Closed-End Funds vs. Open-End Funds: An Overview
Wall Street is full of products that even some experts don't understand and—much like the notorious billion "London Whale" trading loss at JP Morgan in 2012—complicated investments can produce unexpected results. Many of them are inappropriate for regular investors, but that doesn't mean that you have to restrict yourself to mutual funds and exchange-traded funds (ETFs).
If you invest in mutual funds, you're already familiar with the open-end fund. The closed-end fund is less well known.
- Mutual funds are open-end funds. New shares are created whenever an investor buys them. They are retired when an investor sells them back.
- Closed-end funds issue only a set number of shares, which then are traded on an exchange.
- Closed-end funds are considered a riskier choice because most use leverage. That is, they invest using borrowed money in order to multiply their potential returns.
Closed-End Vs Open-End Funds
A closed-end fund is launched through an initial public offering (IPO) in order to raise money for investment. The fund then trades in the open market just like a stock or an ETF.
Only a set number of shares are issued. But since the shares continue to trade, their market price is affected by supply and demand. That means the shares may trade at a price above or below their net asset value (NAV), the price at which it was issued.
But the purpose of these funds is to pay distributions to their investors, which may include earnings, capital gains, and return of principal. Some funds, like BlackRock Corporate High Yield Fund VI (HYT), pay close to 8%, making them an attractive choice for income investors.
At the end of 2020, more than $279 billion was held in the closed-end funds market, yet it is not an investment category that is well known by retail investors.
A key factor that investors need to know about closed-end funds: Nearly 70% of them use leverage as a way to produce bigger gains. Using borrowed money to invest can create big losses as well as big gains.
Mutual funds are open-end funds. There is no limit to the number of shares that they can issue. (Some issuers do close their funds to new investors, as there are downsides to a fund that swells to a gigantic level of assets.)
When investors purchase shares in a mutual fund, more shares are created to accommodate them, When investors sell their shares back to the company, the shares are taken out of circulation. If a large number of shares are sold (called a redemption), the fund may have to sell some of its investments in order to pay the investor.
You can't watch an open-end fund in the same way you watch your stocks because they don't trade on the open market.
The funds do not trade on the open market. Their shares can only be sold back to the company that issued them.
Open-end funds are priced only once per day. At the end of each trading day, the funds are repriced based on the number of shares bought and sold. Their price is based on the net asset value of the shares.