Investment advisor are often asked if they would recommend open or close-ended mutual funds. When it comes to investing in a mutual fund, investors often misjudge their investment objective, risks involved, fund’s investment strategy, and more importantly, fail to understand the structural difference between fund types. It’s only human.
Let’s take the case of open-ended and close-ended mutual funds. During the last quarter ending September, mutual fund assets witnessed the sharpest fall since December 2010. As per the figures by the Association of Mutual Funds of India (AMFI), the assets under management (AuM) of open-ended funds outpace that of close-ended funds by a huge margin. While the AuM of close-ended fund (comprising on income, equity, balanced and ELSS –equity categories) was Rs 125,920 crore, that of open-ended fund was a whopping Rs 604,604 crore, as on September 30, 2013.
But that’s where open-ended funds lose advantage over close-ended ones in terms of data. The fact that the former has greater AuM than the latter is not hampering asset management companies’ (AMCs) plans to launch close-ended fund schemes. In fact, the sales of close-ended fund schemes have far outnumbered their open-ended counterparts. Sample this: As per the latest data by AMFI, as much as 114 close-ended fund schemes (all in income category) were sold mopping up Rs 10,299 crore until September this year. On the other hand, open-ended fund schemes had to make do with a tepid sale of just 6 schemes (four in income, and one each in ELSS and fund-of-funds category) and garnering a paltry Rs 290 crore.
In the previous month i.e. August again, sale of close-ended fund schemes (122 schemes in income category amassing Rs 18,861 crore) had surpassed that of open-ended funds (2 schemes in fund-of-funds and overseas categories, amounting to Rs 116 crore.
Same was the trend in July, when sale of close-ended fund schemes (37 in income category mopping up Rs 7,961 crore) had raced past that of open-ended funds (just one scheme in income category garnering Rs 68 crore). In fact, if you see the past 6 months’ data (from April to September), sales of close-ended funds have always outnumbered that of open-ended funds.
Further, when it comes to redemptions of units too, there have been far too less redemptions of close-ended funds compared to open-ended ones over the last six months.
Does it mean open-ended schemes are losing their sheen as investors are showing increasing preference for close-ended schemes?
“Yes but it has to be seen with a perspective,” responds Kripananda Chidambaram, Director, Fintotal Advisory and Consulting that runs a personal finance portal fintotal.com. “The redemptions in open ended schemes are happening in equity related schemes and preference to close ended schemes is at the debt side. More or less it the shift from equity to debt and it is more because of the perception about the current market situation,” he adds.
Let’s first understand the difference between close-ended and open-ended mutual funds. In terms of structure, mutual funds have three types, namely, close ended funds, open-ended funds and interval funds (that are basically a mixture of open-ended and close-ended funds).
The basic premise a close-ended fund works on is that it has a fixed maturity period (say between 5 to 7 years) and is open for subscription for a certain predetermined period of time. That means a fund investor is able to put his money in the scheme only at the time of the fund’s first public offer (FPO). After the FPO closes, the fund investors are given one of the two exit routes — some fund houses either repurchase units or the fund is listed on a stock exchange for trade just like stocks where investors can buy or sell fund units.
Open ended funds, on the other hand, are the most common type of mutual fund available for investment as they give investors convenience to invest or transact. Unlike close ended, open-ended funds are open for subscription anytime unless the AMC decides to close the fund to new investors in order to manage it better. Further, unlike close-ended funds, the value or the NAV of an open-ended fund is decided every day after the stock market closes.
Another key difference is that while open-ended funds’ price is linked to the funds’ NAV, close-ended funds’ price is determined on demand and supply and not on its NAV. Also, units of closed-end funds are not issued and redeemed on a continuous basis, whereas those of open-ended funds can be bought and redeemed on any business day. Further, close-ended mutual fund schemes disclose NAV generally on a weekly basis, whereas open-ended on a daily basis.
The Good Part
There are many benefits associated with investing in open-ended and close-ended funds. Let’s take open-ended funds first. Although the value of investment in open-ended funds fluctuates with stock market movement (in case of equity funds) and interest rate fluctuations (in case of debt funds), investors can redeem units in case of emergency or when funds are not performing well. In this case, exit load will be applicable only if redemption takes place before one year. Afterwards, the exit load will not be applicable and returns are tax free.
There are many benefits of investing in close-ended funds as well. One of the biggest advantages of close-ended funds is that it gives ample time and flexibility to the fund manager to design an investment strategy accordingly and not worry about any liquidity to be maintained for honoring redemption requests of investors.
As Hiren Dhakan, Associate Fund Manager, Bonanza Portfolio says, “In case of equity close-ended funds, the fund manager knows that the fixed sum of money would stay with the fund for a particular time period and would not be redeemed before that in any case.”
