When talking about mutual funds, the majority of time we are talking about open ended mutual funds. This is important to know because sometimes, new investors hear the term open ended mutual funds and think this is a new type of investment. It’s not. It’s just your standard mutual fund. What are the characteristics of open ended mutual funds and should you invest in them? I answer these questions and more below.
Open Ended Mutual Funds
An open ended mutual fund is your common mutual fund. It is termed open ended because there are an unlimited (in theory) number of shares in a given mutual fund. What does this mean? When you buy into a mutual fund, new shares are created just for you. When you sell shares, those shares are retired.
This is the opposite of what happens with stocks. With stocks, a company issues a set number of shares. If you want to buy a share of the issued stock, you have to find someone willing to sell their shares to you. New shares are not just created for you. Likewise, if you want to sell, you have to find a buyer for your shares. For the most part, this is not an issue. Shares are traded so frequently that finding a buyer or a seller is easy. But if you own stock in an obscure company, it might take some time to actually buy or sell your shares.
In summary, with open ended mutual funds, you can buy and sell shares at will. You do not need to have someone else on the other end of the transaction – the mutual fund acts as the other party. With stocks, you need to have someone else on the other end of the transaction.
Why Open Ended Mutual Funds Shares Are Not Unlimited
I mentioned above how the shares in open ended mutual funds are unlimited. This is only technically true. I’m sure you have heard about a mutual fund closing to new investors. This happens when the stock market or a given sector is hot and investors are buying more shares at a rapid pace. The mutual fund can’t keep up with demand for a few reasons:
- When new money comes into the fund, the mutual fund has to go out in the market and buy more of the underlying securities. If a flood of new money comes in, the mutual fund could technically force prices higher, hurting the fund in the long run.
- Along this same line, too much money coming into a mutual fund can cause harm to all investors. This happens because the fund becomes too large to manage or will have an adverse affect on prices in the market.
In both these cases, the fund manager will close the fund to new investors until things settle back down or enough current shareholders sell their shares. So while you will hear that open ended mutual funds have the potential to have unlimited shares, this is rarely the case.
Charging A Redemption Fee
On the flip side, when selling shares, the fund manager has the ability to calm things down as well. Since an open ended mutual fund doesn’t need someone on the other end of the transaction, there can be problems when the market is in free fall. Every investor could just sell their shares with ease. If this were to happen, the mutual fund manager would need to sell hundreds of thousands of shares of stock, forcing the market to drop even further. This hurts all shareholders – including those not selling – since prices are being driven down more than they otherwise would.
To curb some of the selling, a fund manager may implement a redemption fee on shares sold. The fee is typically small, but since most investors don’t want to pay a fee, they will ride out the drop in the market.
Also note that typically a redemption fee is only charged on shares that were purchased in the past 30, 60, or 90 days. This curbs short term trading regardless if the market is rising or falling.
Are There Close Ended Mutual Funds?
There are actually close ended mutual funds as well. These mutual funds act like stocks in that they have a set number of shares issued. If you want to buy or sell shares, you have to find a buyer or seller as the mutual fund itself cannot issue shares.
The market of close ended mutual funds is relatively small. In fact, the chances that you buy into a close ended mutual fund are slim, unless you actively go looking for one to invest in. Many times, these funds invest more in income producing securities, such as bonds. Again though, if you own bond mutual funds, odds are you own open ended mutual funds.
Should You Invest In Open Ended Mutual Funds?
So should you invest in open ended mutual funds? Yes! They are a great way to not only be diversified from the very start, but you can typically invest in them for very little money. Of course, there are things you need to know about mutual funds (clicking on that link will help you with that). This is especially true when it comes to management fees. While most investors ignore the fees they are charged, if you want to be a successful investor, you need to pay attention to the fees you are paying. (To get a quick rundown on the fees you are paying, check out Personal Capital.)
In the end, open ended mutual funds are a great way to invest in the stock market. Just make certain you pay attention to the fees the fund you are considering investing in charges you and have a good understanding of the basics. Over time, these fees add up to large sums of money. Also, be sure to find a broker that doesn’t charge you a fee for trading mutual funds. You can find a few recommendations in my online broker comparison chart.
Finally, you now should understand that if you hear the term open ended mutual funds, the person is talking about mutual funds as you know them, not some new fancy product.
Readers, what questions do you have about open ended mutual funds that I answer for you?