One of the most fundamental bifurcation in mutual fund space is the one between an Open Ended Fund and a Close Ended Fund....Read on...
Whats Common
Both 'Open Ended' and 'Close Ended' Mutual Fund offer investors an easy and low-cost way to pool their money to purchase a diversified portfolio that reflects a particular investment objective. And investors don't need to have a lot of money to gain entry.
History
Both open-end and closed-end funds have been around for many decades. Closed-end funds are the oldest among these, introduced in the late 19th century.
Background
Typically, when we talk about a Mutual Fund to any new investor, we are referring to an 'Open End' Mutual Fund by default. This doesn't mean that open-end funds are always the best option and close ended fund types should be ignored.
Structural Differences
Mutual funds are classified according to various attributes, such as the nature of investment, risk profile and investment philosophy. Apart from these, the funds are differentiated on the basis of their structure—open-ended and closed-ended. Both these fund types are structured differently.
Open-end funds are what you know as a mutual fund. They don't have a limit as to how many shares (units) they can issue. When an investor purchases shares (units) in a mutual fund, more shares (units) are created in the fund, and when somebody sells his or her shares the shares (units) are taken out of circulation. If a large amount of shares (units) are sold (called a redemption), the fund may have to sell some of its investments in order to pay the investor.
The number of outstanding shares (units) goes up or down every time the fund house sells or repurchases the existing units. This is the reason that the unit capital of an open-ended mutual fund keeps varying. The fund expands in size when the fund house sells more units as more money is flowing in. On the other hand, the fund's size reduces when the fund house repurchases more units.
An open-ended fund is not obliged to keep selling new units all the time. For instance, if the management thinks that it cannot manage a large-sized fund optimally, it can stop accepting new subscription requests from investors. However, it has to repurchase the units at all times - which is a guarantee that you will be able to sell at your will and redeem whenever you wish, unlike stocks - where you need a buyer to sell your stock.
You can't watch an open-end fund like you watch your stocks, because they don't trade on the open market. Open-end mutual fund shares are bought and sold on demand at their net asset value, or NAV, which is based on the value of the fund's underlying securities and is generally calculated at the close of every trading day. Investors buy shares (units) directly from a fund house.
Close-ended funds look similar but they're very different. A closed-end fund functions much more like an exchange traded fund than a mutual fund. They are launched through an IPO in order to raise money and then trade in the open market just like a stock or an ETF. They only issue a set amount of shares and, although their value is also based on the NAV, the actual price of the fund is affected by supply and demand, allowing it to trade at prices above or below its real NAV value.
The unit capital of closed-ended funds is fixed and they sell a specific number of units. Unlike in open-ended funds, investors cannot buy the units of a closed-ended fund after its NFO period is over. This means that new investors cannot enter, nor can existing investors exit till the term of the scheme ends. However, to provide a platform for investors to exit before the term, the fund houses list their closed-ended schemes on a stock exchange.
Trading on a stock exchange enables investors to buy and sell units through a broker in the same manner as transacting the shares of a company. The units may trade at a premium or discount to the NAV depending on the investors' expectations of the fund's future performance and prospects. The demand and supply of fund units and other market factors also affect their price.
Advantages of Open Ended Funds
(1) To me, the biggest advantage with an open ended fund is that you get liquidity, which is vital. You can sell (redeem) your units whenever you wish to. And liquidity is an extremely vital aspect (though often neglected) of any portfolio. Ignore it at your own peril. (Read this blog post : Liquidity is a vital aspect of Portfolio) . Having said that, Close Ended funds can always be traded in the market since they are listed on the exchange. Apart from listing on an exchange, these funds sometimes offer to buy back the units, thus offering another avenue for liquidity. Sebi regulations ensure that closed-ended funds provide at least one of the two avenues to investors for entering or exiting.
(2) You can buy, sell and transfer when you want - which means that you can get in via SIP, and use strategies like SWP and STP - all possible only with open ended mutual funds. (Read these blog posts : 5 Simple Strategies to make your SIPs work harder, VIPs perform better than SIPs, SIPs and their Capital Gains Taxation, What is SWP )
(3) Open-ended funds have outperformed the closed-ended funds comprehensively. Closed-end diversified multi-cap funds' one and two-year average trailing returns stand at 28.5% and 5.85% respectively. The same for open-ended diversified multi-cap funds stand at 33.26% and 10.15% respectively.
Advantages of Close Ended Funds
(1) There are many close-ended funds trading on the market, yet they are not well known by retail investors. Some funds pay a dividend of more than 8%, making these funds an attractive choice for income investors.
(2) The close-ended funds are free from the worry of regular and sudden redemption and their fund managers are not worried about the fund size, thus giving them better leverage on investing.
(3) These funds are best suited if you have a lumpsum amount to be invested in the equity market and are not willing to go the STP route. The market is volatile and risks with any lumpsum investments always stand. However, you might still be better off leaving your lumspum amount in the hands of the Fund Manager rather than your own self.
(4) The lock-in period ensures that investors ride out the volatility without making redemptions. The compulsion to stay invested can make these funds a good choice in a volatile market, but works better only for an immature or a new investor.
Precautions with Close Ended Funds
(1) Nearly 70% of all of these products use leverage as a way to produce more gains. Using borrowed money to invest may produce big returns, but it could also put the fund under intense pressure. This makes difficult for closed-end funds to borrow more money in order to invest. Higher borrowing costs impact the return investors receive from these funds, making them potentially less attractive in the future.
(2) Closed-end equity mutual fund launches have been declining since the Association of Mutual Funds in India (AMFI) asked fund houses to cap up-front commissions at 1%. In the 12 months preceding AMFI's decision (April 2015), 58 closed-end schemes were launched. In the 20 months since the cap, the launches fell to 29.
(3) The multi year lock-in period of closed-end funds was meant to provide fund managers the flexibility to steer their funds without the fear of outflows, but this has not helped generate better returns.
(4) You risk investing when the market is expensive and maybe forced to exit when they are tanking.
Summary
Open-end products may represent a safer, flexible and better choice than closed-end funds. But depending upon your maturity level as an investor (liquidity is not always a boon for a new or an immature investor) and, availability of surplus money, you might decide to go for Close ended mutual funds as well.
Of course, investors should always compare individual products within an asset class; some open-end funds may be more risky than some closed-end funds. In general, open end funds win hands down.
Cheers
Manoj Arora
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