In this lesson, we will look at the differences between closed-end funds and open-end funds, with special attention given to how these funds are bought and sold as well as priced.
Closed-End and Open-End Funds
Bob is an investor who wants his portfolio to benefit from diversification but doesn’t have the time or energy to manage his own investments.
Rather than try constantly to pick which stocks he should buy and sell, he just wants to buy one or two investments that take care of all that for him. His options include investing in closed-end or open-end funds. Let’s help Bob understand what these funds are and how they compare so he can make a decision about his investments.
To Bob’s surprise, he is already familiar with open-end funds. An open-end fund refers to a regular mutual fund. When Bob sends his money, to the fund he receives new shares in the fund.
Those funds are then used by the fund manager to buy stocks, bonds, or other investments according to the prospectus or plan for the fund. For example, the prospectus might say the fund only invests in US-based companies or focuses on a segment such as real estate or healthcare.When Bob wants to cash out, those shares are returned to the fund company and taken out of circulation. If enough shares are sold, the mutual fund company will have to sell some of the underlying investments to get Bob his money. Buying and selling of open-fund shares are transactions between the investor and the mutual fund companyA closed-end fund combines elements of a mutual fund and stock.
An investment company creates shares through an initial public offering (IPO). Once these shares are created, they are traded from investor to investor over an exchange on the open market like a stock. Unlike a mutual fund, shares are not destroyed when an investor sells. Only a limited number of shares are in existence. Management of the fund remains much the same as a mutual fund; a fund company manager using the investors’ money buys and sells different kinds of investments according to the prospectus.
One of the most significant differences in these two types of funds is how they are priced.
With open-end funds, the trade is completed at the end of the business day. The price of the fund is based on the Net Asset Value (NAV), which is the value of all the underlying investments. Closed-end funds can be traded throughout the day between investors, so pricing is affected by supply and demand. The fund shares can be bought and sold for an amount that is above or below the NAV of the underlying investments. Since Bob desires simplicity, he decides to go with an open-end fund and work directly with a mutual fund company rather than rely on having to sell shares on the open market.
An open-end fund is a mutual fund which allows investors to buy and sell shares in the fund directly with the investment management company. A closed-end fund creates a limited amount of shares with an initial public offering (IPO) which are then traded among investors in the open market.
Both kinds of funds use an investment manager to buy and sell the underlying securities owned by the fund according to the plan for the fund outlined in the prospectus. Open-fund prices are set at the Net Asset Value (NAV) of the underlying investment at the end of each business day as shares are created or destroyed with each transaction. Closed-end funds are traded throughout the day and are priced according to supply and demand market forces rather than the NAV.