Open-End Funds vs. Closed-End Funds

Open-end funds are the traditional mutual funds we've been talking about up to now. The fund is called "open-end" because there is no fixed number of shares issued.

The price you pay for a mutual fund share of an open-end mutual fund is based on the market value of all the fund's investments, minus costs, and then divided by the number of mutual fund shares owned by the fund's shareholders. That price is called the Net Asset Value (NAV) per share, and the NAV is set daily, after the market closes.

As with stocks and bonds, the price of an open-end mutual fund rises or falls every day, depending on what happens to the investments that are owned by the fund. Every time an investor buys shares, the mutual fund issues more shares. Higher demand for the fund does not mean a higher share price, as it does with stocks. Each day, a mutual fund must determine both the value of its portfolio and how many shares are outstanding.

Sometimes an open-end fund will close its doors and no longer accept any money from new investors. There are a couple of reasons for this. The primary cause is simply that the fund gets so large its managers can no longer follow their initial strategy and the fund's performance begins to suffer. For example, a fund dedicated to buying small-cap stocks may find itself with so much money that it "outgrows" that sector.

Or, a fund may close if management thinks it has attracted too much "hot" money due to its stellar performance. That money could rush back out the door if its returns temporarily falter, thus hurting existing shareholders, so sometimes the decision is made to close for a short period of time.

Yes, there are also occasions in which the fund may no longer accept any new money from existing shareholders either. However, if you already own shares of the open-end fund before it closes, you still have all the investment and redemption privileges that you had when the fund was open to new investors.

Closed-end funds are a different animal. In fact, they're much more similar to stocks. A closed-end mutual fund sells a fixed number of shares and invests the proceeds. The number of shares doesn't change. As with stocks, closed-end mutual funds are listed on a stock exchange, and the only way to buy shares of a closed-end fund is through a broker (who will charge you commissions, of course, whether you do it in person or online).

Contrary to open-end funds, the value of a closed-end fund is not based on the net asset value (NAV, the underlying value of the portfolio), but, rather, on the market's perception of how the fund is doing. Consequently, the shares of a closed-end fund typically trade above or below the fund's NAV.

When the market value of the fund's shares is less than the NAV of the investments that the fund owns, the fund is trading at a discount. This means you can buy the fund's share for less than its assets are worth. When the market value of the fund's shares is greater than the NAV of the investments, the fund is trading at a premium. This means you're paying more than the investments are worth on the open market.

There are no hard and fast rules as to why a particular fund trades at a discount or premium. For example, as we write this, the India Fund (NYSE: IFN) trades at $54.30, with a NAV of $59.61. As you can see, it is obviously trading at a discount.

You may be interested to know that U.S. closed-end funds commonly sell at an average 5% discount to NAV. But it's important for you to know that there are investors who will purchase shares at either level. We prefer buying closed-end funds at a discount. After all, why pay more than you need to?

There's a third kind of fund that has become increasingly popular in recent years called an exchange-traded fund, or ETF. These funds typically mimic a stock exchange or index and have very low fees because the holdings are determined by what's in the index instead of a professional manager. (Click here for more advice on ETFs at Dolans.com.)