Closed End Mutual Funds: Don't Get Confused
John Caldwell
Traditional mutual funds are not the same as their counterpart, closed end mutual funds. That is, they vary quite considerably. For this reason, new investors should get acquainted with this investment vehicle prior to investing, since they bare more risk.
Characteristics
A closed end fund raises capital by issuing a limited amount of shares to the public. It does this through an initial public offering or IPO. Once it has raised the capital required, the stock begins trading in the stock market.
In a traditional fund, shares can be redeemed and issued on demand, as long as the stock market is open. This is not the case in a closed end fund, share are purchased and sold much like a regular share.
The shares of a closed end fund trades in the stock market based on the supply and demand of the shares. In a traditional fund, the shares are purchased directly from the mutual fund company.
The value or price of the closed end fund grows or shrinks as demand for the fund increases or decrease . On the other hand, an open ended fund grows or shrinks based on the inflow or outflow of money.
In the traditional fund the price of the share is determined based on the net asset value held in the fund. The share price of the closed end fund is determined based on the demand investors place in the stock market.
Caution
We recommend the novice investor stay away from closed end mutual funds, simply because the mechanics of such funds are much more complex than the traditional mutual fund. More important, although the fund is diversified as in the traditional open fund, investor demands greatly affect the value of this fund. That is, such funds are subject to the same risks that shares face in any stock market.
Specifically, most of these funds sell at a discount in the stock market. This being the case investors who buy closed end mutual funds are banking that the gap between the discounted price and the net asset value will shrink, thus making a profit. This means they are speculating, and speculation is risky.
Before you invest in mutual funds, make sure you check John Caldwell's excellent free articles on http://www.tipsonmutualfunds.com/) mutual funds basics.
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