The difference between closed-end and open-end funds is quite simple. It comes down to whether there’s a fixed number of shares or if the fund creates new shares as more people buy into it. The vast majority of mutual funds and exchange-traded funds available to retirement investors are open-end funds, but you might find that certain closed-end funds can play an important role in your portfolio.
- What Is a Closed-End Fund?
- What Is an Open-End Fund?
- How Closed-End Funds Differ From Open-End Funds
- Choosing Open-End vs. Closed-End Funds
A closed-end fund is a fund that offers a set number of shares. Like other ETFs and mutual funds, a closed-end fund is made up of a collection of securities and can provide investors with an easy way to build a fully diversified portfolio. However, after an initial public offering, the only way to buy into the fund is to purchase shares from someone else, like you would do for a stock.
Closed-end funds are actively managed and will have a professional investment manager deciding what goes into the fund. Essentially, they function like publicly traded investment companies, reporting their assets each quarter and letting investors decide if they like what they see in terms of numbers. This structure presents some interesting risks and potential rewards that are different from those of other funds. Asset managers running closed-end funds have more flexibility in many ways, including the option to borrow money against the fund’s assets to make more investments — getting what’s known as “leverage” in the investing world.
So, the quality of the asset manager plays a huge role in the value of the fund. Strong managers with a track record of success will instill confidence and make investors fight over the limited number of shares, driving the price past the actual value of the assets in the fund. But, by that same token, underperforming managers might see their shares fall below the net asset value of the fund.
All in all, the benefits and drawbacks of adding closed-end funds to your portfolio are entirely dependent on the fund that you choose — not unlike a stock. That said, many closed-end funds focus on a particular region or segment of the financial markets, so you might find value in using them to balance out some of the risks elsewhere in your portfolio.
|Asset managers can utilize leverage to boost returns||Higher expense ratios than passively managed funds|
|Typically offer higher returns||Usually carry more risk|
Here are some examples of closed-end funds:
- Eaton Vance Tax-Managed Global Diversified Equity Income (EXG)
- AllianceBernstein Income Fund (ACG)
- DNP Select Income Fund Inc. (DNP)
- Nuveen Municipal Value Fund Inc. (NUV)
- Aberdeen Asia-Pacific Income Fund Inc. (FAX)
The vast majority of mutual funds are open-end funds, which means the fund will create or destroy as many shares as necessary to meet demand. When you buy into an open-end fund, the asset manager will use the money you paid for those shares to purchase more of the assets that make up the fund. This action helps the fund maintain the original proportions of those assets, which is the fund manager’s goal. In short, an open-end fund expands or contracts by buying or selling as needed, while carefully keeping the same balance of assets.
Open-end funds don’t trade continuously throughout the day like closed-end funds or ETFs. Instead, open-end funds are “marked to market” at the end of each trading day — i.e., they take stock of the day’s market moves and reset each fund’s share price to precisely reflect the changes in its underlying net asset value. If you want to buy in, you have to wait until the end of the trading day to see what the new share price is going to be.
As a result, open-end funds will only be worth exactly what their net asset values dictate. Even if a fund manager is wildly successful and attracts millions of new investors to the fund, the company will just keep buying up assets in the same proportions and creating new shares as customers come in. That’s notably different from a closed-end fund, where share prices can rise above or fall below the net asset value of the fund, and the market’s perception of the fund manager can result in customers paying more or less than the value of the actual securities in the fund.
So, the quality of the fund manager is somewhat less important in actively managed open-end funds. The manager will still pick out investments and determine the percentage makeups of the total fund, but they can’t borrow money to leverage assets. As such, while the manager might rebalance the fund, you’ll still be able to count on shares trading at the value dictated by the assets in the fund. Generally speaking, open-end funds will carry less risk but might offer less in the way of rewards.
|Typically offer lower risk||Less opportunity for higher returns|
|Marked to market — i.e., the share price always matches the net asset value||Performance limited by the net asset value|
Here are some examples of open-end funds:
- Fidelity Contrafund (FCNTX)
- American Funds Growth Fund of America (AGTHX)
- Fidelity 500 Index Fund (FXAIX)
- American Funds Fundamental Investors (ANCFX)
- Vanguard 500 Index Fund (VFINX)
Here’s a quick breakdown of the differences between closed-end and open-end funds:
|Open-End Funds||Closed-End Funds|
|Share Price||Marked to market at the end of each trading day to reflect the net asset value||Defined by supply and demand on the open market|
|Leverage||Limited to the fund’s proportions of assets||Can take more risk and borrow against the assets to increase returns|
|Total Number of Shares||Expands and contracts as investors buy and sell shares||Set at the IPO and doesn’t change|
|Seller||Shares purchased directly from the company managing the fund||Shares must be purchased at the IPO or from another investor|
|Trading||Shares trade at the end of the day, after the share price is marked to market||Shares trade continuously throughout the trading day|
|Minimum Investment||Many open-end funds will include a minimum level of investment necessary to buy into the fund||Price of a single share|
There’s no clear set of rules about which approach to a fund is better — or worse — for you as an investor. If you’re deciding between an open-end fund and a closed-end fund that have the same objectives and the same underlying assets, it’s unlikely that the structure of the fund is going to make a ton of difference in your returns. In actuality, the quality of the fund manager means a lot more than the type of fund that they’re managing.
Overall, a fund managed by a company that’s consistently beating its benchmark index is a solid investment — whether it’s open-end or closed-end — and one managed by a consistently underperforming company isn’t. So, opting for an open-end vs. closed-end fund is more of a question about what options are available. Focus on the underlying assets of the fund and how they’ll fit into your portfolio, not to mention how high the fees are and whether the fund’s performance justifies paying them. If a particular fund offers a unique blend of assets that complements your portfolio perfectly, it makes sense to buy.
That said, the types of funds that are typically closed-end or open-end can vary a lot, so you’re unlikely to encounter many instances where you’re faced with choosing between the two types. Closed-end funds are usually more niche and will invest in very specific goals. Therefore, it’s not surprising for average investors to stick solely with open-end funds in their portfolios.
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Understanding the difference between an open-end fund and a closed-end fund is important, particularly for investors shopping around for mutual funds. However, things like the fund objective, fund manager and underlying assets are all going to be more important considerations than whether or not the number of shares is fixed.
Getting a fund that will beat — or at least match — market returns while complementing the other assets in your portfolio should be the primary goal. So, while closed-end funds can be excellent options, you shouldn’t be all that concerned if you don’t own any shares of them.
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