Investing in assets such as stocks that have the potential to increase in value is a common wealth creation strategy, but putting too much money into any individual stock is risky. Mutual funds are professionally managed investments that hold a variety of underlying assets like stocks and bonds. A single mutual fund can hold hundreds of different stocks, which can minimize investment risk. Mutual funds come in two flavors: open-end and closed-end funds. Both types offer professional management and diversification, but they have several notable differences.
Open-End Fund Basics
Open-end funds are the more popular of the two types of mutual funds. Open-end funds can have an unlimited number of shares: When an investor wants to buy shares of an open-end fund, the mutual fund company creates additional shares to satisfy the demand. If an open-end fund investor wants to sell his shares, the fund buys back his shares. Since open-end funds create and buy back shares on demand, investors can buy and sell shares at any time regardless of whether other investors want to buy or sell.
Closed-End Fund Basics
Closed-end funds have fixed number of shares. Similar to a corporation that issues stock, when a closed-end fund forms, it holds an initial public offering at which it issues a set number of shares. Since the number of shares in a closed-end fund doesn’t change based on demand, investors interested in buying shares have to purchase them from other investors who want to sell shares.
The valuation of shares is different for the two types of funds. With open-end funds, the price of each share is equal to the fund's net asset value. Net asset value equals a fund's total assets, minus the fund's fees and expenses, divided by the number of shares held by investors. This means the value of a share of an open-ended fund is determined entirely by the value of the underlying assets the fund holds. In contrast, the share price of closed-end funds is determined by supply and demand for shares rather than net asset value.
Closed-end funds trade on stock exchanges, allowing investors to buy and sell shares throughout the day at prices determined by the market. Open-end funds do not trade on exchanges throughout the day. Since the share price of an open-end fund is determined by net asset value, investors can only buy and sell shares of open-end funds at the end of each day, after the stock market closes and the net asset value can be calculated.