While mutual funds in India differ on the basis of their risk appetite and cater to different classes of investors, they are broadly categorised into two types: close-ended and open-ended. Open-ended schemes can be purchased or sold at any time, while close-ended schemes can only be purchased when the fund is being launched and can be redeemed only when the lock-in period for the investment is over.
Mutual funds can be defined as a form of venture which includes investing the money put together from various investors into a diversified range of securities. They are managed by professional fund managers who invest your capital for you following the highest standards of portfolio management. The investors are issued mutual funds in proportion to their investments.
Open-ended Mutual Funds
Open-ended mutual funds are a category of mutual funds in which there is no time barrier for entry or exit (entry barriers in general are low, allowing more people to invest in passive income). In such funds, the net asset value or NAV determines the units sold or bought. NAV keeps changing daily (ie. at the end of each trading day) in accordance with the changes in the prices of bonds and stocks in the market. No maturity time is prefixed in such funds. The units of the funds are taken off the market just as the investor cashes his/her units invested. Although, if the units are redeemed within a year, the investor is liable to be charged an exit fee.
Pooled investment and withdrawal options for all the investors allows for continuous new contributions. There are hypothetically infinite potential outstanding shares in these funds.
When new shares are bought, the funds generate replacement shares which are new shares, whereas when the shares are sold off, they are taken out of the pool of shares. At times, the fund might sell off a part of its investments in order to reimburse the investors who exit if they redeem a considerable amount of their shares. Open-ended funds provide an easy and affordable way for all levels of investors to accumulate a diversified portfolio.
Open-ended Investment Company
In the UK, similar Open-ended Investment Company (OEIC) operate which have similar offers as open-end funds. The price of a share depends on the value of assets that the OEIC owns. The market value of the net assets (assets minus liabilities) is divided by the number of shares/units in issue. This gives the NAV of the Open-Ended Investment Company and is calculated once every day. Hence, the price of a unit is not affected by demand and supply forces but entirely depends upon the value of assets owned by the Company. So, when you buy shares/units of an OEIC, you become part owners of the assets that it owns.
Closed-ended Mutual Funds
A closed-ended mutual fund, “closed-ended fund” or “closed-ended investment” is a debt or equity fund comprising a pool of assets that are issued in a predetermined number of units during its launch. This offer is called a new fund offer (NFO) and investors cannot buy or sell units once it is closed.
The funds are tradeable but they have a fixed period of maturity, and can be redeemed only after this is achieved. Much like stocks, such funds can be traded on secondary markets by investors. It differs in that the parent company does not issue any additional units after the initial issue and never buys back those units.
Ideally, closed-ended funds should offer better returns than open-ended mutual funds since the cash reserve raised after the initial issue remains the same. The company does not buy back units from the investors either, and investors can trade the units among themselves. Managers can liberally use leverage against the fund accumulated to increase the returns as well.
While the NAV of the closed-end fund is calculated regularly, in effect, its price depends on the demand and supply of its units. This means that closed-end funds can trade at premiums as well as at discounts. Suppose the fund is managed by a manager with a history of successfully picking stocks, chances are that it will trade at a higher price than NAV, that is, at a premium. On the other hand, a risk and return profile that does not appeal to the investor can lead to a discounted price.
Open-ended mutual funds vs close-ended mutual funds:
Open-ended funds have higher liquidity for investors. Since there is no fixed maturity period, these funds have the benefit of flexible redemption at the prevailing NAV. There are hypothetically infinite potential outstanding shares in these funds. This accounts for the greater liquidity of open-ended funds.
Closed-ended funds have high liquidity for the fund manager, which may translate to higher returns. Investment in illiquid securities like emerging-market stocks is high-risk. However, with a closed-end fund, this risk can be taken more freely with the assurance that the fund manager will not lose funds the moment there is a temporary dip in returns. Fund managers have ample freedom to make strategic decisions about the asset base and are not forced to hold excess cash. Therefore the higher risk that accompanies investment in illiquid securities can also result in potentially higher returns for shareholders.
Investors can track performance of fund
In close-ended funds, it is not possible to track the performance data of the mutual fund. The decisions made for the fund and its performance are largely dependent on the fund manager (who is not influenced by any possibility of funds withdrawals).
However, in open-ended schemes, one can keep an eye on the performance of the fund through different economic and business cycles, and the investor if he so wishes can choose to redeem his investment in case he is getting a handsome return. Investing in an open-ended scheme gives you a clearer picture of your investments.
Facility of a systematic investment
Closed-ended funds require an investor to invest a lump sum amount at the launch of a fund. This is comparatively a riskier investment better suited to veteran investors who know the nitty-gritty of the market as well as the fund and can weather volatilities in case the business cycle works against the investment philosophy of the close-ended mutual fund scheme.
In contrast, open-end funds can be through SIPs or in a lump sum with an investment as low as Rs. 500 (perfectly suited for salaried employees). The investment and withdrawal plans have availability of options like SIPs (Systematic Investment Plans), SWPs (Systematic Withdrawal Plans), and STPs (Systematic Transfer Plans) alongside other investments in diversified industries, reducing the associated risks and amplifying the associated returns.
Whereas investments in closed-end funds can only be done during NFO and not through SIPs and the minimum investment value is usually Rs. 5000.
Management of fluctuating asset base
In a close-ended scheme, investors are not allowed to withdraw their investment till the end of the lock-in period. This gives the fund manager an assured asset base that is not prone to frequent redemptions. This helps the fund manager devise a comprehensive investment strategy and remain committed to the investment philosophy despite the volatility in the markets without worries of frequent redemptions.
Managers of open-ended funds have no such luxuries and have to deal with a much more complex fund and are under constant pressure.
Market research shows that open-ended schemes have delivered potentially a much better yield compared to close-ended schemes. Fund managers can supervise the management of a close-ended fund without fearing sudden outflows in a close-ended fund – this may have disincentivized their performance.
Open-end funds are not traded on stock exchanges as opposed to closed-end funds.
Open-end funds are bought on the basis of present NAV allowing 100% returns on the value of securities and assets. While closed-end funds are traded at discounts to their NAVs due to the pressure of liquidity.
Price based on demand and supply of the units
Closed-end funds trade on stock exchanges based on the demand and supply of their units, just like equity shares. If demand rises and supply is low, the closed-end funds can be sold at a price that is higher than the NAV. In contrast, demand for open-ended funds depends only on the NAV.
Neither open-ended nor closed-ended funds are risk-free for either the investors or fund managers – the risks are simply different. In any case, it is important to look at the performance data of companies and investments in order to make an informed investment decision.