November 7, 2009
Close and Open Ended Mutual Funds
A close ended mutual fund has a limited number of units or shares. The investment company normally does not issue new shares under a close ended scheme after the initial subscription offer is closed. On the other hand, the units or shares of open ended mutual fund schemes can be issued at any time.
Typically there are five distinguishing features between the two.
- Close ended funds close after the initial subscription while open ended funds can be bought at any time.
- Close ended funds are not redeemed by the investment company but traded on stock exchanges
- Close ended funds can be traded on stack exchanges at any time of the day but open ended funds can be traded in only at the day’s closing price.
- The mutual fund company pays out the value of the units or shares on a predetermined date regardless of its value.
- Close ended funds carry a premium or discount but open ended funds are redeemed at a net asset value less an exit load, if any.
Close ended schemes are more prevalent in developed markets and may not be the right choice in markets that have still not put up proper rules and regulations governing mutual funds and stock exchanges.
Close ended funds do not have a prior history and investors have no way of evaluating the fund. Another disadvantage of a close ended fund is that it cannot raise fresh funds for investing in a bull market since fresh subscriptions are not allowed.
Close ended funds have limited liquidity. Once invested, you can withdraw from the fund only according to the conditions laid out in the prospectus or sell them at market price, which may be at a premium or a discount to the actual value of the fund. There may also be times when there is no buyer in the market or the fund may not be listed on the stock exchange. There are no such hassles with open ended funds and the mutual fund company must necessarily accept a redemption request at any time.
However, the portfolio manager of a close ended fund has a distinct advantage. Open ended fund managers have to ensure that adequate funds are always available in cash to meet redemption requests. Open ended funds may experience huge inflows in a rising market but once the markets start descending there may be an unusual redemption pressure. Selling investments in a falling market may result in booking unacceptable losses. The close ended fund manager has no such compulsions and can freely invest the entire corpus of the fund. This allows the fund manager to take profitable long term investment decisions.
On the flip side, there may be a case that the tenure of a close ended fund ends during a typical bear market resulting in loss to investors. There have been instances where close ended funds have been converted to open ended funds at the end of the tenure. While the fund may want to extend the tenure it may not suit investors who have planned another investment based on the redemption date.