Open-End Mutual Funds (OEF) vs. Closed-End Mutual Funds (CEF)
July 21st, 2006I suppose if you just have to own mutual funds then it is probably best for you to know the difference between an open-end fund (OEF) and a closed-end fund (CEF). I have bumped into a few people with questions about the differences so here goes.
Most mutual funds are open-end funds. What that essentially means is that there is no fixed number of shares. If millions of people suddenly decide to send money to the fund management company then they simply create new shares to sell to them. Closed end funds are a little different in that they trade a fixed number of shares. Those shares are created and released through an IPO much like a stock would be. The CEF shares are then traded on an exchange throughout the day similar to an ETF. OEFs are bought and sold directly from the mutual fund company and are only priced once per day - at the end of day.
Here are a couple of lists you can use to compare the two:
Open End Funds
- Number in Existence: Somewhere between 8 and 9000.
- How Traded: Bought and sold directly from mutual fund company (or through a broker).
- How Priced: Once per day, the net asset value (NAV) of the fund is used to price the share.
Closed End Funds
- Number in Existence: About 1000.
- How Traded: Bought and sold on an exchange throughout the day just like stocks or ETFs.
- How Priced: The market demand determines the price, which can trade at, above, or below the actual net asset value.
Both types of funds are required to distribute dividends and capital gains on a yearly basis. CEFs are usually a bit less liquid and a tad more volatile than OEFs. The volatility difference certainly comes from the fact that they trade all day. Liquidity seems to be an issue because many of the CEFs are very specialized and investors have to be interested in their theme in order to put their money to work.
One of the major drawbacks of an OEF is the fact that large redemptions can have an effect on the shares of the remaining holders of the fund. If a large redemption is made then the fund may be forced to sell assets in order to meet the cash needs of the redeemer. If that is the case then the fund will incur lots of transaction costs and those costs will ultimately be passed on to the remaining shareholders of the fund in the form of a lower net asset value. It is not really an optimal setup.
All CEFs are actively managed funds so if you are looking for some type of narrow theme investment then they are a worthwhile consideration. Be warned however, you have to believe in the concept of alpha (that is… that markets are not perfectly efficient and that abnormal returns are achievable) in order for this to be logical for you. If you happen to believe in efficient markets and that long term market out-performance is unlikely then you are better off sticking with some type of OEF index fund. Note: I will not choose which side of the fence to argue on today - I will leave that up to you.
"A public-opinion poll is no substitute for thought."
-Warren Buffett
Disclaimer: this post is for informational purposes ONLY. Please read the disclaimer before even thinking about relying on me to make a financial decision!
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