Open end mutual funds: Meaning, Criticisms & Real-World Uses

What Is Open End Mutual Funds?

An open-end mutual fund is a widely used investment vehicle that pools money from numerous investors to invest in a diversified portfolio of securities, such as stocks, bonds, and money market instruments. These funds are termed "open-end" because they continuously issue new shares to investors and redeem existing shares upon request, directly from the fund itself. This structure means the number of outstanding shares fluctuates daily. The fund's net asset value (NAV) per share is typically calculated at the end of each trading day, and investors buy or sell their shares at this price. Open-end mutual funds are overseen by professional investment advisers who manage the portfolio according to the fund's stated investment objectives, aiming to provide diversification and professional portfolio management for investors.

History and Origin

The concept of pooling assets for investment has roots tracing back centuries, with early forms appearing in the Netherlands in the 18th century. However, the modern open-end mutual fund, with its redeemable shares, emerged in the United States in the early 20th century. The first open-end mutual fund, the Massachusetts Investors Trust, was established in Boston on March 21, 1924, introducing the ability for investors to buy and sell shares at the daily calculated net asset value.,¹² This innovation aimed to democratize access to financial markets by offering diversification and professional management to individual investors.¹¹

Following the stock market crash of 1929 and the subsequent Great Depression, regulatory scrutiny increased. The U.S. Securities and Exchange Commission (SEC) was established in 1934, and the Investment Company Act of 1940 later provided a comprehensive regulatory framework specifically for mutual funds.,,¹⁰ This act mandated standards for disclosure, corporate governance, and fiduciary responsibilities, laying the groundwork for the industry's significant growth in the post-World War II era.⁹ The mutual fund industry saw substantial expansion in the 1960s, with continued innovation in the 1970s and 1980s, including the introduction of money market funds and specialized sector and international funds.⁸

Key Takeaways

Open-end mutual funds continuously issue and redeem shares directly with investors.
Shares are bought and sold at the fund's net asset value (NAV), calculated once per trading day.
They offer investors professional management and built-in diversification.
Mutual funds are regulated by the SEC and are required to provide comprehensive disclosure through a prospectus.
Investors can generate returns through dividends, capital gains distributions, and appreciation in the fund's share price.

Formula and Calculation

The pricing of an open-end mutual fund share is based on its net asset value (NAV). The NAV represents the per-share value of the fund's assets minus its liabilities. It is calculated at the end of each business day.

The formula for the net asset value (NAV) per share is:

NAV Per Share = \frac{(Total \: Value \: of \: Assets - Total \: Liabilities)}{Number \: of \: Outstanding \: Shares}

Where:

Total Value of Assets: The market value of all securities and other assets held by the fund.
Total Liabilities: All the fund's obligations, such as management fees, administrative expenses, and other accrued expenses.
Number of Outstanding Shares: The total number of shares that investors currently hold in the fund.

For example, if a fund holds $100 million in assets, has $5 million in liabilities, and 10 million shares outstanding, its net asset value per share would be:

NAV Per Share = \frac{(\$100,000,000 - \$5,000,000)}{10,000,000} = \frac{\$95,000,000}{10,000,000} = \$9.50

Interpreting the Open End Mutual Fund

The daily calculated net asset value is central to interpreting an open-end mutual fund. Investors understand that when they place an order to buy or sell shares, the transaction will occur at the next calculated NAV. This means the precise price is not known at the moment the order is placed but will be the NAV determined at the close of trading for that day. A rising NAV generally indicates that the fund's underlying investments are increasing in value, reflecting positive portfolio management and market conditions. Conversely, a declining NAV suggests a decrease in the value of the fund's holdings. Understanding the NAV's movement over time, along with the fund's distributions, provides insight into the fund's performance.

Hypothetical Example

Consider an investor, Sarah, who decides to invest in an open-end mutual fund focused on large-cap U.S. equities. She has $5,000 to invest and chooses "GrowthProsperity Fund."

Initial Investment: On Monday afternoon, Sarah places an order to buy $5,000 worth of GrowthProsperity Fund shares. At the close of trading on Monday, the fund's net asset value is calculated at $25.00 per share.
Share Purchase: Sarah's investment is executed at this NAV. She receives $5,000 / $25.00 = 200 shares.
Fund Performance: Over the next year, the value of the underlying stocks held by GrowthProsperity Fund increases. The fund also receives dividends from its holdings and realizes capital gains from selling some appreciated securities. These are distributed to shareholders.
Redemption: A year later, Sarah needs cash and decides to sell her 200 shares. On Tuesday morning, she places a sell order. At the close of trading on Tuesday, the fund's NAV is calculated at $28.00 per share.
Cash Received: Sarah's shares are redeemed at this new NAV. She receives 200 shares * $28.00 = $5,600.

