By Lee Sherman
When investing in mutual funds there are two types to consider:
Most likely, the majority of your portfolio consists of Open-end funds. In fact, it’s probably helpful just to think of Open-end funds as what you know as mutual funds.
Almost all mutual funds are Open-end which means there is no limit to the number of shares they can issue. When an investor purchases shares in a mutual fund, more shares are created, and when an investor sells their shares, their value is redeemed and they are no longer available for purchase. These funds are managed by a management company and you buy shares directly from the fund on the primary market. Open-end funds are a long-term investing strategy where the fund manager plays an active role in balancing your portfolio for you and you are far less subject to changes in the market than with Closed-end funds. Open-end funds, therefore, make more sense if you are primarily saving for retirement or other life goals.
Closed-end funds are quite different but increasingly common, especially in Silicon Valley where short term gain is often the goal. In this scenario, companies issue a set number of shares to the public through an initial public offering (IPO). Unlike Open-end funds, where access to a fund is more limited, these shares are traded on the open market just like a stock or an Exchange Traded Fund (ETF). They are appealing because they provide an investor with the opportunity to get in on the ground floor of the latest hot startup but as with any investment, this can be a double-edged sword.
Closed-end funds can deliver higher returns but keep in mind that they are also more volatile because they are subject to the laws of supply and demand and you’re likely to experience extreme highs and lows in the value of your portfolio. If you’re comfortable with this risk, however, they can be a good choice because they will pay out regular dividends that can be used as part of an income investing strategy. These funds are also free to invest in a number of asset classes that provide them with capital appreciation. The vast majority of Close-end funds use leverage as a way to increase their value. Of course, borrowing money in order to invest is always risky but it can also produce big returns.
One con to consider is that Closed-end funds are extremely sensitive to changes in interest rates. When they rise, the share price may go down. A Closed-end fund acts more like an exchange-traded fund (ETF) than a mutual fund
However, despite their appeal to an individual investor. Closed-end funds can be difficult to manage. They might require knowledge that a layperson doesn’t have. That’s why it always makes sense to consult with a financial advisor before taking the plunge.
To sum it up, Open-end funds may be a safer bet than Closed-end funds but Closed-end funds might produce a better return because they provide both dividend payments and capital appreciation.
Lee Sherman is a contributing writer to www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.