Investments in mutual funds have become popular among many Indian investors as these funds offer diversification and professional management, along with the potential for creating inflation beating wealth over the long term. Mutual funds can broadly be classified as open ended and close ended. These two fund types have unique structures, features and benefits, and their risk and return profiles are also different.
Knowing these differences helps investors to make informed investment decisions. This article discusses the various characteristics, advantages and disadvantages of open ended and close ended funds. Furthermore, it also suggests who may invest in these funds.
What are Open Ended Mutual Funds?
Open ended funds allow for issuance or redemption of fund units based on the prevailing NAV on any business day. Most of these funds are not subject to a minimum lock-in period or maturity; hence, investors may enter or exit at any time.
Key features:
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Units Not Limited: The funds may issue an unlimited number of units to its investors.
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NAV Update: Returns of the underlying securities are taken into consideration daily while calculating the NAV, which is revised daily.
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No lock-in period: There is no fixed maturity or restrictions on redemption and reinvestment of units for most open ended funds. There are few open ended schemes which are an exception to this rule – such as ELSS, retirement funds and children’s funds.
What are Closed Ended Mutual Funds?
Closed-ended mutual funds have a fixed maturity date. New units can be purchased only during the New Fund Offer (NFO). Generally, redemptions are permitted only on maturity; however, certain facilities such as Systematic Transfer Plans (STPs), if offered by the scheme, or exchange trading may provide investors with limited liquidity before maturity.
Key features:
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Fixed subscription period: Closed Ended Mutual Fund permits fundraising only during the new fund offer (NFO) and has a set time frame for it.
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Trading: The price at which units of these funds trade on stock exchanges depends on the performance of the underlying securities.
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Time-bound: These funds have a pre-defined period or an investment lock-in period.
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Restrictions on Redemptions: Once the close ended period is undertaken, limits are placed on the amount of funds that can be reinvested or withdrawn.
Comparing Liquidity, Flexibility, and Accessibility
Liquidity
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Open Ended Funds: The investors are free to buy or sell their units anytime they wish (aside from the ELSS funds that have a designated lock-in of 3 years) which makes these units easily convertible to cash.
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Close Ended Funds: Their liquidity is limited and the investors have to hold them until maturity.
Flexibility
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Open Ended Funds: They can be bought with a lump-sum payment or an SIP in accordance with the financial objectives.
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Close Ended Funds: They can only be bought during the NFO period and do not allow any other contributions post NFO.
Accessibility
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Open Ended Funds: These are Ideal for smaller investors as they can sometimes start from as low as Rs. 500.
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Close Ended Funds: There is a high minimum investment, starting from around Rs. 5,000.
Performance Track Record
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Open Ended Funds: There is always a scope to assess the investment and the past performance of the funds before making any decisions.
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Close Ended Funds: For such funds, the investor cannot evaluate any track records due to the shorter period of subscription to NFO. Nonetheless, they can assess what other similar funds did historically before joining in to see the potential rates of return.
Pros and Cons of Open Ended and Close Ended Funds
Open Ended Funds
Pros:
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High Liquidity: There’s always an option with the investors to redeem their investments on any business day. The quality to adjust with the financial needs or market conditions makes these funds suitable for different types of investors.
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Flexibility: An investor can start the investment either through lump sums payments or Systematic Investment Plans (SIPs). There’s a scope to accommodate different financial goals and customised investment strategies.
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Rupee Cost Averaging: Since these funds allow investments through SIPs, investors can buy more units when prices are low and less units when prices high. This averages out the cost of investment and reduces the effect of market volatility.
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Diversification: From equity to debt to hybrid, there are lots of options available in open ended funds for all types of investors
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Track Record: Investors can look at past performance of these funds to help them choose wisely.
Cons:
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Market-Driven Returns: The Net Asset Value (NAV) of open-ended funds changes every day, making returns dependent on market situations.
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Investor Behaviour: Easy access to cash can cause people to withdraw their investments during market fluctuations.
Close-Ended Funds
Pros:
Stability: The lock-in period provides fund managers stability in their capital base, enabling them to focus on long-term growth strategies without being under pressure to exit.
Discipline: The lock-in prevents impulsive withdrawals, encouraging disciplined long-term investing.
Prospects for Increased Returns: A concentrated and steady investment strategy may provide a relatively higher return potential in the long term.
Cons:
Limited Liquidity Close ended funds do not have the ability to redeem until the fund matures which is a constraint.
High Entry Barrier: Retail investors may be discouraged coming in, if NFO minimums are seen as too high.
Less Flexibility: After the NFO, no further investment is allowed, which decreases the ability to adjust to changing financial goals.
Suitability to Various Investor Profiles
Open Ended Funds Are Suitable For:
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Beginner Investors: Ideal for those starting with mutual fund investments.
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Risk-Averse Individuals: Flexibility to exit during market volatility.
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Small Investors: Accessibility with low minimum investment amounts.
Close Ended Funds Are Suitable for:
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Experienced Investors: Those familiar with market dynamics and willing to lock funds for a specific period.
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Long-Term Planners: Investors with defined goals like retirement planning.
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High Net Worth Individuals (HNIs): Those with substantial capital and higher risk tolerance.
Conclusion
The choice of investing in open ended or close ended mutual funds depends on the investor’s objectives and financial situation. While open ended funds offer high liquidity by giving investors the freedom to redeem their investments at any point, close ended funds are associated with lesser liquidity. Small investors are often more suited to open ended funds as they offer accessibility and flexibility along with options like SIPs and minimum investment of Rs. 500. On the other hand, close ended funds may be considered by investors who give prioritise stability and long-term growth potential albeit with lesser liquidity needs.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.