Mutual funds (MFs) are of two types – close ended and open ended. But what is the difference between these? If we do a close-ended versus open-ended comparison, is one better than the other? Is there any advantage in opting for one over the other?
This article explains what these are, and compares these two types of MFs.
We all know what mutual funds are: They collect small amounts of money from many common investors like you and me, and collectively invest it using their expertise.
(Please read “Direct investment in Stocks versus Mutual Funds (MFs)” to know about the advantages and disadvantages of investing through a mutual fund)
There are many ways in which MFs can be categorized – for example, equity or debt is one way. Another way to classify MFs is based on them being open ended or close ended.
What is an open ended mutual fund (MF)?
Open ended MFs are more common compared to close ended MFs.
In open ended MFs, the fund house continuously buys and sells units from investors. New units are created and issued if there is demand, and old units are eliminated if there is redemption pressure.
There is no fixed date on which the units would be permanently redeemed or terminated.
If you want to invest in an open ended fund, you buy units from the fund house. Similarly, when you redeem your units, the fund house directly pays you the value of the units.
Advantages of an open ended mutual fund (MF)
There is no limit on the number of units that can be issued – new units can easily be created and issued. Therefore, a large number of investors can participate in a MF scheme that is performing well.
Since open ended MFs are more prevalent compared to close ended MFs, there are many MF schemes to choose from in case you want to invest in an open ended mutual fund.
No issue expenses
(This used to be an advantage due to an anomaly with close ended schemes, but SEBI took corrective action in January 2008, and this is no more an advantage for open ended schemes).
Fund houses can charge upto 6% of the amount raised as initial issue expense (more details later) for close ended MFs.
Open ended schemes do not have any such issue expenses – they only have an entry load, which is much lesser (around 2.25%) in most cases. Thus, more of your money is actually invested.
Disadvantages of an open ended mutual fund (MF)
Large cash positions and Impact on returns
The fund managers have to be prepared for redemptions at all times. At any time, investor can surrender the units and redeem them.
Selling well-performing shares to meet redemptions is not a good strategy. Therefore, most open ended MFs keep a large balance of cash to meet any redemption pressure.
Since this cash is not invested in equities, and is kept either as cash or is invested in very liquid money market funds, it earns very low returns. Therefore, the overall return for the MF scheme suffers.
Larger participation brings along its own problems. When a scheme is successful, it attracts more people. So, new units are created and distributed, thus increasing the corpus under management.
As the amount managed by a fund manager increases, it becomes difficult to find good investment opportunities for that fund.
This is especially true for mid-cap and small-cap funds, where investment avenues are very limited, and any large-sized investment can swing a stock’s price.
Thus, if the growth in corpus is not managed well, the scheme’s performance can deteriorate.
What is a close ended mutual fund (MF)?
The units of a close-ended mutual fund are very similar to individual shares.
The units of a close ended scheme are issued only at the time of the New Fund Offer (NFO). These units are issued with a fixed tenure or duration, for example, 5 years. New units are not issued on an ongoing basis, and existing units are not eliminated before the term of the fund ends.
At the time of an NFO, you can buy the units from the fund house, and at the time of the closure of the scheme (and at some other pre-defined intervals, like once every six months), you can redeem the units with the fund house.
But if you want to buy or sell the units of a close ended scheme during the lifetime of the units, you have to do that on a stock exchange. The units of such schemes are listed on the stock exchanges just like ordinary shares, and can be bought and sold through a broker.
Advantages of a close ended mutual fund (MF)
No redemption pressure, better returns
When you want to get out of your investment from close ended funds, you sell them on the exchange. The fund house has no role to play in it. The units change hands from one investor to another – there is no impact on the funds with the fund manager.
Therefore, there is no redemption pressure on the fund manager, and thus, there is no need to constantly keep unnecessary cash. This means better utilization of funds, resulting in better returns.
Also, since the fund manager knows that the funds would be with him for a fixed duration, he can invest for the long term, thus reaping the benefits of long term investment.
This is very similar to the philosophy behind ELSS schemes, where a lock-in period results in long term investment, which in turn results in better returns.
(Please read “ELSS is not for someone else” to know more)
Again, since the buying and selling of the units of a close ended scheme doesn’t have any impact on the funds in the hand of the fund manager, the amount or corpus under his management remains constant.
There is no ballooning of the corpus, and the scheme is able to stay devoted to its investment philosophy.
Disadvantages of a close ended mutual fund (MF)
Lack of broad participation
Since the number of units of close ended schemes is constant, there is naturally a cap on the number of investors that can participate in such schemes.
Lack of choice
Since most of the MF schemes in the market are open ended, you would have very little choice if you want to invest in a close ended scheme.
(This used to be a disadvantage, but SEBI took corrective action in January 2008. Now, only an entry load can be charged).
In case of close ended schemes, the fund house can charge upto 6% of the amount collected through the NFO as issuing expense. And this amount is charged in one go, at the very beginning of the investment.
This means that when you buy a unit for Rs. 10 in an NFO, only Rs. 9.4 is actually invested on your behalf! This is a big disadvantage, and can result in significantly lower returns over the long term.
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