Explained: Difference between open and close-ended mutual funds

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Mutual funds are classified according to their structure, i.e. whether they are open-ended or close-ended. The distinction between the two types of funds is flexibility and the simplicity with which fund units may be sold and purchased. Let’s take a look at what is the difference between open-ended and close-ended funds:

What are close-ended mutual funds?

A close-ended fund is an equity or debt fund launched with a fixed number of units by the mutual fund houses. Investors cannot purchase or redeem units of a close-ended fund once the NFO (New Fund Offer) ends.

These funds are raised through an NFO and then traded on the market like stocks, with a specified maturity period. While the fund’s net asset value defines its true price, the traded price can vary based on the demand and supply of units.  In simple words, the trading is done on the stock exchange, where with the help of the broker, investors can buy and sell units similarly as if someone transacts the shares of the company on stock exchange.

In simple terms, a close-ended fund “closes” after the initial launch period and continues to operate until maturity. This gives the fund manager additional discretion in pursuing the fund’s investment objectives.

Advantages of close-ended mutual funds

Since investors cannot redeem their units before the maturity date in a close-ended fund, the fund managers have a fixed asset base to work with. They are less worried about liquidity preservation because there are no redemptions. As with equity shares, close-ended schemes units are traded on the stock exchange at prices established by the scheme’s demand and supply. Thus, if demand for a particular close-ended scheme increases and supply stays limited, the units can trade significantly above the scheme’s NAV.

Disadvantages of close-ended mutual funds

The fund manager of a close-ended fund is well placed on developing investment strategies that will assist him in meeting the scheme’s investment objectives. However, when close-ended funds’ performance is compared to open-ended funds’ performance in the past, it does not appear to indicate higher returns. Due to the fact that you can only purchase units in a close-ended plan during its first launch period, you must make a lump sum investment. This adds to the risk. Additionally, many investors prefer investing through a systematic investment plan (SIP) because it is cost-effective and spreads risk.

What are open-ended mutual funds?

It is safe to assume that when individuals refer to mutual funds, they refer to open-ended funds. Unlike close-ended funds, open-ended funds’ units are not traded on a stock market. Additionally, the fund is not restricted in terms of the number of units it may issue. Investors can purchase or redeem units from the fund house at the scheme’s current NAV on any working day. The NAV is determined by the fund’s underlying securities’ performance. These schemes have no maturity date.

Advantages of open-ended mutual funds

As an investor, you may redeem your open-ended fund units on any business day. This provides the crucial liquidity component to your investment strategy. While numerous investment options offer attractive returns, many of them include a lock-in term as well. You can benefit from optimum liquidity with open-ended mutual funds. Since investors can purchase or redeem units in an open-ended fund directly from the fund house, good research at the fund’s past performance might provide insight into how it has been done during various market cycles. This enables you to make an informed choice and invest in accordance with your strategy.

Disadvantages of open-ended mutual funds

An open-ended mutual fund’s NAV changes in response to the performance of its underlying securities. As a result, open-ended funds are subject to market risk and are volatile. While the fund manager makes an effort to mitigate volatility through diversification, these funds always carry some degree of market risk.