Unlike a traditional mutual funds, closed end mutual funds have little in common to the traditional open end fund. In fact, they defer significantly. As an investor r, you should learn the differences prior to investing in such funds so as to make an informed investment decision.
Characteristics
A closed end fund raises capital by issuing a limited amount of shares to the public. It does this through an initial public offering or IPO. Once it has raised the capital required, the stock begins trading in a stock market.
In a traditional fund, shares can be redeemed and issued on demand, as long as the stock market is open. This is not the case in a closed end fund, share are purchased and sold much like a regular share.
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.
The value in a closed end fund grows or shrinks based on the demand for the fund. In an open ended fund, the asset of the fund grows or shrink based on the inflow or outflow of money.
In the traditional fund the price of the share is determined based on the net asset value held in the fund. The share price of the closed end fund is determined based on the demand investors place in the stock market.
Be Cautious
The novice investor should limit their investment in closed end mutual funds until they fully understand the mechanics of these funds. That is, these funds are far more complex than the traditional mutual funds. More over, the closed end fund bares more risk because it is traded in the open market where speculation has an affect on the price of the share.
Specifically, most of these funds sell at a discount in the stock market. This being the case investors who buy closed end mutual funds are banking that the gap between the discounted price and the net asset value will shrink, thus making a profit. This means they are speculating, and speculation is risky.