Comparing Open-End vs. Closed-End Funds
Main Street Advisors, LLC
A mutual fund is a professionally managed investment arrangement in which investors have access to diversified portfolios consisting of a mix of equities, bonds, and other securities. Investing in these funds is done by purchasing units/shares at the existing net asset value (NAV) of the fund. Professional money managers manage these funds with the goal of producing capital gains and income for the investors. When choosing to invest in mutual funds you will need to know things like what share class you’re investing in, as well as whether you’re buying an open-end vs. closed-end fund.
What is an open-end fund?
An open-end fund is a mutual fund that doesn’t have any restriction on the number of outstanding shares it has, and the fund can issue new shares or redeem existing shares at any time. Open-end funds are bought and sold at their net asset value (NAV), which is calculated at the end of each trading day and reflects the total market value of the assets held in the fund at that time, minus liabilities and divided by the total number of outstanding fund shares.
Most mutual funds are open-end funds. Examples include traditional mutual funds, hedge funds and exchange-traded funds (ETFs). However, unlike mutual funds, ETFs trade throughout the day, similar to stocks.
The main advantage to these funds is their daily liquidity and diversification advantages. The main drawback is open-end funds have to produce enough liquidity to pay off redeeming shareholders at will. Sometimes theyhave to sell their assets in order to generate cash. If this happens, the resulting capital gains don’t get taxed at the fund level, but they are carried out to shareholders through year-end capital gains distributions. These distributions are included in taxable income if you hold your fund shares in a taxable account, even if you decide to reinvest the distributions to buy more fund shares.
What is a closed-end fund?
A closed-end fund invests in a portfolio of securities and is usually managed by an investment firm. Capital does not regularly flow into them when investors purchase shares, nor does it leave when investors sell shares. They have a fixed number of shares and are traded among investor on an exchange. Their share prices are driven by supply and demand. This means that funds can be priced above or below their true value.
Similar to stocks, closed-end funds hold an initial public offering (IPO) at their launch. The portfolio managers use the capital raised during the IPO to buy securities that align with the fund’s investment strategy. The closed-end structure paves the way for discounts and premiums. After the IPO, the shares are traded typically on an exchange, and the market determines the share price. The share price usually does not match the net asset value of the fund’s underlying holdings. If the share price is higher than the net asset value, shares are trading at a premium. If the share price is less than the net asset value, the shares are trading at a discount. Because there is no need to raise cash quickly for unexpected redemptions, it is considered a stable asset base, which allows closed-end funds to invest in illiquid securities and can issue debt.
The main advantage to these funds is the potential to earn higher returns when you buy fund shares at a steep discount as compared to net asset value. You have more opportunity to benefit from pricing movements since they are able to be traded throughout the day, as opposed to an open-end fund that is bought/sold at the end of the day. The main drawback is they carry a higher degree of risk than their counterparts.
Comparison Chart of Open-end vs. Closed-end Funds
| Attribute | Open-end mutual fund | Closed-end mutual fund |
|---|---|---|
| Shares | Continuous buying/selling of share units | Fixed number of shares |
| Price | Fixed once a day and driven by net asset value | Driven by supply and demand and traded throughout the day |
| Transactions | Performed directly through the fund | Launched through an IPO, then listed on an exchange |
| Maturity period | No fixed maturity | Fixed maturity ranging from 2-5 years |
| Management Style | Active, passive or combination | Active style |
| Selling price | Net asset value plus entry or exit load as outlined in prospectus | Traded at premiums or discounts to the net asset value |
| Minimum investment | Smaller investment so ideal for those with limited disposable income (retail investors) | Lump-sum investment is permitted |
| Liquidity | Liquidation is easy | The limited number of shares, as well as the tilt towards illiquid securities cause closed end funds to have less liquidity |
| Trading | Purchased directly from the underwriter of the fund | Bought and sold through brokers |
| Subscription | Available throughout the year | Available only via specified days |
| Entry & Exit | At the investor’s convenience. Can invest and redeem at any time | Participation only until the new fund offer (NFO) is on and exit only after the fund matures |
| Asset allocation & rebalancing | Yes, both occur | No, structural changes are not permitted |
| Corpus | Variable | Fixed |
| Track record | Investors can track the historic returns of these funds | Investors can not track the historic returns of these funds |
| Examples | Traditional mutual funds, hedge funds and exchange traded funds (ETFs) | Can contain a variety of different securities, but many are bond funds. Structure allows it to invest in illiquid securities such as emerging markets stocks, municipal bonds and real estate |
Similarities
While both types of funds have stark differences, they also have similarities.
- Both provide diversification in multiple investment assets rather than a single stock.
- Professional fund managers oversee both open and close-ended funds, supported by a team of financial and market analysts who conduct in-depth research on the investment options where they put their funds in.
- Both support economies of scale through gathering a large pool of funds from multiple investors, which enables the investment and operating costs to be lowered.
- The commission or fees of the investment managers can depend on the returns they are able to collect from the market.
- Both 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).
Whether you choose one type over the other or a combination for your portfolio, your decision will hinge on your investment objectives, time horizon, risk tolerance, diversification and liquidity needs and overall goals.
Sources:
Wall Street Mojo. (2023). Openended vs. Closedended Mutual Funds.
https://www.wallstreetmojo.com/open-ended-vs-closed-ended-mutual-funds/
Smart Asset. (Nov. 2021). Open-End Funds vs. Closed-End Funds.
https://smartasset.com/investing/open-end-fund
Fidelity. (2023). What is a Closed-end Fund?
https://www.fidelity.com/learning-center/investment-products/closed-end-funds/what-are-closed-end-funds
Bankrate. (Nov. 2022). Open-end vs. Closed-end Funds.
https://www.bankrate.com/investing/fund-types-open-end-closed-end-etfs/
Main Street Advisors, LLC. January 2023. Main Street Advisors, Inc. is a Registered Investment Advisor. The articles and opinions expressed in this material were gathered from a variety of sources, but are reviewed by Main Street Advisors, LLC, prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of January 2023 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual situation. Always contact your financial/investment professional before making any financial decisions. Main Street Advisors, LLC is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
