Open-end vs. closed-end funds: What's the difference?

Mutual funds, exchange-traded funds (ETFs) and other managed investments can provide you with diversification and efficiency in your portfolio. Because of that—and the way they simplify investing—funds are appealing. That's why many people choose to invest a portion of their money in funds as opposed to individual stocks or bonds.

The nuances of funds, though, aren't always well known. Even if you've been investing for years and have mastered investing basics, you may not realize there is a difference between open-end vs. closed-end funds.

The core difference between the two is closed-end funds do not create additional shares after the fund is formed, but open-end funds do. Understanding the different characteristics of each can help you choose which type of fund to invest in.

Open-end funds get their name from the way their structure allows for additional shares to be created when new investors want to buy into a fund. It is "open," which means the fund creates new shares when additional investors wish to invest in the fund.

An important thing to understand about open-end funds is net asset value (NAV). In basic terms, this is the per-share value of the fund's assets after subtracting its debts and liabilities. This effectively serves as the price of each share. Rather than buying or selling shares on a secondary exchange, open-end funds are generally redeemed with the issuer at NAV. As a result, open-end shares are usually priced just once per day after the market closes. If you submit an order to buy or sell an open-end fund, the order will occur at the closing NAV. If you place an order after the market closes, the transaction will occur at the next day's closing NAV.

For example, if the fund has $300 million worth of investments and has liabilities of $25 million, then it has $275 million worth of net assets. If the fund has, say, 5 million shares outstanding, the NAV per share is $55.

• Mutual funds are the most common type of open-end fund. They come in many varieties. Some invest in specific equity sectors, or segments of the bond market. Others are very diverse and invest in a mix of both stocks and bonds.
• Exchange traded funds, or ETFs, are another popular type of open-end fund. These are similar to mutual funds, but they trade during open market hours on a secondary exchange like an individual stock. You do not exchange ETF shares at NAV.

Closed-end funds don't typically remain open for new investment after they are created. Instead, they are "closed" to new investors after issuing a fixed number of shares in an initial public offering (IPO). Unlike most open-end funds, shares of closed-end funds trade on exchanges. To invest in a closed-end fund after the IPO, you must purchase shares on an exchange.

Because their shares trade throughout the day, their price fluctuates based on market activity. You don't redeem the shares at NAV. Closed-end funds typically trade at prices close to NAV, but prices often reflect small discounts or premiums.

• Although not all bond funds are closed-end, bond funds represent the largest segment of the closed-end fund market.
• Business development companies are another type of closed-end fund. They typically invest in smaller or distressed private companies that might not have other means of accessing capital.
  

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The vast majority of funds are structured as open-end funds. If you invest in a fund within your 401(k), IRA or brokerage account, then you most likely have an open-end mutual fund or ETF. But if you also have access to closed-end funds, understanding the differences can help you make an informed decision.

These differences are found in the way that the different types of funds trade, how they are priced and the manner in which new shares are created.

Open-end funds can only be redeemed with the issuer once per day at net asset value, so there's only a single daily price. The issuer can create new shares to satisfy investor demand.

Closed-end funds, on the other hand, continuously trade on the secondary market at their current market price. Issuers cannot issue new shares to satisfy investor demand.

In addition to the way shares are created, bought and sold, other differences in the funds impact investors:

• Because they do not need to hold cash to satisfy investor redemptions, closed-end funds are able to invest in fewer liquid assets than open-end funds. This presents a wider range of investment opportunities that could enhance return.
• Closed-end funds are able to use leverage. Leverage can increase the potential return or above-market yield of the fund, but it also poses additional risk.

Although they are generally used for the same purpose, open-end and closed-end funds are different. You may want to compare those differences when making your selections. Each type of fund can be a good investment, but one may be better than the other for you, depending on your preferences and goals.

Investors who want to actively trade their funds may prefer closed-end funds because they offer greater liquidity throughout the day. But if you're a long-term investor who doesn't trade often, that difference may not matter much. In fact, seeing fewer price fluctuations throughout the day could prevent investors from making emotional decisions.

Closed-end funds are often actively managed and tend to be more complex than open-end funds. Sophisticated investors might seek out closed-end funds that employ strategies or invest in assets that may not be available in closed-end funds. Investors who want a less complicated approach may prefer open-end funds, such as index funds.

Open-end fund holdings are typically easier to track than closed-end fund holdings. Investors who value transparency and like to know each position they are invested in may prefer open-end funds over closed-end funds.

A financial advisor can help you understand how each may fit into your portfolio based on your investment objectives.

Closed-end and open-end funds both provide an efficient way to diversify your investments with the help of a professional manager. However, they offer those benefits in slightly different ways. Closed-end funds generally do not create new shares after formation but instead trade on an exchange like individual stocks. Open-end funds can create new shares any time new investors wish to buy them.

Either tool may be a good choice. Consulting with a Thrivent financial advisor can help you weigh how open- or closed-end funds may fit into your portfolio based on your investment objectives and financial goals.