Open-end versus Closed-end Mutual Funds

Open end and closed end are general terms that refer to whether a mutual fund company issues an unlimited or a set amount of shares in a particular fund. Here's some more specific information:

• Open-end funds: Open end simply means that the fund issues as many (or as few) shares as investors demand. Open-end funds theoretically have no limit to the number of investors or the amount of money that they hold.

• Closed-end funds: Closed-end funds are funds for which the mutual fund companies decide up front, before they take on any investors, exactly how many shares they'll issue. After they issue these shares, the only way you can purchase shares (or more shares) is to buy them from an existing investor through a broker. This process happens with buying and selling stock, too.

The majority of funds in the marketplace are open-end funds. Open-end funds are usually preferable to closed-end funds for the following reasons:

• Management talent: The better open-end funds attract more investors over time. Therefore, they can afford to pay the necessary money to hire leading managers. I'm not saying that closed-end funds don't have good managers, too, but generally, open-end funds attract better talent.

• Expenses: Because they can attract more investors, and therefore more money to manage, the better open-end funds charge lower annual operating expenses. Closed-end funds tend to be much smaller and, therefore, more costly to operate.

Brokers who receive a hefty commission generally handle the initial sale of a closed-end fund, siphoning 5 to 8 percent of your investment dollars, which they generally don't disclose to you. (Even if you wait until after the initial offering to buy closed-end fund shares, you still pay a brokerage commission.) You can avoid these high commissions by purchasing a no-load (commission-free), open-end mutual fund.

• Fee-free selling: With an open-end fund, the value of a share (the net asset value) always equals 100 percent of what the fund's investments (less liabilities) are currently worth. And you don't deal with the cost and trouble of selling your shares to another investor like you do with a closed-end fund. Because closed-end funds trade like securities on the stock exchange, closed-end funds sometimes sell at a discount.

Sometimes, a closed-end fund that sells at a discount can be good. You could buy shares in a closed-end fund at a discount and hold on to them in hopes that the discount disappears or — even better — turns into a premium (which means that the share price of the fund exceeds the value of the investments it holds). Never pay a premium to buy a closed-end fund, and you shouldn't generally buy one without getting at least a 5 percent discount.

Mutual fund companies can decide at a later date to "close" their open-end fund to new investors. This doesn't make it a closed-end fund, however, because investors with existing shares generally can buy more shares from the fund company.