How Open-End and Closed-End Funds Work, How They Are Priced, and What the Exam Tests

An open-end fund issues new shares and buys them back from investors every business day at net asset value, so it has no fixed number of shares. A closed-end fund issues a fixed number of shares through an initial public offering, and those shares then trade on a stock exchange at a market price that can sit above or below the value of the fund’s assets.

That single difference, whether the fund itself stands ready to buy back your shares, drives almost everything else the Series 65 tests on this topic: how the shares are priced, how you buy and sell them, how much leverage the fund can use, and what can go wrong for investors.

This guide covers all of it, with a comparison table, worked examples, a client scenario, the exam traps candidates fall for and five practice questions with explanations. Getting ready for a January exam? Explore every FRC video playlist and pick out the exam topics you want to lock in first, with exam traps called out in every topic.

Where Both Funds Sit Under the Investment Company Act

The Investment Company Act of 1940 divides investment companies into three types: face-amount certificate companies, unit investment trusts and management companies. Open-end and closed-end funds are the two kinds of management company, meaning a professional manager actively selects and changes the portfolio.

The Act defines an open-end company as one that offers redeemable securities, which investors can sell back to the fund. Every other management company is a closed-end company.

That is the legal test the exam relies on. If the fund must redeem shares on request, it is open-end; if it does not, it is closed-end.

Where This Topic Appears on the Series 65

Investment company products are a core part of the Series 65, alongside the client recommendations that come with them. Questions test the structure of each fund, how shares are priced, the fees investors pay and which product suits which client.

FRC’s Series 65 Exam Preparation course covers pooled investment vehicles, their costs and their suitability for different clients, and the exam requires no sponsor. The SIE Examination Preparation course covers investment company products as part of the exam you can pass before you are hired.

Every FRC course can be spread across interest-free monthly payments, so cost is no reason to delay. Fund structure is one of the most dependable topics on the exam once the core rules are clear.

Open-End Funds: Continuous Offering and Redemption

An open-end fund, commonly called a mutual fund, sells new shares to investors whenever they want to buy and redeems shares whenever they want to sell. The number of shares outstanding rises and falls every day as money flows in and out.

Investors buy and sell directly with the fund, usually through a broker-dealer or the fund company itself, rather than with other investors. There is no secondary market for mutual fund shares.

Under Section 22(e) of the Investment Company Act, a fund must pay redemption proceeds within seven days of receiving a request, except in limited circumstances such as when the New York Stock Exchange is closed. That guaranteed exit is the defining feature of an open-end fund.

How Open-End Funds Are Priced

An open-end fund calculates its net asset value, or NAV, at least once each business day, usually at the 4:00 p.m. Eastern close of the New York Stock Exchange. NAV is the fund’s total assets minus its liabilities, divided by the number of shares outstanding.

Under SEC Rule 22c-1, purchases and redemptions receive the next NAV calculated after the order is received, a system known as forward pricing. An order placed at 2:00 p.m. receives that day’s closing NAV, while an order placed at 4:30 p.m. receives the next day’s.

Investors redeem at NAV, minus any back-end sales charge. They buy at the public offering price, which is NAV plus any front-end sales charge, so a no-load fund’s offering price equals its NAV.

Sales Charges on Open-End Funds

Many mutual funds charge a sales load. Class A shares typically carry a front-end load, Class B shares a back-end load, known as a contingent deferred sales charge, and Class C shares a level load collected through ongoing fees.

Under FINRA Rule 2341, the maximum front-end sales charge is 8.5% of the public offering price. Funds also often charge 12b-1 fees, annual marketing and distribution fees taken from fund assets.

Breakpoints reduce the front-end load for larger purchases, and investors can reach them through rights of accumulation or a letter of intent. FRC’s guide to rights of accumulation vs letter of intent explains both, and the guide to FINRA Rule 2341 vs Rule 2342 covers the sales charge limits and breakpoint sales.

Closed-End Funds: A Fixed Pool of Shares

A closed-end fund raises its money through an initial public offering, much like a company issuing stock. Once the offering is complete, the fund generally stops issuing new shares, and the pool of capital the manager invests stays largely fixed.

