To a new investor, the differences between a traditional open end mutual fund and a closed end fund might be hard to comprehend. Actually, the two types of funds have very little in common and need to be researched before you invest your money. Doing a little research ahead of time can prevent big losses down the road.
Open End vs. Closed End Mutual Funds
With a closed end fund, capital is raised by issuing a specified number of shares to public investors. This process is called an initial public offering. Only after the necessary capital is raised will the stock begin open trading in the stock market.
With a traditional, open end mutual fund, the investor has a lot more flexibility. As an investor in this type of fund, you can buy or sell all the shares you want when you want instead of just a limited amount of shares like with a closed end fund. The closed end funds are totally based on supply and demand. With the traditional fund, however, you can buy an infinite number of shares from the mutual fund company.
The inflow or outflow of money in an open end fund determines the amount the fund is worth. With a closed end fund, however, the amount you make will depend on how much demand there is for that particular fund. The share price is totally based on investor demand, and the assets the fund holds are not considered in the mix. With an open end fund, share prices are based on the asset values alone.
A Word of Caution
As a new investor, it’s wise to stay away from closed end mutual funds until you know exactly how they work. They are much more complicated than open end funds, and it requires a certain degree of expertise to be able to invest in closed end funds successfully. Because they are traded on the stock market, closed end funds come with a much higher risk factor than open end funds.
Playing the closed end mutual fund game requires a lot of risky speculation. What investors do is buy the funds at a discount and hope that the gap between the price they pay and the asset value of the fund will shrink, netting them a profit.