Mutual funds are identified based on how they work, i.e., if they’re open-ended or closed-ended schemes. The gap between the two different funds is flexibility and the ease of purchasing and selling finance units. Having a better understanding will go a long way in helping you in your mutual investment journey.
An open-ended fund gives you extreme independence and flexibility as investors to enter and exit whenever you feel like, and your faith entirely determines its variant as an investor. In contrast, a close-ended mutual capital offers you a predetermined timeline for participating in and out of the fund.
You can read more about mutual funds here. Today we are going deeper to have a better understanding of Open-ended and Closed-ended mutual funds.
Open-Ended Mutual Funds
Open-end mutual funds don’t limit the number of shares they can offer. Also, they are purchased and sold on demand. When you buy shares in an open-ended fund, the fund issues you the unit of shares. When someone sells their units of shares, they are repurchased by the fund.
When you sell your shares in exchange for cash (redemption), the fund pays you using the money available. Otherwise, it must sell some of its investments to make money available to you.
Open-ended mutual funds are also priced differently from closed-ended mutual funds. They are somewhat like a stock exchange. Shares of open-ended funds are purchased and sold straight from the fund at a price per share based on their fund’s underlying securities’ value.
On every trading day, naturally, at the end of the day, the net asset value (NAV) is calculated by dividing the fund’s assets (less expenses) by the number of stocks held by investors.
Pros of Open-Ended Mutual Funds
Open-ended funds offer you high liquidity. As a result, you can redeem your units or shares at your convenience.
If you compare it with other types of long-term investments, open-ended funds offer the flexibility for redemption at the prevailing Net Asset Value (NAV).
The ease of buying and selling is what makes the open-ended fund investors favorite.
Availability of Data
When investing in an open-ended fund, you have access to the historical performance of the available fund. This record will guide you accordingly in your decisions.
Compared with the closed-ended fund, where you can’t review the fund’s performance over different market cycles due to data’s non-availability, open-ended funds come highly recommended.
Gradual Planned Investment
With open-ended funds, you can invest according to the options you desire. For instance, you can go big or just in small bits, which is why this fund is suitable for many salaried investors. You can invest in systematic investment plans (SIP).
On the other hand, closed-ended requires you to invest in large lump sums to buy units at launch. This is a risky approach to investment, and it will expose you to uncontrollable risk.
Cons of Open-Ended Mutual Funds
Exposure to Market Fluctuations
Funds managers of open-ended funds manage a highly diversified portfolio. These securities are subject to market risk.
The NAV of the funds keeps changing according to the movement of the underlying benchmark.
You Have no Control
Open-ended funds appoint fund managers that are well-qualified and have the expertise within the industry of fund administration.
They take all of the decisions associated with the choice of securities for the fund. So, as an investor, you don’t have a say in determining this fund’s composition.
Closed-Ended Mutual Funds
Considering that closed-ended mutual funds are exchanged between investors in a market, they have a fixed number of stocks. Like we have in shares, closed-ended funds are established through an initial public offering (IPO) to raise cash before they could exchange in the open market.
Their worth can also be dependent on the fund’s NAV. The actual price of this fund is dependent on demand and supply. So, it could exchange at prices above or below the value of its holdings.
Closed-ended funds will, in general, be effectively managed, unlike exchange-traded funds(ETF), which track an index and, for the most part, don’t exchange at a discount or premium to their NAV.
Shares of Closed-ended funds are issued via a new fund offer (NFO) to raise money and then trade in the open market, which is very similar to stocks. Though the fund’s value is based on the NAV, this fund’s actual cost is proportional to demand and supply. It could trade at prices above or below its actual price.
Shares of Closed-ended funds are bought and sold by agents or brokers. The brokerage firm underwrites and sells newly issued shares of the fund.
The broker fees on those newly issued stocks are often very high, eroding the stock’s purchase price when they exchange in the market.
Let’s look at an example. Suppose a closed-end fund sells 1 million shares at $10 per share, and there’s a brokerage commission of 7%. In that case, the fund receives $9.3 million to invest ($700,000 is deducted from the $10 million earnings). The share price drops in value from the $10 initially paid and trades at a discount to the offer price.
Pros of Closed-Ended Mutual Funds
Stable Asset Base
In a closed-ended fund, you can only redeem your units on predefined dates, i.e., on the fund’s maturity. This enables portfolio managers to get a stable foundation of resources, which isn’t subject to regular redemptions.
A steady asset base allows the fund manager to formulate investment plans comfortably. The fund managers can also keep the fund’s objective holistically in mind without worrying about the inflows and outflows in the case of stable asset bases.
