Understanding open ended funds versus close ended funds
Mutual funds in India are classified on a variety of parameters. One of the parameters is the nature of the fund. Broadly, there are two types of funds viz. open-ended funds and closed-ended funds. Let us look at the key difference between open-ended and close-ended mutual fund in India. Let us also explore which is better; open ended or closed ended mutual fund. How do you decide whether a fund is open ended or closed ended? Interestingly, while both collect monies from investors and then invest them in the market, there are some basic differences which need to understood to grasp the basic crux of the issue! Here is how to go about comparing closed ended funds and open ended funds.
Corpus of the fund
In terms of the corpus of the fund, once the closed ended fund collects the monies from the public via the new fund offering (NFO) then that is the corpus of the fund. There is no scope for any subsequent addition or reduction to the closed ended fund. The original corpus remains the same in case of closed ended funds although the value of the fund does appreciate with the appreciation in asset prices. On the other hand, open ended funds are open for fresh subscription and for redemption round the year. When an open ended fund comes with an NFO, then it gives a time lag of a few days after the closure of the NFO and then the actual buying and selling in the fund begins. The open ended fund will announce the NAV of the fund each day evening on market days and that will be the basis for the buying and selling of the open ended fund on the next day. The corpus of the open-ended fund keeps changing on a daily basis depending on the extent of net accretion or net depletion to the fund.
How they compare on liquidity?
In terms of liquidity, obviously, the open ended funds will score higher. On any day you can go over to the fund and apply for a fresh application or redemption. In case of open ended equity funds, when you apply for redemption of your fund then sale proceeds are credited to your account on T+2 day. In case of debt funds and liquid funds, the credit is sooner than that. Closed ended funds are not liquid in the sense that they do not offer any-time fresh applications and redemptions on these funds. However, as per SEBI regulations closed funds have to be mandatorily listed and hence you can always sell and buy these closed ended funds from the secondary market. However, there is a caveat here. Closed ended funds typically quote at a discount to the NAV of the fund and that is the loss that you will have to absorb when you redeem your closed ended funds in the secondary market.
Fund managers can take a longer term view on closed ended funds
One of the big advantages of closed ended funds is that fund managers do not have to worry about redemption pressure and hence the entire corpus can be invested in return generating assets. In case of open ended funds, it is essential for the fund manager to maintain liquidity and these assets typically earn sub-optimal returns. That depresses the returns of the fund. The problem can get quite acute when there is redemption pressure in times of market sell-off. In this case, the open ended funds can also see redemption pressure and may be forced to undertake a distress sale of some of their equity holdings.
Which funds are suited to different circumstances?
Open ended funds are ideally suited for normal equity funds, debt funds and also for liquid funds. You need the benefit of easy entry and exit into these funds, which is the factor that makes mutual funds as an asset class valuable. Also, these open ended funds largely reduce the liquidity risk of mutual funds and that is the key to mutual funds. Closed ended funds are not suited to liquid funds and to equity funds since exit is critical in both these cases. However, closed ended funds do make a lot of sense in case of certain category of debt funds. A classic example is the Fixed Maturity Plans (FMP) where the fund is necessarily locked in for a fixed period of 1 year to 3 years. In such cases a closed ended fund helps to reduce the interest rate risk by creating a portfolio of bonds that has a maturity that is sync with the term of the FMP. In such cases, closed ended funds make a lot of sense!
The open ended fund is the preferred choice if you are in equity fund investor, especially via the SIP route. The only area where closed ended funds are meaningful is in case of FMPs of debt funds and for long term solution-oriented plans.