Mutual funds are the most prominent form of investing for individuals, and for good reason. They allow smaller investors diversify – to spread risk – across a wide range of securities, often aligning with specific industries or by objective.
The Nature of Mutual Funds
Most mutual funds are open-ended – meaning their managers have the latitude to buy and sell securities as they please, increasing or shrinking the number of stocks owned in an effort to optimize performance. This means that on any given day the per share value of the fund depends on the composition of the funds and their value in the market, combined with idle cash on hand (un-invested funds), rather than the supply of and demand for the fund itself.
In other words, the price per share of an open-ended mutual fund is a function of mathematics – it’s simply the aggregate total value of the fund divided by the number of active shares held. The per share price, then, is a function of the market value of the stocks, not of the fund itself as a discreet security.
The Opposite of Open-ended
But there is another type of mutual fund that is valued on a completely different basis. These are known as closed end mutual funds.
These funds have a fixed composition of stocks in their portfolio, and the quantity of each share doesn’t change. Nor are there cash balances that managers can manipulate – cash generated through dividends are invested according to inflexible standards.
With closed-end funds, new money doesn’t ever come into the fund, while open-ended funds can grow infinitely depending on the amount of new investor money that flows into it. Once a closed-end fund begins trading, that’s it, the size of the capital within the fund will change only by virtue of the stocks themselves going up in value.
The Dow Jones Industrial average, for example, if aggregated into a mutual fund, and if once a certain amount of capital has been reached became a closed-end mutual fund, would be an example of this type of investment. The value would be comprised solely by the performance of the Dow Jones Industrial Average, based on the daily fluctuations of the market (such a fund does exist, by the way).
Closed end funds are traded just like individual stocks. They are, in fact, simply a static (unchanging) block of stocks with a certain performance record, and just like company profits, that track record becomes the criteria by which investors either buy or sell the security.
Price Drivers in Closed End Funds
If the fund outperforms the market, the price will go up because investors will demand more of it. And vice versa. The specific value of the stocks within the fund aren’t the issue that defines value, market supply and demand is.
With open-ended funds this can’t happen, the value is simply a formula that divides total aggregate value by the number of active shares. If may indeed go up in value, but not necessarily if the number of new shares outpace the increasing value of the stocks, resulting in a static or even lower price per share.
As always, factors or risk tolerance and individual objectives drive the selection of mutual funds, both open and closed end. The data is readily available, and should be carefully analyzed before any investment decision is made.
