What Are Close Ended Mutual Funds - Types and Advantages (2024)

Among the various types of mutual funds, close-ended mutual funds present a unique investment structure that distinguishes them from their open-ended counterparts. Understanding the characteristics and functionalities of close-ended mutual funds is crucial for investors. This article aims to provide details about close-ended mutual funds, shedding light on their features, benefits, and considerations for potential investors.

What are closed-ended funds?

A close-ended mutual fund is an equity or debt fund which is initiated with a predetermined number of units issued by the fund house upon its launch. Following the conclusion of the new fund offer (NFO) window, the purchase or redemption of units in a close-ended fund becomes unfeasible for investors. These funds are introduced through an NFO and subsequently enter the market for trading, like stocks, featuring a fixed tenure of maturity. While the net asset value (NAV) dictates the true value of the fund, the trading price can fluctuate either above or below this benchmark, contingent on the interplay between unit supply and demand. In simpler terms, a close-ended fund 'closes' its investment phase post-launch, remaining sealed until its maturity date. This puts a higher level of flexibility in the fund manager’s hands to actively pursue the predefined investment objectives of the fund.

How do close-ended funds work?

Once the asset management company initiates a new fund offer, investors secure units of this scheme at a designated price. As the NFO period concludes, new investors are barred from joining the scheme, and invested investors are unable to exit prior to the scheme's maturity. Upon reaching maturity, the scheme is dissolved, and the invested funds are transferred to investors at the prevalent net asset value on the specified date. However, should any investor wish to exit before the maturity period concludes, they can opt to trade the units on the secondary markets.

A closed-end mutual fund's inception often involves an initial public offering to generate capital for the fund. Contributors to the mutual fund receive units in exchange for their financial input. These units are subsequently listed on the secondary market, where trading takes place in accordance with supply and demand. Like its name, a closed-end mutual fund refrains from issuing new units or buying back existing ones. Units of a closed-end fund are introduced just once. The only way to participate in this fund later is through the acquisition of existing units available in the open market.

Features of close-ended mutual funds

• Close-ended mutual funds lack liquidity during the lock-in period, limiting redemption options until this period concludes.

• Investment opportunities in close-ended schemes are restricted to the new fund offer (NFO) phase, eliminating prior track records. Additionally, Systematic Investment Plans (SIPs) are not applicable.

• Averaging facilities are unavailable once the NFO period ends, as investment opportunities cease.

Types of investments in close-ended funds

There are primarily two key types of investments within closed-end funds:

1. Bond Closed-End Funds: The predominant composition of assets in closed-end funds comprises bond funds. Inherent in all closed-end bond funds are market risk and credit risk. Market risk involves the potential impact of increasing interest rates, which could lead to a decrease in the value of the fund's bond holdings. Typically, market risk results in greater fluctuations in the net asset value (NAV) when the remaining maturity of a portfolio security is longer.
2. Equity Closed-End Funds: The vulnerability of seeing a decline in their NAV and market price is a shared risk among all equity closed-end funds. Factors such as the operational and financial health of the stock's issuer, market dynamics affecting the issuer's industry, or the overall state of the stock market can influence the value of a specific stock within a fund's portfolio.

Advantages of close-ended funds

• Potential for capital appreciation:The share price of a closed ended mutual fund may appreciate over time, just like the price of a stock. This can provide investors with the potential for capital gains.
• Ease of access:Closed ended mutual funds are traded on the stock exchange, so they are highly accessible. This means that investors can easily buy and sell shares of the fund on the stock exchange.
• Stability: Closed-ended funds grant fund managers a stable asset base since investors can't redeem units prematurely. The absence of constant redemptions eliminates liquidity concerns, enabling strategic planning aligned with investment objectives.
• Market price dynamics: Like equity shares, closed-ended fund units are traded on stock exchanges, their prices shaped by supply and demand. High demand and low supply can drive unit prices significantly above the scheme's nav.

Disadvantages of close-ended funds

• Limited flexibility:Closed ended mutual funds are not as flexible as open ended mutual funds. Investors cannot redeem their shares from the fund at any time. They can only sell their units on the stock exchange.
• Highly driven by fund manager’s decisions: Investors often look at a mutual fund's performance over multiple market cycles to assess whether it is a good investment. The financial data for open-ended funds are updated half-yearly, and NAV is updated daily.
• Historical performance concerns: Past performance of closed-ended funds has not consistently demonstrated superior returns compared to open-ended schemes, despite fund managers' strategic flexibility.
• Limited lump sum investment: Closed-ended schemes only allow lump sum investments during the launch phase, increasing risk. Investors favour the affordability and risk spread of systematic investment plans (SIPs).

Who should invest in a Closed Ended Mutual Fund?

1. Long-Term Investors: Closed-ended funds are suitable for long-term investors who can commit their funds for this duration without needing liquidity.
2. Goal-Oriented: Investors with specific financial goals, like saving for a child's education or creating a retirement corpus, can use closed-ended funds to match the fund's maturity with the target date.
3. Risk Tolerance: These funds may invest in a variety of assets, including equities, which can introduce risk. Investors should have an appropriate risk tolerance and an understanding of market volatility.
4. Patience: Since these funds don't allow redemptions before maturity, investors must be patient and prepared to stay invested throughout the fund's tenure.
5. Averseness to Frequent Changes: Investors in closed-ended funds should be comfortable with the fund manager's strategy and avoid frequently changing their investment portfolio.

Key differences between open-ended and close-ended funds