Millions of investors use mutual funds to help them get diversified exposure to a broad range of investments without having to invest huge amounts of money. Most of the mutual funds that people use to invest are open-end funds. An open-end fund is a mutual fund that doesn't have any inherent restriction on the number of outstanding shares it has, and the fund can issue new shares or redeem existing shares at any time. By contrast, closed-end funds, which are also a type of mutual fund, have fixed numbers of shares, and they can only offer new shares through formal secondary offerings. Open-ended funds are simpler for investors to understand, but they do have some aspects that don't fit every investor's needs.
The primary advantage of open-end funds
The biggest benefit of open-end funds is that it's easy for investors to buy into or sell out of their share positions in a given fund. Every day, open-end funds establish their net asset value by taking the total amount of their assets and dividing it by the number of shares outstanding. The resulting net asset value per share is used to pay those who sell their shares on that day, and any new investments that the fund receives are exchanged for new shares using the same per-share price.
It might sound trivial that investors can get back the true value of the fund's underlying assets, but that isn't always the case with all investment vehicles. For example, closed-end funds often trade at premiums or discounts to their net asset value, because there's no mechanism by which fund shareholders can sell their shares back to the fund company and receive their intrinsic value. Instead, investors have to rely on the supply and demand for closed-end fund shares on the open market. That can lead to wide disparities between market price and net asset value, and that can produce unexpected fluctuations in closed-end fund share prices even if the value of the fund's underlying assets is stable.
Some downsides of open-end funds
Unfortunately, the same trait of open-end funds that produces their key advantage also has a negative impact. Because open-end funds have to produce enough liquidity to pay off redeeming shareholders at will, they sometimes have to sell their assets in order to generate cash. When they do, the resulting capital gains don't get taxed at the fund level, but they are carried out to shareholders, typically through year-end capital gains distributions. These distributions are included in taxable income if you hold your fund shares in a taxable account, even if you decide to reinvest the distributions to buy more fund shares.
In addition, some find it frustrating that they can only trade open-end funds once per day. By contrast, closed-end funds are traded on public exchanges, and you can therefore buy or sell shares at any time during the trading session. Sometimes, not being able to sell open-end fund shares intraday means suffering greater losses than you would if you could have sold right away.
Even with these shortcomings, open-end funds are the mutual funds that most investors use in their portfolios. Because of the daily liquidity and diversification advantages they provide, open-end funds offer an attractive combination of reward and risk that's appropriate for many investors.
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