Open vs. Closed End Funds Differences

Posted By: Advisor Analyzer Team

For a majority of investors, especially those unfamiliar with investment analysis, mutual funds have been the go to investment. Why would anyone take time to analyze hundreds of charts and financial statements when a team of professionals can do the same work for a nominal fee? Seemed like a pretty bullet proof idea at first, but as anyone who’s lost money in a mutual fund will tell you, if it sounds too good to be true, it usually is.

 

For those who aren’t familiar with how mutual funds work, here’s a quick and dirty explanation. Mutual funds are nothing more than a portfolio of stocks (and sometimes bonds or derivatives) with shares that can be bought or sold by the investing public. Usually, mutual funds tend to focus on a specific sector or industry and have one or more portfolio managers, who generally are experts in the field the fund invests.

 

There are generally two types of mutual funds: open end and closed end funds. Both funds are structured and traded differently. This article will focus on the differences in the two types of mutual funds. Later we’ll discuss how ETF’s function and how they have been steadily claiming their stake in the modern investor’s portfolio. But for now, let’s discuss open end mutual funds.

Open End Funds

Open end funds, are what a majority of mutual fund investors own. Open end funds usually have five letters in their ticker such as (ticker: ABCDE) and the likes. They are considered a continuous offering, which basically means they have can offer an unlimited number of shares to the investment community. So if every single investor in the world would like to purchase the ABCDE fund, they would be able to accommodate at (roughly) the weighted average market price of all the stocks in the portfolio. What this means is the amount of buying and selling of the mutual fund shares are not dictated by the supply and demand of investor’s, but rather based on the underlying assets. Therefore, they don’t trade too far off from their intrinsic value, a major benefit of continuous offerings.

A drawback of open end funds is they are not traded throughout the day.  If that sounds a bit confusing, let me clarify how they trade.  When someone gives $100 to a mutual fund company, the money isn’t invested automatically right there, like stocks or other securities do.  They aren’t actually invested until the end of the day, when the fund’s overall value is calculated from closing prices of all the stocks in the portfolio.  Then depending on the fund price, say $5 a share, they purchase $100 dollars worth of the fund (20 shares).  If the market had a great day and the fund closed $10 a share, your $100 would buy only 10 shares and so on.  The main problem with this is the inability to time the market.  If your investment will depreciate then bounce back significantly between 2- 3:00pm today, there is little you can do besides watch.  Basically, open end funds have a prohibitive design for trading and market timing, which can be frustrating for some.   

However, aside from the inability to trade at whim, open end funds usually have high sales and redemption fees that are charged.  Investors must be aware of the overall fee structure for investing in the mutual fund’s portfolio.  To learn more about the different open end mutual funds structures, click here.

Closed End Funds:

Closed end funds are structured differently from their open end older brothers.  As the name implies they are a closed offering, so just like an individual equity position, the number of shares available to trade is limited.  Also, similar to stocks, investors can purchase and sell shares of the fund in the open market at any time with no sales or redemption fees.  There is are administrative and management fees that are charged annually.  The fees compensate the portfolio managers who decide which investments to hold in the closed end fund, but investors do not have their funds locked up.  These funds are generally better for the day traders and investors with short term investment horizons due to fewer fees, which provide the flexibility to trade in and out of positions at whim.

 

However, while overcoming the obstacles of sales and redemption charges, there is another potential caveat that must be addressed aside from the annual administrative and management fees.  Since these positions are a fixed number of shares, the price of each share is dictated by market participants, not the underlying value of the assets.  For example, suppose there is a fund AB that holds 50/50 positions in Stock A and B.  A is trading at $2 per share and B is trading at $4.  Since it is a 50/50 split, one would assume the price of AB fund is $3 (the fair average price of A and B).  If this were an open end fund, your assumptions are correct (in the absence of fees of course).  However, closed end funds do not work this way. 

So why do these funds trade at a premium or discount?  Usually, it’s a combination of various factors; the portfolio manager’s popularity, the average trading activity, the overall number holdings etc.  Many very intelligent market experts are still riddled by the phenomena.  The original belief was investors would be able to profit from such mispricing (arbitrage) and the discounts or premiums would be short lived.  Investors would purchase the undervalued fund and short the underlying assets and wait for the prices to converge back to intrinsic. 

Conclusion

While far from an all encompassing overview, investors should be aware of the basic characteristics that distinguish open end from closed end funds.  Mutual funds may be a great way to obtain instant diversification and expert analysis from industry professionals, but there are always tradeoffs made.  Investors usually end up bearing the cost, whether monetary or otherwise, in exchange for these benefits.  As the famous saying in finance goes, “there’s no free lunch”.