Investors who want to buy or sell after the offering do so on a stock exchange, through a broker, with other investors. The fund itself does not redeem shares on request.

A closed-end fund can raise more capital later, for example through a rights offering to existing shareholders or a follow-on offering, but it does so occasionally, not continuously. That fixed capital is what gives closed-end managers more freedom in what they own.

How Closed-End Funds Are Priced

A closed-end fund still calculates its NAV, but investors do not buy or sell at NAV. They trade at the market price set by supply and demand on the exchange, and that price can move throughout the trading day.

When the market price is above NAV, the fund trades at a premium. When it is below NAV, it trades at a discount, and many closed-end funds trade at a discount for long periods.

Investors pay a brokerage commission to buy or sell, just as they would for a stock. There is no sales load on secondary market trades, although investors who buy at the initial public offering pay an underwriting cost built into the offering price.

Premiums and Discounts Explained

A discount means you can buy a dollar of the fund’s assets for less than a dollar. That can look attractive, but discounts can widen, so an investor who buys at a 10% discount may sell later at a 15% discount and lose money even if the fund’s assets hold their value.

Discounts tend to widen when markets are stressed, when the fund cuts its distribution or when investors lose interest in its strategy. They tend to narrow when demand returns.

Premiums carry the opposite risk. An investor who pays more than NAV for a popular fund can lose money simply because the premium disappears.

Leverage in Closed-End Funds

Because a closed-end fund does not face daily redemptions, it can use leverage more easily, borrowing money or issuing preferred shares to buy more investments. Many closed-end bond and income funds use leverage to increase the income they pay.

The Investment Company Act limits that leverage. Under Section 18, a closed-end fund must maintain asset coverage of at least 300% for borrowings, and at least 200% for preferred stock.

Leverage magnifies both gains and losses. In a falling market, a leveraged fund’s NAV can drop faster than an unleveraged fund’s, and its market price can fall further still if the discount widens at the same time.

Why Closed-End Funds Can Hold Less Liquid Assets

An open-end fund must always be ready to pay redemptions, so SEC Rule 22e-4 limits it to holding no more than 15% of its net assets in illiquid investments. It needs assets it can sell quickly.

A closed-end fund has no such daily pressure, so it can hold larger positions in less liquid investments, such as municipal bonds of smaller issuers, emerging market debt, senior loans or private credit. That is one reason many income-focused strategies use the closed-end structure.

Interval funds and business development companies are also closed-end funds. FRC’s guide to how to invest in private equity funds explains how interval funds offer periodic repurchases instead of daily redemptions.

Where ETFs Fit

Most exchange-traded funds are legally open-end funds, even though their shares trade on an exchange like closed-end funds. The difference is that large institutions called authorized participants can create and redeem ETF shares in large blocks directly with the fund.

That creation and redemption process keeps an ETF’s market price close to its NAV, because traders profit from closing any gap. Closed-end funds have no such mechanism, which is why their premiums and discounts can persist.

On the exam, treat ETFs as their own category. They combine exchange trading with an open-end structure, and they are not the same as closed-end funds.

Diversified and Non-Diversified Funds

Both open-end and closed-end funds can be diversified or non-diversified. To be diversified under the Investment Company Act, at least 75% of the fund’s assets must be invested so that no more than 5% of total assets is in any one issuer and the fund owns no more than 10% of any issuer’s voting securities.

This is known as the 75-5-10 test, and it is a favorite exam question. A non-diversified fund can concentrate more heavily, which can increase risk.

Diversification status has nothing to do with whether a fund is open-end or closed-end. A question that implies otherwise is setting a trap.

Comparing the Two Structures

The table below summarizes the main differences between open-end and closed-end funds.

Worked Example: Pricing Each Fund

An open-end fund has a NAV of $20.00 and a front-end sales charge of 5%. Its public offering price is NAV divided by one minus the sales charge, or $20.00 divided by 0.95, which is about $21.05. An investor buying 100 shares pays about $2,105, and if they redeemed immediately, they would receive $2,000.

A closed-end fund also has a NAV of $20.00, but its shares trade on the exchange at $18.00. It is trading at a discount of $2.00, which is 10% of NAV.

