They're similar but when you get under the hood with these products, they're very different and that can affect the outcome of your investment. Here are the basics of each.
Open End Funds
You know open end funds as mutual funds. As more investors enter the fund, it creates more shares. When a current investor sells all or a portion of the shares, they're removed from circulation. This creates a constant cycle of issuance and buybacks. If a large investor sells, the fund's manager may have to liquidate some of the fund's positions to pay the investor.
If the total value of a mutual fund is so high that the management team can no longer meet the fund's stated objective, they may close the fund to new investors or in extreme cases, not allow current investors to purchase additional shares.
Open end funds do not trade on the open market. You can't watch the price fluctuate on an exchange as you can with an ETF or equity. At the end of each trading day, the fund is repriced based on the number of shares bought and sold. Pricing is based on the net asset value-the total value of the fund.
If you have a 401(k) or other company sponsored retirement vehicle, you likely already have exposure to open end funds.
Closed End Funds
A closed end fund functions like an ETF. In fact, it's not difficult to find articles that provide ETF recommendations that contain closed end funds even though they are different. Closed end funds are often actively managed while ETFs track an index. CEFs may trade at a discount or premium to their net asset value. ETFs generally do not. Finally, the fees associated with CEFs are often higher than ETFs.
How do closed-end funds compare with open-end funds? Closed end funds launch through an IPO just like a publically traded company. Only a set number of shares enter the market with supply and demand determining the price. This is how CEFs are able to trade at a discount or premium to their NAV.
CEFs trade on an exchange just like a stock or ETF. If you own shares of a mutual fund, you can thank ETFs and to a lesser extent, CEFs for bringing the expenses of your mutual funds down. These cheaper products have taken market share from mutual funds causing open end fund managers to lower the expense ratio of the fund in order to compete.
With more than 650 CEFs on the market, there are plenty of options. One of the most popular among investors is BlackRock Corporate High Yield Fund VI (NYSE: HYT ). It has a current yield of 8.2 percent and currently trades at a 2 percent discount to NAV.
Invest in CEFs with caution. Nearly 70 percent of these funds are leveraged. Any investment product that relies on leverage to produce income exposes itself to potential liquidity issues as well as higher fees.
In 2012, Moody's downgraded the rating of some of the banks that issue these funds. This could make it more expensive for the funds to borrow money, causing the fund's expenses to rise. Don't just evaluate the fund. Also, research the bank that issues it.
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