There could be many ways of categorizing a mutual fund, the most basic of which is based on whether a fund is “open-ended” or “closed-ended”. The main difference in these two kinds of funds lies in how units are being created and redeemed.
It is important to keep this difference in mind or else your investments could easily end up as a square peg in a round hole. It is better to catch surprises in the beginning than to let surprises catch you in the end.
Johnny: It seems surprises and mutual funds are made for each other. But let’s keep no room for hide and seek. Tell me, what is an open-ended mutual fund scheme?
Jinny: Mutual fund schemes, based upon the date of their maturity, come in two varieties: open-ended and closed-ended. An open-ended scheme is one in which the tenure of the scheme is not fixed and the inflows and outflows of money are a constant feature.
You can say that an open-ended scheme always keeps its doors open for investors. There is no limit on the number of units that can be issued. New investors can join the scheme any time while old ones can redeem their investments directly with the mutual fund.
Illustration: Jayachandran / Mint
A successful open-ended scheme continues to attract a large number of new investors. The funds declare the net asset value (NAV) of open-ended schemes on a daily basis. Any new investment in the scheme is at the prevailing NAV; however, any redemption might fetch you a price slightly lower than the NAV, depending on the applicable “exit load”. This difference between the rates of buying and selling illustrates some of the costs involved in keeping money rotating.
Even considering this, the convenience of making and liquidating your investments at your chosen time makes open-ended schemes popular among investors.
Johnny: Well, I don’t want to jump to any conclusion. Tell me about closed-ended schemes also so that I can make some comparison.
Jinny: Closed-ended schemes are offered to new investors only for a limited period of time at the beginning of the scheme, and once the period of subscription is over, no new investor can directly purchase the units from the mutual fund.
Closed-ended schemes have a fixed period of maturity before which an investor can’t directly redeem his investments with the mutual fund. However, much like stocks of a company or exchange-traded funds, units of a closed-ended scheme are listed on a stock exchange where all secondary trading takes place. So it’s possible for an existing investor to sell his existing units to a new investor.
But trading of mutual funds through a stock exchange is not as inviting as trading stocks. There is no way of ensuring that units would trade at their NAV. You might end up paying a higher price than the current NAV while purchasing or get a lower price than the current NAV while selling. You are at the mercy of demand and supply. Due to this, many closed-ended schemes were not listed at all on stock exchanges. Instead closed-ended schemes used to provide a facility of redemption to existing unit holders at fixed intervals.
The listing of closed-ended schemes has now been made compulsory by the Securities and Exchange Board of India while, abolishing the practice of direct redemption with the mutual fund. Now it seems closed-ended schemes must learn to make better use of stock exchanges if they wish to flourish.
Johnny: I think there is scope for both kinds of schemes to flourish side by side. Tell me about the hidden virtues and drawbacks of both types of schemes.
Jinny: Well, there are certainly many things we could talk about but I just wanted to highlight one important point. Behind every open-ended scheme you would find a drawback which in fact becomes a virtue when it comes to closed-ended schemes. The easy availability of liquidity in open-ended schemes comes with a hidden cost. The fund managers of open-ended schemes have to keep a part of the money idle for meeting day-to-day redemptions, which means that they can’t fully invest the entire money available for investments. In a similar manner, open-ended schemes might fail to make the optimum use of available money to take care of frequent redemptions.
In this respect, closed-ended schemes have an edge. Their fund managers can deploy every bit of money in return-generating investments without being worried about day-to-day redemptions. Moreover, the fixed time horizon of closed-ended schemes provides a clear focus. You have the flexibility of choosing the investments that suit your time horizon.
The best of results are often generated when you can focus on the long term without being worried about the short term.
Johnny: Now it seems I have gained a better insight. Open-ended schemes are always in season, whereas, closed-ended schemes keep reappearing in different seasons.
What:Mutual fund schemes could be classified into open-ended and closed-ended types depending on the period of their maturity.
How: Open-ended schemes can be purchased and sold directly with the fund company, whereas, closed-ended schemes can be purchased and sold through trading at stock exchanges.
Why: Open-ended schemes are more popular among investors due to ease and convenience of direct redemption with the fund company.