The major mutual funds split is interval, open, and close ended mutual funds based on their structure. The structural type of mutual fund was categorized depending upon the frequency of buy or sell funds.
Many investors prefer investing in open end funds, as it doesn’t have any restriction to buy and sell the funds. But, you should be aware of what closed-end fund is, what are their benefits, and how these funds work.
Also, we will share with you an unbiased difference between open end and close end funds. So, stay tuned till the end.
Definition of Close Ended Mutual Fund:
Closed ended fund is a type of mutual fund that allows the investment only during the NFO (New fund Offer) period, and the fund gets locked. The purchase (NFO period) and redemption (Maturity of funds) happen only once in these funds.
Closed-end mutual funds can be both equity and debt, but the fund house estimates a fixed unit of fund shares during the launch. Once all the units get sold, the fund becomes closed, and investors in these funds can make no more buy or sell.
Post the launch; the fund will be traded in the open stock market. Unlike open-ended funds, the NAV keeps changing regarding the market’s demand and supply.
These funds are only actively managed funds(i.e., index funds, ETFs can’t be closed-ended funds). This provides the fund manager’s full legitimacy in achieving the fund’s investment objective.
How Does Close-ended Mutual Fund Works?
Investors buy units of a fund at a certain price after an asset management company launches a New Fund Offer (NFO). New investors cannot enter the fund after the NFO period has ended.
As well, investors cannot exit the fund before the scheme matures. It usually takes 3-4 years for the scheme to mature.
The units can be traded on a stock exchange by an investor who wishes to exit the fund before maturity. Like any other public security, closed-end fund units are traded on stock exchanges.
Prices of the units change depending on market fluctuations and the performance of the scheme’s investment portfolio.
The fund’s closed-end price can sometimes discount a fund’s Net Asset Value (NAV). As redemptions occur at NAV on maturity, new investors can take advantage of this difference to earn decent returns in the future.
Difference between Close-ended and Open-ended Mutual Fund
There is five difference that makes a huge impact on investment returns. These 6 reasons have made many investors stay invested in open-ended mutual funds.
- Investment Mode
- Fund Performance record
- Benefits of SIP (Systematic Investment plan)
- Investing small amount.
Open ended Fund – They are highly liquidable in nature, as it allows investors to buy or sell any amount of fund units, except ELSS, which requires 3 years lock-in period (as it holds tax exemption benefits).
Closed-Ended Fund – The fund has no liquidity during the performance period. The only way to redeem is to trade on the stock exchange. The price of the mutual fund units fluctuates depending on the supply and demand.
Open ended Fund – These funds come with multiple options for investing. Systematic investment plans (SIP) and lumpsum. Sametime allows the investor to purchase the units for ‘n’ number of periods.
Closed Ended Fund – The only way to invest in these types of funds is Lumpsum, and that too during the NFO period.
Fund Performance Track Record:
Open ended Fund – These funds have a past performance record that is shared by the AMC, and other detail like portfolio, expense ratio, and fund manager details in the track record sheet. You can avail of these details in the AMC website portal.
Closed Ended Mutual Fund – There is no track record available in these funds, as you can only buy during the NFO
Benefits of SIP:
Open ended Fund – As these funds come with multiple investment options, investors can benefit from the rupee cost average or a Systematic investment plan (SIP). This helps investors to reap decent returns in a long term.
Closed Ended Fund – There is only one investment option (lumpsum), and investors can only invest once in these funds. So, investors can’t avail any benefits of SIP.
Investing Small Amount:
Open ended Fund – There are many funds available in India that investors can start with Rs. 100 per month. So, it’s easy to start investing in these funds with a small amount.
Closed Ended Fund – Investing in these funds starts with a minimum of Rs. 5000. So, investors looking for a smaller amount will be excluded from these mutual funds.
Open ended Fund – The returns of these funds are calculated using both CAGR (Compound Annual Growth Rate) and XIRR (Extended Internal Rate of Return).
Closed Ended Fund – The returns are calculated using CAGR, as the investment is one time.
Advantages of Close Ended Mutual Funds:
Stability – The closed-ended funds hold a stable asset base, i.e., stable asset valuations. Since there is no redemption or investments further, the NFO period is closed, and the fund manager and the investor never get weird about the stability in assets the fund holds.
Tradable in Stock Market – Despite being illiquid, investors can trade these funds in open stock exchanges. It has both advantages and disadvantages as the NAV depends on supply and demand in the market. It can sometimes provide investors with great returns.
Freedom from a large flow of Funds: Generally, open-ended mutual funds will see a huge inwards and outwards of funds. Huge redemption on the portfolio makes fund managers make void decisions, and it might lead to collateral damage. This situation can be avoided with these funds.
Disadvantages of Closed Ended Mutual Funds:
Poor Performance – Close-ended schemes have not performed as well as open-ended peers across different time horizons. Closed-ended funds have lock-in periods to give fund managers flexibility in allocation but haven’t been able to increase returns much because of the lock-in period. Another reason is these funds are actively managed and are associated with a high expense ratio.
Only Lumpsum Investment – Since these funds are associated with lumpsum investments, and lock-in period is estimated to be 3-5 years. Lumpsum investments are risky, and they might return negative in some cases. SIP is the solution to average the investment, and lumpsum can benefit investors if the fund is held for a longer period.
No Track Record: Investing in such funds is one-time, and that is at the time of inception by lumpsum mode. So, investors can’t redeem it till the maturity period. So, no performance track record is available for these funds, and it’s a big disadvantage for investors to track performance with the NAV.
The Portfolio is highly Fund Manager Driven: Since the fund manager completely manages the fund portfolio, investors don’t know about the portfolios and the asset allocation. So, the complete fund performance is relaid on the fund manager.
Who Should Invest in Close-ended Funds?
Investors with long-term investment plans who do not need the invested money during the lock-in period should invest these close-ended funds. Investors cannot make spontaneous decisions in times of unstable market conditions because the fund has a lock-in condition.
By locking in investments until maturity, investors can guarantee sufficient capital gains if they hold long term, as the 35 years SENSEX has produced 12% CAGR amidst various market falls.
As a way to diversify a portfolio, close-ended mutual funds are also an option for investors since they come with unique investment and management characteristics.