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Open-end vs Closed-end Mutual Funds

Know the similarities and differences

What are Open-end vs Closed-end Mutual Funds?

Many investors consider open-end vs. closed-end mutual funds similar due to both mutual funds allowing them an inexpensive way to pool capital together and invest in a diversified, professionally managed portfolio of securities. However, it is key to realize that there are substantial differences that affect the returns of the mutual fund and how it is traded among investors.

 

Open-end vs. Closed-end Mutual Funds

 

Quick Summary:

  • Open-end and closed-end mutual funds are similar in that they are both managed by a fund manager who collects management fees.
  • Open-end and closed-end mutual funds are dissimilar in fund structure, fund pricing, and liquidity requirements.
  • Assuming that both an open-end and a closed-end mutual fund invest in the same assets with the same portfolio allocation, the latter performs better.

 

What is an Open-end Mutual Fund?

 

Management and Fee Structure

Open-end mutual funds are generally actively managed by a fund manager who charges management fees. There may be instances where an open-end mutual fund trades passively to match an index.

 

Fund Structure and Fund Price

In an open-end mutual fund, investors pool capital together and are issued shares based on the amount of capital pooled. New investors who want to invest in an open-end mutual fund can do so through providing capital to fund managers who then issue them new shares. On the other hand, investors who sell their shares are sold back to the fund manager, who then redeems the shares and decreases the number of shares outstanding in the mutual fund.

Such a method of buying and selling shares in an open-end mutual fund results in the share price of the fund to trade at the net asset value per share. Additionally, the share price of an open-end mutual fund is typically priced daily at the end of the day.

 

Liquidity Requirements and Performance Impact

Due to investors being able to redeem shares through the fund manager, open-end mutual funds typically come with a liquidity requirement. In other words, open-end mutual funds typically include a cash requirement to account for share redemptions that may occur in the future. Holding cash decreases the overall returns of an open-end mutual fund.

 

What is a Closed-end Mutual Fund?

 

Management and Fee Structure

Closed-end mutual funds are actively managed by a fund manager who charges management fees.

 

Fund Structure and Fund Price

In a closed-end mutual fund, the fund manager initiates an initial public offering (IPO) and determines the amount of capital required for the fund and the resulting shares that are to be issued to investors who provide capital through the initial issue. Afterward, a closed-end mutual fund trades on a stock exchange where shares of the closed-end mutual fund would trade based on supply and demand.

Such a method of buying and selling shares in a closed-end mutual fund results in the share price of the fund to trade at a premium or discount to the net asset value per share. Additionally, the share price of a closed-end mutual fund is priced continually due to the shares being traded on an exchange.

 

Liquidity Requirements and Performance Impact

Due to investors trading shares of a closed-end mutual fund through other investors, there is typically little to no liquidity requirements required. In other words, closed-end mutual funds generally come with a cash requirement as shares cannot be redeemed. Not requiring holding cash increases the overall return of a closed-end mutual fund relative to an open-end mutual fund.

 

Summarizing the Similarities and Differences Between Open-end and Closed-end Mutual Funds

The following table summarizes the similarities and differences between open and closed-end mutual funds:

 

Type of FundOpen-end Mutual FundClosed-end Mutual Fund
ManagementActively/Passively managedActively managed
FeesManagement feesManagement fees
Fund StructureUnlimited share purchases and share redemptions from fund managerFixed number of shares from an IPO
Fund PriceNet asset value per sharePremium or discount to net asset value per share
PricingPriced daily (end of day)Priced continually (trades on an exchange)
LiquidityWith cash requirements to account for future share redemptionsLittle to no cash requirements

 

Performance Comparison between Open-end and Closed-end Mutual Funds

Generally, the consensus is that closed-end mutual funds perform better than open-end mutual funds. To understand why, consider an open-end and a closed-end mutual fund that invest in the same securities and with the same portfolio allocation to each security:

  • Security 1: Portfolio allocation (40%) with a return of 8%
  • Security 2: Portfolio allocation (40%) with a return of 9%
  • Security 3: Portfolio allocation (20%) with a return of 10%

 

Open-end mutual funds, as mentioned above, come with a cash requirement to account for share redemptions. Assume the figure to be 5%. Therefore, we can determine the return for each mutual fund as follows:

Open-end mutual fund

Return = [(40% x 8%) + (40% x 9%) + (20% x 10%)] x 95% = 8.36%.

Note that the open-end mutual fund was multiplied by 95% (total assets allocated to securities) to account for the 5% cash requirement.

Closed-end mutual fund

Return = (40% x 8%) + (40% x 9%) + (20% x 10%) = 8.8%.

The closed-end mutual fund does not come with a cash requirement and therefore invests all of its assets in the securities listed above.

As one can see, although both mutual funds invest in the same securities, a closed-end mutual fund’s underlying assets generated a higher return because the fund is not restricted by a cash requirement. By having to hold cash (as with open-end mutual funds), the overall return of the portfolio decreases.

 

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • 2 and 20
  • List of Top Fund Managers
  • Net Book Value
  • Transaction Costs

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