Closed-End vs. Open-End Investments: An Overview

Closed-end and open-end investments have basic characteristics in common. Both are professionally managed funds that achieve diversification by investing in a collection of equities or other financial assets, rather than in a single stock. And both pool the resources of many investors to be able to invest in a larger and wider scale. They're also both known as closed-end and open-end funds.

But there are also several differences between these two types of investments. The primary differences lie in how they are organized, and how investors buy and sell them. There may also be some significant differences in the investments that make up the funds' portfolios.

Key Takeaways

  • There are significant differences in the structure, pricing, and sales of closed-end funds and open-end funds.
  • A closed-end fund has a fixed number of shares offered by an investment company through an initial public offering.
  • Open-end funds (which most of us think of when we think mutual funds) are offered through a fund company that sells shares directly to investors.

Closed-End Investments

A closed-end investment is overseen by an investment or fund manager, and is organized in the same fashion as a publicly-traded company. This type of fund offers a fixed number of shares through an investment company, raising capital by putting out an initial public offering (IPO). After the IPO, shares are listed on an exchange. Investors are able to purchase shares through a brokerage firm on the secondary market.

Closed-end funds can be traded at any time of the day when the market is open. They can’t take on new capital once they have begun operating, but they may own unlisted securities in the U.S.

The nature of each type of fund also affects how it is priced. Closed-end investment shares reflect market values rather than the net asset value (NAV) of the fund itself. That means they can be purchased or sold at whatever price the fund is trading at during the day. Demand is what drives share prices. Since market demand determines the price level for closed-end funds, shares typically sell either at a premium or a discount to NAV.

Closed-end funds are more likely than open-end funds to include alternative investments in their portfolios such as futures, derivatives, or foreign currency. Examples of closed-end funds include municipal bond funds. These funds try to minimize risk, and invest in local and state government debt.

There are several possible areas where distributions come from in closed-end funds. These can come from dividends, realized capital gains, or interest from fixed-income assets held in the funds. The fund company passes the tax burden on to shareholders, issuing them a form 1099-DIV with the breakdown of distributions every year.

Open-End Investments

If you hear the term open-end fund and think of a mutual fund, you won't be entirely wrong. That's because a mutual fund is one type of open-end fund. Other types of of open-end investments include hedge funds and ETFs. These are offered through fund companies, which sell shares in each directly to investors. Outside the U.S., open-end funds can take the form of SICAVs in Europe, and OEICs or unit funds in the UK.

Open-end funds are traded at times dictated by fund managers during the day. There is no limit to how many shares an open-end fund can offer, meaning shares are unlimited. Shares will be issued as long as there's an appetite for the fund. So when investors buy new shares, the fund company creates new, replacement ones.

Prices for open-end funds are fixed once a day at their NAV, and reflect the fund's performance. This value is the fund's assets minus its liabilities. This is the only price at which fund shares can be purchased that day.

Some open-end funds may charge investors a fee either the purchase of shares or when they are sold. A front-end load is a fee or commission charged when an investor initially purchases shares in the fund. This is a one-time charge and is not incurred as an operating expense. The back-end load is a fee charged to investors when they sell shares in mutual funds. The amount of the fee depends on the value of the shares being sold, usually charged as a percentage. Other open-end funds will not charge investors a fee at all. These are known as no-load funds.

Open-end investments such as mutual funds do not pay taxes on their own, but also pass on the tax burden to their investors. This means investors pay taxes on any capital gains or income derived from these funds.