By: Investor Solutions
Ah, the beginning of a new year. The time where we make our resolutions to be healthier, spend more time with our loved ones, get our financial house in order and the like. For those of you seasoned investors this topic may seem elementary but humor me just this once. For the more novice investors who have resolved to invest in a globally diversified portfolio of mutual funds, I trust this article will help you on your journey to becoming financially well versed.
Mutual funds can be classified as closed-end or open-end. Both closed-end and open-end mutual funds are investment companies that pool the monies from various investors in a fund established to accomplish a financial objective. The funds are then “managed” by a money manager in order to achieve this objective which is delineated in the fund’s prospectus. These managers invest in a wide range of securities including stocks, bonds, money market instruments and a combination of these. Delivery of profits are also the same in closed-end and open-end funds. Profits to shareholders can be in the form of income and capital gain distributions and capital gains realized from the sale of shares with increasing share value.
Closed-end and open-end mutual funds also differ in many respects. Characteristics of closed-end mutual funds include:
- Fixed number of shares issued at Initial Public Offering (IPO)
- Shares are bought from and sold to other investors in the open market
- Net Asset Value (NAV)* is published weekly
- Shares of the fund may trade at a discount or premium based on the supply and demand for that particular issue
- Additional profit potential from selling shares if the discount from NAV decreases, if the premium increases or if the discount becomes a premium
- Broker commissions on purchases and redemptions
- Ability to buy on margin and sell short
- Allowed to issue preferred stock and debt
Historically, the best time to purchase closed-end funds has been just after they are issued. At the IPO, the fund’s shares are issued at their actual value. Shortly thereafter, the funds tend to drop under net asset value and sell at a discount. Exactly why these funds sell at a discount after the IPO remains one of finance’s greatest mysteries.
On the other hand, open-end funds (commonly known as mutual funds) have the following characteristics:
- Open to new investors due to continuous issuance of shares
- Shares are purchased directly from the fund’s underwriter
- Net Asset Value (NAV) is published daily
- Shares of the fund sell at their NAV
- Larger commissions to brokers with open-end funds than with closed-end funds after their IPO
It is possible that an open-end fund restrict the issuance of new shares at some unknown point in time. However, this does not cause the fund to become closed-end.
Investing in closed-end funds may be a bit confusing for an inexperienced investor. Since these securities sell at discounts or premiums, it requires the ability to determine the intrinsic value of the underlying securities to conclude whether or not making the investment makes sense. This adds an additional layer of risk and goes against the theory that markets are efficient.
If you are uncertain on which investment vehicle is best for you, consult your financial advisor.
*NAV is the total assets less total liabilities of a mutual fund divided by the number of shares outstanding.