Federal securities laws classify investment companies into three different categories -- mutual funds, closed-end companies and unit investment trusts. Most investors have some familiarity with mutual funds, but the closed-end fund or company rarely even gets a head nod of respect from the average investor. Closed-end funds offer some advantages (and disadvantages) over their open-end fund cousins.
Why Mutual Funds?
Investment companies, whether a mutual fund or closed-end company, offer the investor (especially the small investor) the opportunity to invest in a very wide and diverse number of companies. Mutual funds have professional fund managers that manage the content of the fund’s investment portfolio. Most mutual funds sell their shares continuously, but on occasion a fund will stop selling its shares if it feels its assets under management have reached a threshold. (See references 1.)
The vast majority of mutual funds function as open-end funds. Open-end funds have an unlimited amount of shares to sell. In other words, if your buddy tells you about an open-end mutual fund that’s performing well you can immediately buy shares of the fund because it always has shares available to trade. When you’re ready to sell or redeem the shares, you sell them back to the mutual fund. Shares of an open-end fund trade at something called net-asset value or NAV. To calculate NAV, the mutual fund totals up all of the assets it owns, subtracts the fund managers’ salaries and any other liabilities and it divides that number by the total number of shares outstanding. NAV gets calculated at the end of each trading day. (See references 2.)
This type of investment company is legally called a closed-end company. While an open-end mutual fund always has shares available to sell, the closed-end company only has a fixed amount of shares to sell. It sells these shares in an initial public offering (IPO) and the secondary market (regular trading on the NYSE or the NASDAQ exchange) trades these shares after the IPO. Also, the price of closed-end shares can fluctuate from their net-asset value. Unlike open-end mutual fund shares, closed-end shares are not redeemable. The fund does not have to buy back shares from its investors. (See references 3.)
Most open-end mutual funds make investments in securities that offer a great deal of liquidity. In other words, they invest in things that allow them to quickly sell and receive cash from the sell of the securities. This allows the open-end fund to redeem shares and pay the proceeds to the investor within seven days. Closed-end funds trade in more illiquid securities; securities that typically cannot get sold at NAV within seven days. For this reason closed-end funds are not redeemable to the investor.
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