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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

Through an initial public offering or IPO, closed end funds raise capital by issuing a limited amount of shares to the public. Once the funds have been raised the shares of such mutual funds are traded in the stock market.

In the traditional mutual fund, the investor is able to buy or redeem unlimited number of shares on demand, thus allowing more flexibility. This is not the case in a closed end fund. They have a limited amount of shares.

A closed end fund trades it shares in the open stock market, where investors will buy based on supply and demand. In a traditional fund, the shares are purchased through the mutual fund company.

In an open-ended fund, the asset of the fund grows or shrink based on the inflow or outflow of money. This is not the case in a closed end mutual funds. That is, the fund grows or shrinks based on the demand for the fund.

The share price of the closed end fund is determined based on investor demand and not the asset value the fund holds. The share price in the traditional fund is determined by the asset value the fund holds.

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 are selling at a discount in the stock market. As a result, investors who buy closed end mutual funds are trying to capitalize the gap shrinking between the discounted price and the net asset value. This can only mean investors are speculating, and speculation is risky.

Last 5 posts by John Caldwell

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Tags: Mutual Funds