Very often, mutual fund investors consider both closed-end and open-end mutual funds to be similar, since both pool money from investors and invest them in various securities. However, there are substantial differences between these two types of mutual funds.
At CreditMantri, we help you make smart financial decisions. Here, in this guide, we explain the differences between closed-end and open-end mutual funds, analysing their advantages and disadvantages, so that you can pick the right one that best suits your financial goals.
What are open-end mutual funds?
Generally, when we refer to mutual funds, we refer to open-end funds. These funds pool money from investors to purchase equities, debts and other securities, based on the fund type.
Here are a few critical features of open-end mutual funds:
Open-end funds are not traded in the open market.
There is no limit on the number of units that can be issued in an open-end fund.
The NAV (Net Asset Value) of the fund changes every day based on market fluctuations and the bond price of the fund.
Open-end funds are sold/purchased on-demand at their NAV. The NAV value of the fund is calculated at the end of a trading day.
Open-end funds do not have a fixed maturity tenure, and investors can redeem/buy units as and when required. Investors purchase units directly from the fund.
Pros of Open-End Funds
One major complaint of investors is that long-term investments like PPF, NPS do not offer liquidity. The funds are locked-in for a specific period. You cannot withdraw these funds for emergencies.
The significant advantage of open-end funds is that they offer high liquidity to investors. Investors can redeem units at prevailing NAV values, as per their financial requirements and convenience.
Performance Record of the Fund is Available
When it comes to closed-end funds, investors cannot review the performance of the fund during various market cycles, as it is unavailable. On the other hand, open-end funds provide a performance track record that has the historical performance of the fund. You can use this record to make an informed investment decision.
Systematic Investment is Possible
Closed-end funds require investors to invest a bulk sum in one go. Besides being risky, this approach is not suitable for all categories of investors.
On the other hand, open-end funds offer the flexibility to invest in small amounts using SIP (Systematic Investment Plans). This approach is ideal for salaried individuals who cannot spend a lump sum in one-go.
Cons of Open-End Funds
Prone to Market Risks
Even though fund managers monitor the fund at all times and maintain a diversified portfolio, open-end funds are subject to market risks. The NAV of the fund fluctuates based on the market conditions.
Investors cannot decide the Asset Composition
In an open-end fund, asset allocation is at the discretion of the fund manager. The fund manager takes all investment decisions based on market conditions and his/her experience. As a result, investors cannot decide which assets to invest in.
Now that we have seen the advantages and disadvantages of open and closed-end funds, let's take a look at the other category of mutual funds: closed-end mutual funds.
What are closed-end mutual funds?
Closed-end mutual funds are similar in structure to ETFs (Exchange Traded Funds). They have a fixed number of units that are traded on the stock market. Just like stocks, closed-end funds are issued via NFOs (New Fund Offers) and then traded in the open exchange.
Here are a few critical features of closed-end mutual funds:
The actual price of the fund depends on the supply and demand, and not on the actual NAV. Hence, a fund can trade at prices above or below the real NAV value. It's common for closed-end funds to trade at discounts or premiums to the actual NAV.
Brokers purchase and sell units of closed-end funds in the stock market.
Unlike an open-end fund, closed-end mutual funds have a predetermined maturity period.
Pros of Closed-End Funds
In closed-end funds, investors can withdraw their funds only on specific dates. Hence, fund managers have the freedom to choose stable assets without worrying about liquidity. As a result, the fund manager can formulate a robust investment strategy that has the potential to offer higher returns. Since fund managers are not worried about cash inflows and outflows, they can achieve the fund objectives holistically.
Investors can buy/Sell Units at Market Prices
Closed-end funds trade on the stock market, just like shares. Hence, investors can purchase/redeem units of the fund at prevailing market prices, which can be either above or below the fund’s NAV. Also, investors can make use of various trading strategies like margin trading and market/limit orders to make smart investment decisions.
Additional Reading: 6 Best Risk-free Investments in India to Grow your Wealth
Cons of Closed-End Funds
Comparatively Poor Performance
When compared with open-end funds, closed-end funds have not performed well historically, for all investment horizons. Even though fund managers enjoy higher flexibility in closed-end funds, they have not been able to generate higher returns.
Closed-end funds require investors to invest a lump sum. This is a risky approach, as it exposes a large amount of funds to market risks in one go. Also, investing a lump sum amount in one go is not possible for salaried individuals.
Not possible to Review the Performance of the Fund
When it comes to open-end funds, investors can review the historical performance of the fund and make an informed investment decision. With closed-end funds, it is not possible due to the unavailability of the track record. Hence, most investors have to blindly trust the fund manager and the fund house to make an investment decision.
Differences between Open-end and Closed-end Mutual Funds at a Glance
|Open-End Mutual Funds||Closed-End Mutual Funds|
|Not traded in the open market||Traded via brokers in the open market|
|No fixed maturity period||Has a pre-determined maturity period|
|Units are sold/purchased at the NAV value||Units are sold/purchased at discounts to the NAV value|
|High liquidity||Limited liquidity|
|Investments can be done as SIPs||Investments are done in the form of lumpsum amounts|
Which is the better fund option? Closed-end or Open-end?
It's not possible to state whether one fund category is superior to the other. The performance of a fund – irrespective of whether it is closed-end or open-end – depends on several factors like fund category, investment style, and fund management.
It all depends on the scenario. For instance, when open-end funds perform well, certain investors redeem their units quickly to enjoy short-term profits. This impacts the other investors who remain invested in the fund. In such cases, closed-end funds are the better option as the mandatory lock-in period prevents early redemptions.
On the other hand, open-end funds are ideal for beginner mutual fund investors who do not have sufficient knowledge of the market. Since professionals manage these funds, they can enjoy annualised returns in the range of 12 to 15%, just by staying invested in the fund.
As you can see, it depends on several factors like investment objectives, investment horizon, and investor knowledge. Make sure to analyse these funds based on your requirements and choose the right fund, regardless of whether it is open-end or closed-end.