Open end fund

What Is an Open-End Fund?

An open-end fund is a type of investment fund that continuously offers new shares to investors and redeems existing shares on demand. As a core component of investment vehicles, the most common example of an open-end fund in the United States is a mutual fund. These funds pool money from many individual shareholders to invest in a diversified portfolio of securities, such as stocks, bonds, and money market instruments. A key characteristic of an open-end fund is its flexibility in asset size; the number of shares outstanding fluctuates daily as investors buy new shares or redeem existing ones directly with the fund.

History and Origin

The concept of pooling investor money for collective investment has roots centuries ago, but the modern open-end fund emerged in the United States in the early 20th century. The first open-end mutual fund with redeemable shares, the Massachusetts Investors Trust, was established in Boston on March 21, 1924, and is still in existence today.⁷ This innovation allowed individual investors to participate in financial markets with professional management and a level of diversification previously difficult to achieve. The growth of these funds accelerated, but the stock market crash of 1929 and the subsequent Great Depression led to increased regulatory scrutiny. In response, the U.S. government enacted the Investment Company Act of 1940. This landmark legislation, enforced by the Securities and Exchange Commission (SEC), established a comprehensive regulatory framework for investment companies, including open-end funds, to protect investors and minimize conflicts of interest.⁵, ⁶

Key Takeaways

• An open-end fund continuously issues new shares and redeems existing ones directly with investors.
• The price at which investors buy or sell shares of an open-end fund is based on its net asset value (NAV), which is calculated at the end of each trading day.
• Open-end funds are the most common structure for mutual funds in the United States.
• They offer investors benefits such as professional management, diversification, and daily liquidity.
• Investors in open-end funds incur various fees, including management fees and an expense ratio.

Formula and Calculation

The price of an open-end fund's share is determined by its Net Asset Value (NAV) per share. The NAV is calculated at the end of each business day.

The formula for Net Asset Value (NAV) per share is:

Where:

• Total Assets: The market value of all securities, cash, and other assets held by the fund.
• Total Liabilities: All the fund's debts and expenses, such as accrued management fees, administrative costs, and other operational expenses.
• Total Shares Outstanding: The total number of shares of the fund currently held by investors. This number fluctuates daily as investors buy or sell shares.

When an investor places an order to buy or sell shares of an open-end fund, the transaction is processed at the next calculated NAV, typically after the market closes. For example, if an investor places a buy order during market hours, the order will be filled at the NAV determined at the close of that day's trading.

Interpreting the Open-End Fund

An open-end fund's NAV per share reflects the per-share value of its underlying investments. When the value of the securities held by the fund increases, the NAV rises, benefiting investors. Conversely, if the value of the fund's holdings decreases, the NAV falls.

Investors typically evaluate an open-end fund based on its stated investment objectives, historical performance, and fees. A fund's NAV performance, combined with any distributions of capital gains or income, determines the total return to the investor. Understanding how the NAV is calculated is crucial because it directly impacts the price at which investors buy and sell shares, ensuring fair transactions based on the fund's current worth.

Hypothetical Example

Consider an investor, Sarah, who wants to invest in a diversified portfolio without individually selecting stocks. She decides to invest in the hypothetical "Diversified Growth Fund," an open-end fund.

On Monday, the Diversified Growth Fund has:

• Total Assets: $100,000,000
• Total Liabilities: $1,000,000
• Total Shares Outstanding: 10,000,000

The NAV per share is calculated as:

Sarah places an order to buy 100 shares. Her order will be executed at Monday's closing NAV of $9.90 per share. Her total investment is $9.90 * 100 = $990. The fund now has 10,000,100 shares outstanding.

On Tuesday, due to positive market performance, the fund's Total Assets increase to $101,500,000, while liabilities remain at $1,000,000.
The new NAV per share is:

If Sarah were to sell her shares on Tuesday, she would receive approximately $10.05 per share, reflecting the growth in the fund's underlying assets.

Practical Applications

Open-end funds are widely used in personal finance and institutional investing due to their accessibility and diversification benefits. They are a cornerstone of many retirement savings plans, such as 401(k)s and IRAs, allowing individuals to invest in professionally managed portfolios. Investors can choose from a vast array of open-end funds tailored to different investment objectives and risk tolerances, including equity funds, bond funds, and money market funds.

For instance, money market funds, a type of open-end fund, are popular for their stability and liquidity, often used by individuals and businesses for short-term cash management. During periods of financial stress, such as the COVID-19 pandemic, the Federal Reserve has taken measures to support the liquidity of money market mutual funds to ensure they can meet redemption demands.⁴ Open-end funds also offer convenience, as investors can easily buy and sell shares through a brokerage account or directly from the fund company.

Limitations and Criticisms

Despite their advantages, open-end funds have certain limitations. One common criticism, particularly for actively managed open-end funds, is their tendency to underperform their benchmark indexes after accounting for fees. Numerous studies and reports, such as the SPIVA (S&P Index Versus Active) Scorecards published by S&P Dow Jones Indices, consistently show that a majority of actively managed funds fail to beat their respective market indexes over various time horizons.², ³ This underperformance can be attributed to higher expense ratios associated with active management, including management fees and trading costs, which erode returns. Academic research has extensively documented this trend, suggesting that consistently identifying actively managed funds that will outperform is challenging.¹

Another limitation stems from the open-end structure itself. Because they must be prepared to redeem shares daily, fund managers need to maintain a certain level of liquidity, which can sometimes constrain their investment decisions or force them to sell holdings at inopportune times during large redemption waves.

Open-End Fund vs. Closed-End Fund

The primary distinction between an open-end fund and a closed-end fund lies in their capital structure and how their shares are traded.

Open-end funds expand or contract based on investor demand, always trading at their NAV. In contrast, closed-end funds have a fixed number of shares that are initially offered in an initial public offering (IPO). After the IPO, these shares trade on stock exchanges, similar to individual stocks, meaning their market price can deviate from their NAV, trading at either a premium or a discount. This difference in trading mechanism can lead to different investment considerations, particularly regarding entry and exit prices for investors.

FAQs

What is the main purpose of an open-end fund?

The main purpose of an open-end fund is to provide individual investors with a convenient and cost-effective way to achieve diversification and professional management of their investments. By pooling money, these funds allow access to a broad portfolio of securities that might be difficult or expensive for an individual to construct.

How often is an open-end fund's price updated?

An open-end fund's price, or net asset value (NAV) per share, is typically calculated once per day, usually after the close of the major U.S. stock exchanges. All buy and sell orders received throughout the day are processed at this single end-of-day price.

Are all mutual funds open-end funds?

In the United States, the terms "mutual fund" and "open-end fund" are often used interchangeably because nearly all mutual funds are structured as open-end investment companies. However, other types of investment companies exist, such as closed-end funds and unit investment trusts, which have different structures.

What information should I review before investing in an open-end fund?

Before investing in an open-end fund, you should carefully review its prospectus, which provides essential information about the fund's investment objectives, strategies, risks, fees (including the expense ratio), and past performance. Understanding these details helps ensure the fund aligns with your personal financial goals and risk tolerance.