While the overall mutual fund industry can be broken down into various segments— stock vs. bond, growth vs. value, etc. – one important distinction must be made regarding the mutual fund’s structure: is it open-end or closed-end?
Many investors are not even aware of the existence of closed-end mutual funds, as this industry is much smaller than the open-end fund industry. However, the distinct characteristics of closed-end funds can provide unique investment opportunities. The biggest distinctions between these types of funds are due to 1) the way shares are traded in the marketplace and 2) deviations from Net Asset Value.
When an investor transacts in shares of an open-end mutual fund, shares are purchased and sold directly with the mutual fund company. When the mutual fund company receives a purchase order, they create new shares and issue them to the investor, and redeem the shares when they are sold back to the fund company. This means that the number of shares issued changes every day, and the price changes to reflect the underlying value of the mutual fund portfolio.
However, closed-end funds issue a fixed number of shares when the mutual fund is first launched, and the shares trade hands on the stock exchanges (often the AMEX) between anonymous buyers and sellers. No new shares are created or removed from the market during this period, and share price is determined by supply and demand.
Net Asset Value (NAV)
The difference in the way transactions are structured (discussed above) results in one of the most unique differences between open-end and closed-end funds— deviations from Net Asset Value. The Net Asset Value (NAV) of a mutual fund is the per-share value of its assets, calculated as the total asset value divided by the number of shares.
For an open-end mutual fund, the share price is always equal to the NAV, since shares are issued and redeemed by the mutual fund company at the NAV each day. However, because closed-end funds are traded on public exchanges, the prices are determined by supply and demand, which means that the trading price can deviate substantially from the actual NAV of the fund.
To illustrate, imagine that you invested in one open-end technology mutual fund and one closed-end technology mutual fund. If technology stocks all crashed by 40% and investors were fleeing technology mutual funds, the fund NAV (price) would decline 40% to reflect the change in the value of the portfolio.
However, a closed-end fund may decline by 60%, since the underlying portfolio declined in value by 40%, and the number of sellers now outweighs the number of buyers (supply is higher than demand), thus pushing the price per share below the value per share.
Open-end mutual funds have distinct structural differences from their closed-end fund cousins. One of the main differences is that open-end funds have a flexible number of shares which are all traded through the mutual fund company, rather than a fixed number of shares available on the stock exchange.
This difference means that open-end funds are always priced appropriately at the NAV per share, while the price per share of closed-end funds is not always equal to the NAV per share. This feature of closed-end funds provides unique investment opportunities if the price of a closed-end mutual fund deviates significantly from the NAV.