Contrasting Mutual and Closed-End Funds

Although mutual funds and closed-end funds are both management companies, they're actually quite different from each other. Despite the fact that the financial media may occasionally make mention of a "closed-end mutual fund, the legal definitions of a closed-end fund and an open-end fund under the Investment Company Act of 1940 actually make the term mutually exclusive and technically impossible for a closed-end mutual fund to even exist. When used, this term probably refers to an actively managed closed-end fund. Many aren't actively managed; therefore, such a fund's investment portfolio of securities changes very little. A closed-end fund that's actively managed might resemble a mutual fund, but it must be remembered that the number of outstanding shares remains relatively fixed, unlike those of a mutual fund.

It's likely that the average investor is much more familiar with mutual funds than closed-end funds, and mutuals tend to be considerably more prevalent. There are basically four key reasons that have led to the popularity of mutual funds over closed-end funds. First, there are simply many more mutual funds (over 7,000 of them) than there are closed-end funds (under 700 as of this writing). And mutual funds are much more heavily advertised than closed-end funds. Therefore, when investors are looking for places in which to put their money, mutual funds show up and are recommended with much greater regularity.

The second reason for the popularity of mutual funds over closed-end funds is their certainty of pricing. At the end of each business day a mutual fund computes and publishes the value of its outstanding shares. Conversely, the real value of a closed-end fund tends to be less certain. Market forces drive the value of the fund's shares up or down, causing them to trade either at a premium or a discount to their net asset value (NAV). And uncertainty of price is a concept that most investors particularly loathe. They're much more comfortable knowing precisely what their shares are worth at all times.

The third basic reason for mutual funds' overwhelming popularity is their size. Mutual funds typically have more money to invest than what's available to closed-end funds. Each time an investor buys a mutual fund share, the fund itself receives new money that can be used to purchase more securities. These additional dollars allow it to attain greater diversity much more easily than a closed-end fund. The mutual fund can obtain shares of additional companies in different industry sectors. In contrast, when an investor buys a closed-end fund share on a stock exchange, the purchase money goes to the seller of the share and not the fund.

The final reason is the low initial investment cost necessary to buy mutual funds. Shares can be purchased with investments of as little as $25. This low initial monetary requirement makes mutual funds available to vast numbers of people, turning ordinary individuals into potential investors. These reasons, combined with the convenience of a mutual fund's professional management, largely explain why these funds are the investment of choice for many millions of people worldwide.

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