An investor buying 100 shares pays $1,800 plus commission. If the discount narrows to 5%, with NAV unchanged, the price rises to $19.00 and the investor gains $100 before costs, without any change in the fund’s underlying assets.

Client Scenario: Choosing a Structure for Income

A retired client wants monthly income and asks an investment adviser representative about a leveraged closed-end bond fund trading at a 12% discount and paying a high distribution. The client may need to access part of the money at short notice.

The adviser should explain that the client would buy and sell at market prices, not NAV, and could sell at a wider discount if they need cash during a market downturn. Leverage would magnify losses, and a high distribution may include a return of capital rather than income alone.

A suitable recommendation depends on the client’s need for liquidity, tolerance for price swings and understanding of these features. As a fiduciary, the adviser must put the client’s interests first; FRC’s guide to fiduciary standard vs suitability standard explains what that duty requires.

The Exam Traps

The first trap is assuming closed-end shares can be redeemed with the fund. They cannot; investors sell them on an exchange to other investors.

The second trap is pricing. Open-end funds are bought at the public offering price and redeemed at NAV under forward pricing, while closed-end funds trade at market prices that can be above or below NAV.

The third trap is mixing up costs. Sales loads and breakpoints apply to open-end funds; closed-end shares bought on the exchange carry a commission instead. The fourth trap is treating ETFs as closed-end funds, when most are legally open-end.

A Memory Aid

Think of an open-end fund as a door that stays open. Money flows in and out every day, the fund always buys your shares back, and you always deal at NAV, plus any sales charge when you buy.

Think of a closed-end fund as a room with the door shut. The capital stays inside, you leave only by finding someone on the exchange to take your seat, and the price you get depends on what they are willing to pay.

Practice Questions

Question one: what is the defining feature of an open-end investment company? It issues redeemable securities, meaning it must buy back shares from investors on request, at NAV.

Question two: a closed-end fund has a NAV of $25 and a market price of $22.50. Is it trading at a premium or a discount, and by how much? It is trading at a 10% discount, because the $2.50 difference is 10% of the $25 NAV.

Question three: an investor places an order to buy mutual fund shares at 3:30 p.m. Eastern time. What price will they receive? That day’s NAV calculated at the close, plus any sales charge, because mutual funds use forward pricing.

Question four: under the Investment Company Act, what asset coverage must a closed-end fund maintain for borrowings? At least 300%.

Question five: an investor wants to sell closed-end fund shares. How do they do it? They sell the shares on the exchange through a broker, at the market price, and pay a commission.

Related Questions

Fund structure connects to several other Series 65 topics. FRC’s guide to fixed vs variable annuities covers another pooled product with its own fee and liquidity trade-offs, and the guide to private equity ETFs and what they actually hold explains how business development companies, a type of closed-end fund, end up inside ETFs.

Together with the breakpoint and sales charge guides linked above, they give you a complete picture of how investment company products are structured, priced and sold.

Get Exam-Ready for January

January is when many candidates book their exams, and investment company structure is among the most reliable marks on the Series 65 once the pricing rules are clear. The FRC video playlists linked at the top of this guide cover every exam section, with the traps to look out for in each one.

The FRC dictionary is more than a dictionary. It is a library of explainer videos, written explanations and on-page quizzes covering the FINRA and SEC rules you are tested on, so you can open any rule and go deeper whenever a question catches you out.

Study With FRC

FRC’s programs and memberships are open to everyone. Whether you are preparing for the Series 65, the SIE or both, structured exam preparation turns topics like fund pricing and share classes into marks you can rely on.

FRC’s Professional Membership adds verified progress and a Digital Profile, so when you apply for roles, employers can see your exam progress and the knowledge you are building, not just read about it on a resume.

Your Next Step

An open-end fund continuously issues and redeems shares at NAV, using forward pricing and often charging sales loads. A closed-end fund issues a fixed number of shares that trade on an exchange at market prices, often at a discount to NAV, and can use more leverage and hold less liquid assets.

Master the redemption test, the pricing rules and the premium and discount math, and you will be ready for every version of this question the exam can ask.