Further, he adds, “In the case of , close-ended debt funds like fixed maturity plan or FMPs, the fund manager carefully chooses debt instruments with equal or lesser maturity than that of the fund and holds all securities till maturity; thus eradicating any interest rate risk in the fund. This may or may not be possible with open-ended debt funds.”
FMPs that invest in debentures, government securities, bonds and other short term fixed return instruments that have fixed maturity tenure such as 3 months, 6 months or 12 months, have another advantage.
“Investors can avail the benefit of these funds [FMPs] by investing in regular intervals. For example, quarterly payment of children school fees can be invested in 3 month maturity plan which will earn a decent return for the quarter and also one can plan payments much in advance,” advises Rashmi Roddam, Director, WealthRays group.
Further, close-ended funds also provide opportunity to diversify risk as an investment strategy from taxation point of view, adds Roddam. For instance, FMPs being closed-ended are useful for investors in higher tax-bracket and also provides indexation benefits, which are deprived of in open-ended funds.
Moreover, close-ended debt funds such as FMPs carry lesser risk than open-ended debt funds. “Close ended funds like FMPs give an indicative return which makes it more attractive to conservative investors but due to its basic feature of being close ended, investor will not be able to invest at any point in time or redeem these funds. In case of emergency one can exit it by paying steep exit load before maturity,” says Roddam.
…And The Bad
Notwithstanding the benefits, there are many risk factors a fund investor should be cautious about while investing in a close ended as well as open-ended mutual funds, advise investors.
For instance, open-ended funds have a higher operating cost than close-ended funds. “Due to high portfolio turnover ratio and high expense ratio in open-ended funds, operating cost of these funds are higher as compared to close-ended funds. Since there would be redemptions in open-ended funds, brokerage costs, STT that are charged on sale of shares has to be incurred by these funds,” says Roddam of WealthRays group.
Since open-ended fund managers churn their portfolio frequently to give good returns from their funds by entry and exit in stocks regularly, it requires expertise and professional management to make an ideal portfolio which comes at a higher cost.
Adds Raajeev Chawla, Certified Financial Planner, Fundmitra.com, “Most of the open-ended funds are active funds while closed ended funds are passive funds. Portfolio Turnover Ratio of open ended funds is usually more than similar closed ended funds thus resulting in higher operating cost of open ended funds.”
Further, inflexibility that is one of the advantages of close-ended funds also turns out to be its one of the biggest disadvantages. “Even when you know that the fund is not performing from the very beginning, you cannot redeem from such funds. This can be very detrimental to your portfolio in cases when the fund's tenure is long say 5 or more years,” says Dhakan of Bonanza Portfolio.
Another disadvantage of close-ended funds is that one cannot redeem in case of emergency even by paying any load/penalty fees.
“Yes the funds are listed on exchanges for liquidity but one can sell only when there is a ready buyer on the exchange at that point. Even if there is a ready buyer, due to low liquidity, the buyer may demand the security at much lower price than what you expect,” Dhakan adds.
Overall, investing in a closed-end fund is a riskier proposition for a novice investor than an open-ended fund, experts add.
“For a beginner, it is advisable to opt for an open-ended fund due to lock-in period in close-ended funds. Though these funds may be listed on the exchange, value completely depends on the price that gets traded than on its real value. These funds may trade at premium to NAV or at a discount. When it comes to open-ended funds, an investor can also take SIP route where investments would go in installments than at once which is mandatory as in the case of close ended funds,” adds Roddam of WealthRays group.
However, she adds, “Though open-ended funds looks safer to close-ended funds, returns on close-ended funds are much better as fund will be invested for a longer time period with less of shuffling in the portfolio that reduces cost and investor also receives dividends at regular intervals. However, some open-ended funds may be risky depending on the portfolio in which investments are made by fund managers. It is good to take advice of an expert before investing in open ended or closed ended funds.”
What To Look For
There are many factors a fund investor should be cautious about while investing in open-ended or closed ended mutual funds. For instance, an investor must look at his time horizon, investment objective, investment strategy and the risks involved. Not to forget the recently introduced color code by AMFI to indicate the type of fund and the level of risk the fund has.
As Chawla of Fundmitra.com says, “A person who may need the money any time should choose open ended funds instead of closed ended funds. [Similarly] a fund which has a unique strategy and investment objective, which suits the investor and which needs the investor to stay for a stipulated time may be preferred by the investor instead of an open ended fund.”
Further, he adds, “A closed-ended debt fund (such as an FMP) has lesser risk than an open-ended debt fund. Thus an investor who does not want to take any market risk may opt for a close-ended fund than an open-ended one.”
Experts also add that when it comes to close-ended debt funds investors need to be fairly sure with the current interest rate before investing in them. As Chidambaram of Fintotal Advisory says, “closed-ended debt funds is appropriate only when the current market interest scenario is at a peak, you then end up locking your funds at higher rate.”