A few weeks ago, The Sterling Report spoke about how mutual funds work and the advantages and disadvantages of same. Today, we’ll take a closer look at other classifications of mutual funds.

Mutual funds, as previously discussed, can be categorised according to the assets they invest in, or the indices or industries they track among a multitude of other details. Today, we’ll take a look at another technicality which focuses on the issuance, pricing, valuation, and liquidity of shares. These are important factors to consider when making an investment into any pooled investment product.

Closed-end mutual fund vs Open- ended mutual fund

A closed-end mutual fund is a fund that issues a fixed number of shares. After issuance, this type of fund is “closed” to the intake of additional funds. If an investor wants to get into a closed-end fund after issuance, he will have to purchase shares from an existing investor. The shares of a closed- end fund can be traded on the open market or on the stock market if the fund is listed on a stock exchange. However, there is no change in the total number of outstanding shares and as a result, the trading of shares has no impact on the fund’s performance.

With an open-ended mutual fund, the investment manager is responsible for issuing and redeeming shares to and from investors. In other words, an investor can buy shares at any point in the life of the fund directly from the investment manager. Similarly, if an investor wishes to sell his shares in the fund, the investment manager is usually responsible for purchasing same. These types of mutual funds usually have rules governing the redemption process to help the investment managers carefully manage their liquidity. For example, the investment manager may require the investor to give a minimum of 2 weeks’ notice if she/he wants to redeem their shares. This gives the investment manager enough time to plan the fund’s liquidity needs appropriately. The investment manager can be thought of as the “market maker” for the fund, he facilitates the entry and exit of investors.

Impact on Pricing

One of the most important distinctions between a closed-end fund and an open-ended fund is the price that investors pay for the units in the fund.

A common valuation used in most pooled investment products is the net asset value (NAV). The net asset value is simply the difference between the fund’s assets and its liabilities. This figure is then divided by the number of outstanding units to calculate a net asset value per share. Investors in an open-ended fund will pay the NAV per share (plus a standard fixed mark-up added by the investment manager) in order to purchase a unit in the fund. However, investors who wish to purchase shares in a closed- end fund will have to pay the market price of the units instead of the NAV per share. The market clearing price of the units is essentially what other investors will pay for the same number of units. If this price is less than the NAV, then the fund is said to be trading at a discount and if the market price is above the NAV, the fund is trading at a premium.

Understanding the distinction between a closed-end fund and an open-ended fund is instrumental in assessing the liquidity and price risk inherent in your investment. Be sure to ask for information that will allow you to gauge these risks: How large is the market for this fund? How many shares are outstanding? How many investors are there? What are the rules governing redemptions?

Marian Ross is a business development officer at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm