The difference between open ended and close ended funds
There are really two distinctions in structure between index funds open to an investor which are important being:
- Open Ended Funds – includes exchange traded funds (generally listed) and managed funds (not listed)
- Close Ended Funds – mainly listed investment companies (but also some unlisted managed funds)
Closed Ended Funds
Close ended funds are like a pool of people that have gotten together and contributed some money to an investment pool and employed an investment manager. And one of the conditions of the deal was that none of the original investors could leave, unless they could find someone else to sell their whole investment to.
In other words the original investors cannot withdraw money directly from the fund, hence why they are called ‘close ended’. But in order that the original investors can leave without selling their investment they can still sell their shares on the stock exchange if the fund is listed. Closed ended funds were the first on the scene – in the 1890’s investment property trusts were introduced to US investors (and you though REITS were a new idea!). A more common example are listed investment companies there are many listed on the ASX including AFIC and several others.
Essentially LIC close ended funds raise cash from investors and buy a bunch of investments, meanwhile their shares are traded on the stock exchange. Investors buy and sell the shares freely on the stock exchange and the investment company does not need to find cash to pay investors in/out. The shares however often trade a discount to net asset value (that is the shares can be bought for significantly less than the value of the funds net assets). This is a major disadvantange with a close ended fund structure, the market price is determined by supply and demand for the shares not the underlying companies investments/assets.
Open Ended Funds
An open ended fund is the opposite to a close ended, the fund manager sells investments in order to let investors leave and accepts money from new investors on a regular basis. The Masssachusetts Investors Trust was the first open ended mutual or managed fund and was created in 1924. Open ended funds represented an important step forward as they issued new units to admit new investors and allowed investors to withdraw their money at the funds full net asset value – each day after the market is closed and the value of the investments could be calculated.
In the 1990’s open ended mutual funds were taken a step further and ETF’s were created. An ETF combines the benefits of both a close ended fund (it can be traded on the stock exchange) with the benefits of an open ended mutual fund (the investor is assured of receiving or paying the net asset value of the underlying investments).