This example illustrates how investors buy and sell open-end mutual fund shares directly with the fund at its NAV, which reflects the underlying value of its holdings. Sarah's overall return would also include any dividends or capital gains distributions she received during her holding period, in line with the fund's stated investment strategy.

Practical Applications

Open-end mutual funds are widely used in various aspects of personal finance and institutional investing due to their features like professional management, diversification, and liquidity.

Retirement Planning: They are a common component of individual retirement accounts (IRAs) and 401(k) plans, allowing individuals to build diversified portfolios for long-term growth.
Wealth Accumulation: Investors use them to grow their wealth over time, often employing strategies like dollar-cost averaging by regularly investing fixed amounts.
Specific Investment Goals: Funds can be chosen based on specific objectives, such as income generation (bond funds), growth (equity funds), or a combination (balanced funds).
Accessibility: With typically low minimum investment requirements, open-end mutual funds make professional portfolio management accessible to a broad range of investors.
Regulatory Compliance: Open-end mutual funds operate under strict regulations from the U.S. Securities and Exchange Commission (SEC), which mandates specific disclosures through prospectuses and periodic reports to protect investors.⁷,⁶ Tools like the Financial Industry Regulatory Authority (FINRA) Fund Analyzer can help investors compare the costs and potential returns of various mutual funds.⁵

Limitations and Criticisms

While open-end mutual funds offer numerous advantages, they also have limitations and have faced criticism.

Fees and Expenses: Investors incur various costs, including the expense ratio, which covers management fees and operating expenses. Some funds also charge sales loads, which are commissions paid when buying (front-end load) or selling (back-end load) shares. These fees can erode investment returns over time. The SEC has focused on ensuring clear disclosure of these fees to investors.⁴,³
Tax Inefficiency: Actively managed open-end mutual funds may frequently trade underlying securities, generating capital gains that are then distributed to shareholders. Even if investors do not sell their shares, they may be liable for taxes on these distributions, potentially reducing after-tax returns, especially in taxable accounts.
Investor Behavior: Studies suggest that investors often exhibit poor timing, buying into funds after periods of strong performance and selling after declines, which can lead to "investor return gaps." This means the actual returns investors experience are lower than the reported total returns of the funds themselves.²,¹ This behavior can significantly impact long-term wealth accumulation.
Lack of Intraday Trading: Unlike exchange-traded funds (ETFs) which trade on exchanges throughout the day, open-end mutual fund shares are priced only once per day at their net asset value. This means investors cannot react to real-time market movements by trading fund shares instantly.

Open End Mutual Funds vs. Closed-End Funds

Open-end mutual funds and closed-end funds are both types of pooled investment vehicles, but they differ significantly in their structure and trading mechanisms.

The primary distinction lies in how their shares are issued and traded. Open-end mutual funds continuously issue new shares when investors want to buy and redeem shares when investors want to sell, directly with the fund itself. This means the number of outstanding shares is variable, and the fund's share price is always its net asset value.

In contrast, closed-end funds issue a fixed number of shares through an initial public offering (IPO) and do not continually issue or redeem shares. Once issued, these shares trade on stock exchanges, much like individual stocks. Consequently, the market price of a closed-end fund can fluctuate based on supply and demand and may trade at a premium or discount to its net asset value, unlike open-end funds which always trade at NAV.

FAQs

Q: How do I make money with open-end mutual funds?
A: You can make money in three ways: from dividends earned by the fund's underlying investments, from capital gains distributions when the fund sells appreciated securities, and from an increase in the fund's share price (its net asset value) between the time you buy and sell.

Q: Are open-end mutual funds safe?
A: While open-end mutual funds offer diversification and professional management, they are not guaranteed investments. Their value can fluctuate with market conditions, meaning you could lose money, including your initial investment. The level of risk depends on the types of securities the fund invests in and its specific investment strategy.

Q: How do I buy and sell open-end mutual funds?
A: You typically buy and sell open-end mutual fund shares directly from the fund company or through a brokerage firm. Orders are processed at the fund's net asset value (NAV) calculated at the end of the trading day after your order is received.