Closed end mutual funds have little in common to the traditional open end fund, better known as mutual funds. In fact, they vary quite significantly. As a novice investor, you should learn the differences prior to investing in such funds so as to reduce your risk of losses.
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 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.
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 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.