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Open end and closed end are general terms that refer to whether a mutual fund company issues an unlimited or a set amount of shares in a particular fund:

 Open-end funds: Open end simply means the fund issues as many (or as few) shares as investors demand. Open-end funds theoretically have no limit to the number of investors or the amount of money that they hold. You buy and sell shares in such a fund from the fund company.

 Closed-end funds: Closed-end funds are those where the mutual fund companies decide upfront, before they take on any investors, exactly how many shares they’ll issue. After they issue these shares, the only way you can purchase shares (or more shares) is to buy them from an existing investor through a broker. (This process happens with buying and selling stock and exchange-traded funds, too.)

You can buy or sell open-end funds at a price determined once a day after the markets close. In contrast, closed-end funds and ETFs can be bought and sold throughout the trading day. Close-end funds and ETFs trade at market price, which is heavily influenced by the value of the specific investments they own but can vary a bit based on supply and demand. ETFs are technically open-end funds though, since they create and retire shares when demand thresholds are met.

The vast majority of funds in the marketplace (now about 99 percent) are open-end funds, and they’re also the funds that I focus on in this book because the better open-end funds are superior to their closed-end counterparts.

Open-end funds are usually preferable to closed-end funds for the following reasons:

 Management talent: The better open-end funds attract more investors over time. Therefore, they can afford to pay the necessary money to hire leading managers. I’m not saying that closed-end funds don’t have good managers, too, but generally, open-end funds attract better talent.

 Expenses: Because they can attract more investors, and therefore more money to manage, the better open-end funds charge lower annual operating expenses. Closed-end funds tend to be much smaller and, therefore, more costly to operate. Remember, operating expenses are deducted out of shareholder returns before a fund pays its investors their returns; therefore, relatively higher annual expenses depress the returns for closed-end funds. Brokers who receive a hefty commission generally handle the initial sale of a closed-end fund. Brokers’ commissions usually siphon from 5 to 8 percent out of your investment dollars up front, which they generally don’t disclose to you. (Even if you wait until after the initial offering to buy closed-end fund shares on the stock exchange, you still pay a brokerage commission, although it’s generally a lot less than the initial sale commission.) You can avoid these high commissions by purchasing a no-load (commission-free), open-end mutual fund. (See the section “Funds save you money and time,” later in this chapter, for details on no-load funds.)

 Fee-free selling: With an open-end fund, the value of a share (known as the net asset value) always equals 100 percent of what the fund’s investments (less liabilities) are currently worth. And you don’t have the cost and troubles of selling your shares to another investor as you do with a closed-end fund. Because closed-end funds trade like securities on the stock exchange and because you must sell your shares to someone who wants to buy, closed-end funds sometimes sell at a discount. Even though the securities in a closed-end fund may be worth, say, $20 per share, the fund may sell at only $19 per share if sellers outnumber buyers.You could buy shares in a closed-end fund at a discount and hold on to them in hopes that the discount disappears or — even better — turns into a premium (which means that the share price of the fund exceeds the value of the investments it holds). You should never pay a premium to buy a closed-end fund, and you shouldn’t generally buy one without getting at least a 5 percent discount (to make up for its deficiencies versus its open-ended peers, especially higher expenses).

Sorry to complicate things, but I need to make two clarifications. First, open-end funds can, and sometimes do, decide at a later date to “close” their funds to new investors. This doesn’t make it a closed-end fund, however, because investors with existing shares can generally buy more shares from the fund company. Instead, the fund becomes an open-end fund that’s closed to new investors! Second, exchange-traded funds, which I discuss at length in Chapter 5 and which have similarities to closed-end funds, may have low costs if they are modeled after an index fund.