Investment funds come in two general types: open-end funds and closed-end funds. The most common type is the open-end fund -- the structure usually associated with mutual funds.
The name explains how the fund manages new investments and withdrawal requests. When you invest in an open-end fund, like a mutual fund, the fund creates new shares to issue to you. The fund manager then invests your money into new investments, often in proportion with its existing holdings.
Likewise, when you sell shares of an open-end fund, the fund manager often sells a portion of the portfolio to buy your shares from you.
Naturally, a closed-end fund is the opposite. A closed-end fund has a limit on the number of shares outstanding. To buy shares of a closed-end fund, you do so by purchasing shares from an existing investor, usually by buying a fund in the open market. Investors redeem their shares by selling their shares to another investor. There is no interaction between the investor and the fund management company when closed-end funds are bought and sold.
Why buy open-end funds?
Open-end funds have a major advantage over closed-end funds. Open-end fund shares are always bought or sold at their "net asset value." Net asset value is the value of the assets in the fund on a per-share basis. (A fund with $120 in assets and 10 shares outstanding would have a net asset value of $12 per share.)
Because open-end funds are bought and sold at their net asset value, you neither have to worry about overpaying to buy one, nor selling it for less than it is worth in the future.
Closed-end funds add an additional layer of risk to your investment. It's possible to pay a premium for a closed-end fund and sell it later at a discount. Imagine paying $10 to buy a fund worth $8 per share, only to sell it for $10 per share when the fund is actually worth $12 per share!
For this reason, open-end funds are a better choice for investors who intend to make regular and recurring contributions, such as a biweekly contribution to a retirement account. You don't have to worry about whether the fund's price is currently above or below net asset value -- open-end funds are always bought and sold at net asset value.
The only downside to open-end funds, if you can call it that, is that they are not always the most tax-friendly investment vehicles.
Because open-end funds occasionally have to sell investments to meet redemption requests, they can create unnecessary capital gains on which all fund investors have to pay capital gains taxes. Of course, most investors completely avoid this "downside" by holding mutual funds in tax-deferred retirement accounts like a 401(K) or IRA, negating any issues with a fund's tax efficiency. After all, the majority of open-end fund investments (mutual funds) are owned through retirement accounts.
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