Mutual funds make it easy for investors to diversify their portfolios without having to pick and manage stocks on their own.
Of all types of mutual funds, closed-end and open-end funds stand out.
For many people, these terms might not seem as important as other considerations, such as selecting a particular fund manager, asset class, industry sector, and so on.
However, these different ways of structuring funds have an impact on the risks and returns of your investment. As such, it is important to understand the features of a fund before making an investment choice.
In this post, we’ll look at the differences between these two common mutual funds, including their pros and cons. This would allow you to make informed decisions when deciding which mutual fund to invest in.
What is a closed-end mutual fund?
A closed-end mutual fund is a type of investment fund that issues a fixed number of shares through an initial public offering (IPO) and then trades those shares.
Like stocks, closed-end mutual funds are traded on stock exchanges, so buyers can buy and sell shares. This means that the market determines its share prices.
However, because a close fund has a fixed number of shares that are traded, this market-driven pricing can lead to share prices that differ from the fund’s underlying net asset value (NAV).
A closed-end may also distribute dividends, though the frequency and amount can vary. They also invest in niche or specialized sectors or strategies, offering investors exposure to unique opportunities.
Closed-end funds may use leverage by borrowing against fund assets and then investing it to increase investor returns. This process is known as gearing. This means a manager can make the investment trust’s assets bigger than the money that was raised from clients in the first place.
While gearing can greatly increase returns, it can also greatly increase losses, based on how well the investment does.
Some examples of closed-end funds are Eaton Vance Tax-Managed Global Diversified Equity Income and Alliance Bernstein Income Fund.
What is an open-end mutual fund?
An open-end mutual fund is a type of investment fund that continuously issues and redeems shares based on investor demand.
Unlike closed-end funds, which issue a fixed number of shares, open-end funds create new shares as investors buy into the fund and redeem shares as they sell. This allows the fund managers to adjust the fund’s size based on market demand and ensure the fund’s share price reflects its NAV.
Open-end funds often hold a diversified portfolio of securities, allowing investors to gain exposure to a variety of asset classes, industries, or geographic regions.
Additionally, they are supervised by qualified portfolio managers who make investment decisions on the fund’s behalf in accordance with its investment objectives.
Traditional mutual funds, hedge funds, and exchange-traded funds (ETFs) are all types of open-end funds.
Differences between open-end funds and closed-end funds
Let’s look at the differences between open-end funds and closed-end funds.
#1. Structure
Open-end funds issue and redeem shares based on investor demand. This allows share prices to be bought and sold at the fund’s net asset value (NAV).
Closed-end funds, on the other hand, issue a fixed number of shares through an IPO and after that, do not issue any new shares. This allows for discrepancies in pricing between the fund’s NAV and its share price due to supply and demand factors.
#2. Trading
Investors can buy or sell shares of open-end funds directly from the fund.
On the other hand, you can only buy shares of a close-end fund on an exchange during an IPO. Afterwards, you have to buy from other investors in the secondary market.
#3. Pricing
Shares of open-end funds are priced once a day at the NAV.
Shares of closed-end funds are driven by the market, which means they can trade at a premium or discount to the NAV.
#4. Management Style
Open-end funds are actively managed by a fund manager who aims to mirror an index or outperform the market.
Closed-end funds on the other hand, can be actively or passively managed, depending on the fund.
#5. Size and liquidity
Open-end funds are larger and more liquid due to continuous issuance and redemption of shares.
Closed-end funds are smaller and less liquid, with shares traded on the secondary market.
#6. Leverage
Open-end funds: Fund managers of open-end funds cannot use gearing to boost returns.
This is in contrast to closed-end funds, where gearing can be used to increase the amount of money available for the fund manager.
Pros and cons of open-end mutual funds
Pros:
- offers liquidity as shares can be bought and sold at the fund’s NAV
- the fund size grows over time because it is adjusted based on investor demand
- diversified portfolios
- actively managed by a fund manager
- good for long-term investment
Cons:
- higher management fees due to more active management of the fund
- NAV-based pricing might lead to potential premiums or discounts to the fund’s actual value
Pros and cons of closed-end mutual funds
Pros:
- can offer potentially higher returns due to their ability to use gearing
- can sometimes trade at a discount to NAV, presenting a buying opportunity
- managers face less pressure from inflows and outflows of capital
Cons:
- limited liquidity as shares are traded in the secondary market or only through an IPO
- subject to market fluctuations due to limited trading options and fixed number of shares
- potential illiquidity
- fund does not change in size, limiting the manager’s ability to adjust the portfolio
Are closed-end funds riskier than open-end funds?
Because they are less liquid and can trade at a gain or discount to their net asset value (NAV), closed-end funds often have higher risk.
Closed-end funds are subject to market forces because they trade on exchanges, while open-end funds let buyers buy and sell shares at NAV. Because of this, their shares may trade above (premium) or below (discount) their NAV.
Closed-end funds may have higher instability and price changes because they don’t have as much cash on hand. The fund’s fixed capital structure also means that its size doesn’t change based on customer demand.
This could make it harder for the manager to make the portfolio better or adapt to changes in the market.
But it’s important to remember that even though closed-end funds have more risk, they can also offer more chances. A closed-end fund that trades at a big discount to its NAV could give buyers a chance to buy assets for less money.
Before investing in a fund, it’s important to know about its plan, management, fees, and past performance, just like with any other investment. A financial advisor can also give you good advice based on your business goals and how much risk you are willing to take.
Closed-end mutual funds vs open-end mutual funds: Choosing the right investment
There is no clear advantage to either closed-end or open-ended funds as a financial vehicle.
Picking the right fund type depends on your investment goals, how much risk you are willing to take, and your personal preferences.
People who want flexibility and access to cash might like open-end funds. On the other hand, investors who are willing to give up some liquidity in exchange for possible discounts on the fund’s real value might like closed-end funds.
Think about your financial goals, read fund prospectuses, and understand fees before you invest. You might also want to talk to a financial advisor to make sure your choices fit with your general investment strategy. Ultimately, the best choice for you will depend on your goals and financial situation.