Availability at Market Prices
Closed-ended funds mostly trade on stock markets such as equity stocks. This gives you a chance to buy/sell fund units based on real-time rates, which may be above (premium) or below (discount) the fund’s NAV.
You can also use the typical stock trading approaches, for example, market/limit orders and margin trading.
Liquidity and Flexibility
You are allowed to liquidate a closed-ended fund according to the fund’s criteria. You can use real-time prices available through the trading day to buy/sell closed-ended fund units in the prevailing market rates.
This gives you the essential flexibility to choose your investments by using real-time market information.
Cons of Closed-Ended Mutual Funds
The performance of these closed-ended schemes hasn’t been on par with open-ended peers over various time horizons.
The lock-in interval on closed-ended funds intends to provide the fund managers the flexibility to allocate funds without the anxiety of outflows. It hasn’t helped much in creating greater returns for investors.
Closed-ended funds require you to spend a lump sum at the time of the launch. This may be a risky strategy for your investments. It lets you take larger bets than otherwise justified.
A lot of salaried category of investors are not able to afford lump sum investments. They, instead, prefer staggered investments using systematic investment plans (SIP).
Non-Availability of Track Record
In closed-ended funds, the track record isn’t offered. Thus, buying a closed-ended fund brings uncertainties that you can count on the fund manager.
Differences Between Open and Closed-Ended Mutual Funds
As an investor, it’s essential to know the key differences between open and closed-ended funds. This knowledge not only helps your decision, but it also enables you to understand the workings of the funds.
|Opened-Ended Mutual Funds||Closed-Ended Mutual Funds|
|You can invest through SIP||You can’t invest through SIP|
|These funds have entry or exit options. The issuing firm takes responsibility for entry and exit.||New units are not always issued. It issues shares only if there’s any right issue or bonus. An investor can purchase or sell units of this scheme on the stock market when listed.|
|No fixed maturity period, but it has unlimited capitalization. No limit on the amount you can buy in the fund, but its unit capital keeps growing.||They have fixed maturity periods. Investors can buy units only during the period the funds are open in the initial market.|
|It provides readily available liquidity to the shareholders.||As a result of investors’ expectations, supply and demand factors, and other variables, the market prices of the shares of closed-end funds fluctuate in the scheme’s NAV value.|
|The NAV per share is arrived at by dividing the Total Net asset by the number of outstanding shares. All additional expenses will be deducted from the total assets.||The value is based on NAV, but the actual price is determined by demand and supply making it possible to trade at prices above or below the value of its holding.|
|Management style can be passive, active, or a combination of both, depending on the circumstances.||Fund management style is active.|
|No fixed maturity period||Fixed maturity period and can be between 2-5 years.|
|NAV is published daily||NAV is published weekly|
|Profits depend on when the investor exits the fund. If they have exceeded their original investment, then it is considered a capital gain.||Profit to the shareholders can be in the form of income or capital gain. It can also be capital gain realized from shares’ sale with increasing the share value through its exposure to tax liability.|
|Capital varies depending on investor confidence.||Capital remains fixed until new shares or units are offered.|
|The selling price is NAV plus entry or exit load, as stated in the prospectus.||The selling price is traded at a premium or discount to their NAV.|
|Shares or units are bought directly from the underwriter of the fund.||Shares or units are bought and sold through brokers. Brokerage firms underwriter and sell newly-issued shares|
|A reasonable restriction on investment in leverage due to high levels of volatility and risk involved||Fewer restrictions with respect to leverage and liquidity but strict regulatory limits would be applicable.|
|Smaller investments are allowed, which makes it attractive to retail investors with limited disposable cash.||Predominantly Lump sum investment.|
|Investment can be liquidated with ease.||Investment is mostly in illiquid securities, which makes it difficult to pull out any time.|
It’s tough to state categorically if open-ended capital is far better than closed-ended funds or vice versa.
Some open-ended fund shareholders are fast to redeem their units after the NAV appreciates 5 to 10% to save short-term gains. This hurts the shareholders that stay invested in the fund. Closed-ended funds are much better choices in these situations since the lock-in time prevents premature redemption and protects investors’ interest in it for the long run.
Open-ended funds could be the best option for somebody who has minimal or no understanding of their markets and needs a yearly yield in the range of 12 to 15%. As professionals and investment experts handle these funds, together with the NAV being updated every day and very liquid, these give the investor a marginal benefit compared to closed-ended funds.
I’m always excited to hear your opinions and views, So I look forward to seeing your comments.