What Is the Difference Between Open and Closed-Ended Funds?

Are you tired of analysing when the right time to enter the stock market is? Mutual funds are the best investment option for you. Since professionals manage your funds, it eliminates the need for you to do any guesswork. So, you can sit back and watch your money grow. 

But before you go ahead and type buy mutual funds online on your web browser, you must understand the different categories of funds available for you to invest in. Based on their structures, there are two types of funds:

1. Open-ended mutual funds 
2. Closed-ended mutual funds

Let us explore how these two categories of funds work. We will also list the pros and cons to help you understand their differences.

What are open-ended mutual funds?

Open-ended funds are perennially open for investment and redemptions. Generally, investors refer to open-ended funds when talking about mutual funds. These funds do not have any maturity period or have any maximum limit on investments they can collect from the public. You can purchase and trade open-ended funds even after the New Fund Offer (NFO) period. Equity-linked savings scheme (ELSS) mutual funds and flexi-cap funds are examples of open-ended funds. 

Note that ELSS mutual funds have a lock-in period of three years where you cannot redeem your investment. However, they are open-ended funds because, after three years, you can keep your investment for an extended period and withdraw whenever you need funds.

The Net Asset Value (NAV) of open-ended funds fluctuates daily depending on the prices of market securities. You can invest in open-ended funds through SIPs and systematic withdrawal plans (SWPs).

Pros

• Liquidity: You get high liquidity as you can redeem your fund units on any working day unless you invest in ELSS mutual funds as they have a lock-in period of three years.
• Flexible trading: You get the flexibility to invest and redeem your funds at your convenience.
• Several investments and withdrawal options: You can invest in open-ended funds through systematic plans – SIP, SWP and STP.
• Tax benefits: You can enjoy tax benefits if you invest in schemes such as ELSS mutual funds.
• Diverse portfolio: You can diversify your portfolio by investing in flexi-cap funds, allowing you to invest in companies with different market caps and sectors.
• Performance tracking: You also get access to past track records of open-ended funds, which you can use to analyse funds' performance and make informed investment decisions.

Cons

• Exit load on premature redemption: If you withdraw your money before a set period (one year in most cases), you will have to pay an exit load.
• Market risks: Open-ended funds are more vulnerable to market risks, and you might lose money due to fluctuating NAV daily.
• Volatile: These funds are vulnerable to large inflows and outflows. If an investor sells a large number of shares at once, the fund manager may have to sell other units to pay the investor. If those units trade at a profit, the fund house distributes the capital gain among investors, and you have to pay tax on it. And if units sell at a loss, all investors bear the loss.

What are closed-ended mutual funds?

Unlike open-ended funds, closed-end mutual funds are equity or debt mutual funds that do not provide trade flexibility in terms of maturity, number of units, and redemption. You can only purchase units of these funds during the NFO period, and they trade in the open market like stocks. Fund houses issue a fixed number of units to investors with a predetermined maturity period, and you cannot redeem your investment before maturity.

Debt mutual funds can have a maturity period as low as one day. They are closed-ended funds because you can only redeem them when they mature after a day.

No new investment is allowed once the NFO period ends, and the fund house lists them on the stock exchange. NAV of closed-ended funds determines their price, but their trade price fluctuates based on supply and demand. At maturity, investors receive their capital at the NAV rate of that day.

Pros

• Better returns: You are more likely to have better returns because you invest your funds for an extended period. 
• Avoid losses: Since you cannot redeem your investment before maturity, you reduce the risk of loss due to bad investment decisions.
• Trade at market price: Since these funds trade on the stock exchange, you get an opportunity to sell them at their real-time prices.
• Easier to manage: Closed-end funds are also easier to manage for fund managers as they do not have to worry about premature redemptions.
• Accurate asset valuation: Since the funds are locked in, fund managers have a stable asset base which is not subject to fluctuations. It helps them do accurate asset valuation while investing your funds.

Cons

• Lack of performance records: Most fund houses dissolve closed-ended funds at maturity. So, you do not get access to past tracking records to analyse the fund's profitability. 
• Lumpsum investment: You can only make lumpsum investments in these funds. Investments plans such as SIPs are not available. 
• Riskier: The closed-ended funds are riskier than open-ended mutual funds. Because these types of funds trade on the open market, their price depends on demand and supply. So, in an unfavourable market condition, the fund manager might have to sell your units at a loss.

Which fund is best for you?

Whether you should invest in closed-ended or open-ended funds depends on these three factors:

• Financial situation: Do you have funds for investing, and can you bear market risks?
• Financial goal: What do you want to achieve? Save for retirement, an additional income source, or maybe diversify your portfolio.
• Financial literacy: Can you predict your investment's market trends and profitability?

So, if you have a large sum of money lying idle, you can invest it in a close-ended debt mutual funds. You can park your money in any closed-end fund, let it grow and withdraw it at maturity.

Debt mutual funds such as treasury bills, bonds, commercial papers, etc., are ideal for growing your wealth without bearing serious market risk.

In case you are a salaried professional with limited savings. Open-ended funds are a better option for you. You can invest in flexi-cap funds or equity-linked savings schemes through a starting SIP at Rs 500. 

Additionally, if you invest in ELSS mutual funds, you can save up to Rs. 46,800/year in taxes. However, if you want to build a diverse portfolio, can bear the moderate risk and are ok with paying capital gains tax, flexi-cap funds are the best open-ended fund for you.

In conclusion

Now that you understand what closed-ended and open-ended mutual funds offer, you can start making intelligent investment decisions. Since professionals manage both types of funds, you do not have to worry about assessing the market and investing independently. You can even buy these mutual funds online from investment platforms like Tata Capital's Moneyfy app and website.

Moneyfy allows you to invest in a wide range of mutual funds right from your smartphone. Register on the app, complete a simple 3-step KYC process, and select suitable MF schemes through goal-based investment tools. Download today!