Types of Mutual Funds: Open-Ended vs. Closed-Ended Funds

A person is preparing for an entrance exam. He wishes to purchase a book for his exam preparation but has no prior knowledge of the subjects and the syllabus. In this case, what would happen if he chooses the wrong book to prepare for an important exam? 

He could get a very bad score or worse; he might end up failing that exam and could lose a year. And all this will be because of the wrong choice he made. On the other hand, if he gets to know about his exact syllabus and course in advance and picks up the right book, he will have a chance of getting positive results in the same exam.

The same thing can happen with new investors wanting to invest in mutual funds if one does not have any prior knowledge of the structure, rules and regulations, and types of mutual funds. 

In order to achieve positive results from their mutual fund investment, it is important for an investor to understand the industry and have prior knowledge of what all it has to offer, in order to make the best possible investment choice. Indian mutual funds are categorized into various types on the basis of their structure, investments objectives, asset class, speciality and other such factors.

So, first, let's walk you through the types of mutual funds based on their structure.

Structure-Based Mutual Funds

The structure of a fund defines the flexibility and ease of investments and redemptions of the fund. Following are the two most popular structure-based mutual funds:

Open-Ended Funds

As the name suggests, open-ended mutual funds is a scheme that allows investors to buy or sell their fund at any time as per their convenience at the Net Asset Value (NAV) of their funds.

This scheme does not have any specific number of units that can be traded. It doesn't have any maturity period for the funds. Investors directly contact the mutual fund company to buy and sell their funds. The majority of the funds (approx 59%) in the markets are open-ended funds. 

In open-ended funds, when the AMC's (Asset Management Company) requirements of the funds are fulfilled, it can stop taking new investments at any time. 

Due to the continuous investments and redemptions in the mutual funds and change in the underlying securities values, the AUM (Asset Under Management) keeps changing.

Continuous investments and redemption are always the concern of fund managers of open-ended funds, which is why fund managers always keep cash reserves with them. This is also why open-ended funds are more investment-friendly because they offer any time investments and redemptions.     

SIP(Systematic Investment Plan), STP(Systematic Transfer Plan), and SWP(Systematic Withdrawal Plan) plans are also available in the open-ended funds, which makes it more valuable.

Closed-Ended Funds

The 'Close' in closed-ended funds indicates that there are some rules and restrictions in the closed-ended funds. These funds have a maturity period of 3 years, 5 years, 7 years, etc. and investors can only invest during the launch period of a new fund offer called the NFO(New Fund Offer).

Any new investment is not possible after the closure of the NFO, and redemption is not possible in the middle of the period. Investors can make a redemption once the maturity period is over, and that is the reason why outstanding units fund always remain the same. 

The AUM can purely go up and down due to the change in the value of underlying securities. A fixed AUM offer provides flexibility to the fund manager. 

Redemption of the fund is not possible for the investor of the closed-ended fund because of the maturity of the fund. However, to provide some liquidity to their investors, close-ended fund managers list their funds on the stock exchange where those funds can be traded like other stocks in the market which depends on the demand and supply of the funds. All those units may be traded at a higher price or at a discount. 

A long period of time keeps the investors to stay invested in the closed-ended funds, and the expense ratio can be 0-2.5% of AUM. 

Difference Between Open-Ended and Closed-Ended Funds

Following are some of the key differences between open-ended and closed-ended mutual funds:

Final Thoughts

Suppose an investor wishes to invest his money and has a trading mindset. In that case, they can invest in the open-ended fund, which allows investors to buy and sell their funds at any time of period and also have SIP, STP, and SWP plans as per the investor's convenience. 

However, if an investor wishes to invest his money for a longer time period, then the closed-ended fund might be a better choice as closed-ended funds accept investments in the time of NFO and allow the investors to make redemption at the maturity period which keeps the investors stay invested in the funds for a longer time. An investor must know the classification of mutual funds in order to make wise decisions in creating a healthy investment portfolio that can meet your monetary goals.

It is important for an investor to analyze all possible choices present in order to arrive at the right decision. At the same time, it is also crucial to be clear on what you demand from your investment and hence, be clear on your requirements as an investor.