by Archie M. Richards, Jr., CFP^® March 1, 2004

All mutual funds provide diversification, professional management, and convenient methods of investing and withdrawing automatically. But some funds are open-end and others closed-end. What's the difference? Using small dollar amounts for simplicity, here are illustrations:

Open-End Funds: A mutual fund has a portfolio worth $1000. Investors own 100 shares of the fund. The portfolio value ($1000) is divided by the shares outstanding (100), making each share worth $10. That's the net asset value, also called the NAV.

You decide to buy 2 shares. (You can do so only after the market closes.) You pay $20 to the fund and receive 2 shares. This being an open-end mutual fund, you buy the shares from the fund. The fund creates 2 new shares for you. When you later sell, the fund redeems the shares at the net asset value then prevailing, and the shares disappear. Each day, shares are created and dissolved according to investor demand. The number of shares outstanding is always equal to the demand. Therefore, the fund's price is always equal to the net asset value.

Because of your $20 purchase, the value of the fund's portfolio grows from $1000 to $1020. The number of fund shares outstanding increases from 100 to 102. The new portfolio value divided by the outstanding new shares ($1020 / 102) means that the net asset value (NAV) remains at $10. The fund manager can invest the cash as she thinks best. The NAV doesn't rise unless the value of the securities goes up.

Let's say the fund has 97 percent stocks and 3 percent cash. The stock market crunches, panic selling occurs, and fund investors sell 5 percent of the shares. With only 3 percent cash, the fund manager has to sell another 2 percent of the stocks at lousy prices in the thick of the panic. To avoid this, the fund manager holds 5 or 6 percent cash all along. This reduces the fund's efficiency, because not all of the money is invested as the investors intend.

Closed-End Funds: Again, the mutual fund has a portfolio worth $1000. Investors own a total of 100 shares of the fund. Once again, the net asset value (NAV) is $10. You decide to buy 2 shares.

You cannot buy the shares from the fund. The shares were originally offered to the public in an initial public offering (IPO). The number of shares available to the public generally remains fixed. Shares can be bought only from investors who already own them. You buy the shares as you would any stock. Most closed-end funds are listed on the New York Stock Exchange and trade throughout the day.

If the market endures panic selling, the fund manager is not required to sell at the bottom, because no shares of the fund are redeemed. (Remember, the shares are bought only from other investors.) The fund manager can therefore invest all of the fund's cash. She needn't hold any to cover the possibility of redemptions.

Shares of closed-end funds do not appear or disappear according to investor demand. Therefore, the number of shares outstanding is seldom equal to the demand, and the price is seldom equal to the net asset value. If most investors are bullish about the fund or the stock market, the price might rise to a premium over the NAV. If most investors are bearish about the fund or the stock market, the price might fall to a discount below the NAV.

If you buy a closed-end fund at a significant premium and the market hits a down draft, you're likely to suffer a double loss. The net asset value declines, and the premium also turns into a discount. Better to go the other way: Buy at a discount and sell at a premium.

So much for the basics: Shares of open-end funds are bought from the fund, with the price always equal to the NAV. Shares of closed-end funds are bought from other investors and usually stand at a discount or premium.

Class dismissed.