Mutual funds are differentiated based on their structure, i.e. whether they are open-ended or closed-ended schemes. The difference between the two types of funds is a function of flexibility and the ease of sale and purchase of fund units. This article covers the following:
Open-ended funds are what you know as a mutual fund. These funds do not trade in the open market. They don’t have a limit as to how many units they can issue. The NAV changes every day because of the share/stock market fluctuations and bond prices of the fund.
Open-ended mutual fund units are bought and sold on demand at their Net Asset Value or NAV, which is dependent on the value of the fund’s underlying securities and is calculated at the end of every trading day. Investors buy units directly from a fund.
The investments in open-ended funds are valued at the fair market value, which is also the closing market value of listed public securities. These funds also do not have a fixed maturity period.
Liquidity: Open-ended funds offer high liquidity due to which you can redeem your units at your convenience. When compared to other types of long-term investments, open-ended funds provide the flexibility for redemption at the prevailing Net Asset Value (NAV).
Availability of Track Record:In case of a closed-ended fund, you cannot review the performance of the fund over different market cycles on account of non-availability of track record. However, in the case of open-ended funds, the historical performance of the fund is available. Hence, investing in an open-ended fund is a well-informed decision.
Systematic Investment Form: Closed-ended funds require investors to invest a lump sum to buy the units of the fund at the time of their launch. This can be a risky approach to deal with your investments. It exposes you to take bigger bets than otherwise warranted. However, open-ended funds is a suitable investment option for a large number of salaried class of investors. It is because they can invest via systematic investment plans (SIP).
Suffers from Market Risk: Even though the fund manager of open-ended funds maintains a highly diversified portfolio, they are subject to market risk. The NAV of the fund keeps fluctuating according to the movements of the underlying benchmark.
No Say in Asset Composition: Open-ended funds appoint fund managers who are well-qualified and have experience in the field of fund management. They take all the decisions related to the selection of securities for the fund. Hence, the investors do not have a say in deciding the asset composition of the fund.
Closed-ended mutual funds assign a fixed number of fund units that are traded on stock exchanges. Close-ended funds function more like an exchange-traded fund (ETF) rather than a mutual fund. They are issued through new fund offer (NFO) to raise money and then traded in the open market, similar to stocks.
Though the value of the fund is based on the NAV, the actual price of the fund is proportional to supply and demand as it can trade at prices above or below its real value.
Hence, closed-end funds can trade at premiums or discounts to their NAVs. Units of closed-ended funds are purchased and sold through brokers. Closed mutual funds usually trade at discounts to their underlying asset value. These funds also have a fixed maturity period.
Stable Asset Base: In closed-ended funds, the investors can redeem their units only on predefined dates, i.e. when the fund matures. This allows portfolio managers to get a stable base of assets, which is not subject to frequent redemptions. A stable asset base allows the fund manager to formulate an investment strategy more comfortably. The fund managers can also keep the fund objectives holistically in mind without having to worry about the inflows and outflows in the case of stable asset bases.
Availability of Market Prices: Closed-ended funds primarily trade on stock exchanges like equity shares. This provides an opportunity for investors to buy/sell fund units based on real-time prices, which can be above (premium) or below (discount) the fund’s NAV. They can also make use of the usual stock trading strategies like market/limit orders and margin trading.
Liquidity and Flexibility:Investors are allowed to liquidate closed-ended funds as per the fund norms. Investors can utilise real-time prices available during the trading day to buy/sell closed-ended fund units at the prevailing market prices. This provides the necessary flexibility to decide on their investments by using real-time information.
Poor Performance: Performance of the closed-ended schemes has not been on par with open-ended peers across different time horizons. The lock-in period on closed-ended funds are aimed at giving the fund managers the flexibility to allocate the funds without the fear of outflows has not helped much in generating better returns.
Lump Sum Investment: Closed-ended funds require you to invest a lump sum at the time of their launch. This can be a risky approach to deal with your investments. It exposes you to take bigger bets than otherwise warranted. Moreover, a large number of salaried class of investors are unable to afford lump sum investments. They, instead, prefer staggered investments by way of systematic investment plans (SIP).
Non-Availability of Track Record: In case of open-ended funds, investors can review the performance of the funds over different market cycles on account of availability of historical data. However, in the case of closed-ended funds, the track record is not available. Hence, investing in a closed-ended fund attracts uncertainties for which you can only depend on the fund manager.
It is difficult to say whether open-ended funds are better than closed-ended funds or vice versa. The performance of a fund, whether open-ended or closed-ended depends on the fund category, fund management, and investment style.
Some open-ended fund investors are quick to redeem their units after the NAV appreciates by 5%–10% to book short-term profits. This hurts the investors who remain invested in the funds. Closed-ended funds are better options in such situations because the lock-in period prevents early redemption and protects the interest of long-term investors.
Open-ended funds can be useful for someone who has minimal or no knowledge of the markets and desires an annualised return in the range of 12%–15%. As professionals and experts manage these funds, with the NAV being updated daily and highly liquid these get slightly more advantage for investors than the closed-ended funds.