing and returns built-in.
On the other hand, open-end funds can become problematic when a redemption happens. This is when an investor sells off a large number of fund shares all at once. In that scenario, the fund may have to sell assets to generate cash they can use to pay investors. If assets are sold at a profit, a capital gains distribution gets passed on to investors. You’ll have to pay tax on that distribution at the end of the year.
Something else to keep in mind is that prices for these funds are set once per day at the end of trading. That means you have to wait until the end of the day to determine what your profit (or loss) on the trade is, based on the NAV at close.
Pros and Cons of Closed-End Funds
The chief pro of closed-end funds is the potential to earn higher returns if you buy fund shares at a steep discount compared to net asset value. Assuming share prices rise, closed-end funds could be profitable. The ability to trade these funds throughout the day like you would a stock means you have more opportunity to capitalize on pricing movements than you would with an open-end fund.
The trade-off is that closed-end funds can carry a higher degree of risk compared to their open-end counterparts. If you’re considering this type of fund, it’s important to do your research first to make sure you understand what you’re buying. A few things to consider include:
- What type of underlying assets the fund holds
- Historical performance
- How fund pricing corresponds to NAV
- Dividend yield if the fund pays dividends
- The amount of debt the fund is carrying
With both open-end and closed-end funds, consider the cost as well. Both types of funds will charge an expense ratio, which is the percentage you pay annually in management fees. The lower this number, the better it is for preserving your returns. Also, consider any commission fees you’ll pay to trade these funds in a taxable brokerage account.
The Bottom Line
Whether you choose open-end or closed-end funds for your portfolio ultimately depends on your investment objectives. Reviewing your risk tolerance, risk capacity, diversification needs and overall goals for investing can help you decide which funds are the best fit for your strategy in the short- and long-term.
Tips for Investors
- If you’re planning to buy fund shares through a brokerage, remember to compare the fees carefully. Some online brokerages may be more fee-friendly than others, which is good to know if you plan to trade frequently. Also, look into which brokerages offer commission-free trading for open-ended mutual funds and ETFs.
- Consider getting help from a professional financial advisor if you want to learn more about how mutual funds work. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
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