Mutual funds are classified into different categories to cater to the diverse goals of investors. One such category is the organisational structure of the fund.
Mutual funds are classified into different categories to cater to the diverse goals of investors.
Considering the organisation structure of mutual funds, the Association of Mutual Funds in India (AMFI) classifies the funds into three types:
- Open-ended funds: Offers flexibility to buy or sell units anytime.
- Close-ended funds: Funds with a fixed number of units available during the initial offering.
- Interval funds: A mix of open-ended and close-ended features, allowing buying or selling at specific intervals.
In this article, we will delve into everything about open-ended mutual funds and understand the pros and cons of opting for open-ended funds.
What are open-ended mutual funds?
Open-ended funds are funds schemes that allow investors to buy or sell fund units anytime, directly from the fund itself.
Usually, when people refer to mutual funds, they mean open-ended mutual funds. Unlike closed-ended funds, the units of open-ended funds are not traded on the stock exchange.
They have the advantage of no restrictions on the number of units the fund can issue, allowing investors. This liquidity makes open-ended mutual funds a popular choice for investors.
How do open-ended mutual funds work?
Open-ended mutual funds are managed by professional fund managers who make investment decisions on behalf of the investors. When investors decide to invest in an open-ended fund, they purchase units or units at the current net asset value (NAV) of the fund. The NAV represents the total value of the fund’s assets divided by the number of outstanding units.
When new investors enter the fund by buying units, the fund issues new units, thereby increasing the number of outstanding units. Similarly, when an investor wishes to exit the fund, they sell their units back to the fund. The fund redeems these units and reduces the number of outstanding units. The buying and selling of units take place at the NAV prevailing at the time of the transaction.
For example, suppose an open-ended mutual fund has an NAV of ₹10, and an investor decides to invest ₹1,000. They will receive 100 units. If the NAV increases to ₹12, the value of the investor’s units will increase to ₹1,200. Conversely, if the NAV decreases to ₹8, the value of the investor’s units will decrease to ₹800.
Advantages
Here is a quick look at some advantages of open-ended mutual funds-
- High Liquidity: Open-ended mutual funds provide high liquidity as investors can redeem their units on any working day. Unlike other investment options that have lock-in periods, open-ended funds allow investors to access their money when needed.
- Performance Across Market Cycles: Since investors can purchase or redeem units at any time, the historical performance of open-ended funds can give insights into how they have performed across different market cycles. This helps investors make informed decisions based on the fund’s track record.
- Flexibility: Investors can choose the amount they wish to invest, making open-ended funds suitable for both small and large investments. Additionally, investors have the flexibility to increase or decrease their investment amounts as per their financial goals.
Additionally, investors have the flexibility to increase or decrease their investment amounts as per their financial goals.
- Systematic Investment Plan (SIP): Open-ended funds offer the flexibility to set up a SIP, allowing investors to invest a fixed amount at regular intervals. This is advantageous for individuals with a regular income or those looking to build an investment corpus gradually.
Disadvantages
Here is a quick look at some disadvantages of open-ended mutual funds-
- Volatility: Open-ended funds are subject to market risks and can be highly volatile. The Net Asset Value (NAV) of these funds fluctuates based on the performance of the underlying securities. Despite efforts by fund managers to diversify investments and manage volatility, there is inherent risk associated with market fluctuations.
- Expense Ratios: Open-ended funds have ongoing expenses, including management fees and administrative costs. These expenses are passed on to investors in the form of expense ratios, which can erode the overall returns.
- Inflows and Withdrawals: Open-ended funds are susceptible to significant inflows and withdrawals, which can impact the fund’s performance. A sudden large-scale redemption can force the fund manager to sell units at unfavourable prices, potentially resulting in losses for all investors in the scheme.
- Cash Flow Risks: Open-ended funds face cash flow risks due to daily changes in the NAV in response to market volatility. Fluctuations in the NAV can affect the value of an investor’s holdings in the fund, introducing potential risks to the overall investment.
Who should invest in open-ended funds?
Open-ended mutual funds are suitable for a wide range of investors, including those seeking convenience, flexibility, and professional management. They are ideal for individuals with varying investment amounts and time horizons. Whether you are a novice investor or an experienced one, open-ended funds can be an excellent choice to meet your financial goals.
What should you look for before investing?
Before investing in open-ended mutual funds, consider the following factors:
- Fund Objective: Understand the fund’s investment objective, whether it aligns with your financial goals, and whether it invests in the asset classes you are comfortable with.
- Past Performance: While past performance doesn’t guarantee future returns, it can provide insights into how the fund has performed in different market conditions. Look for consistent performers over multiple market cycles.
While past performance doesn’t guarantee future returns, it can provide insights into how the fund has performed in different market conditions.
- Expense Ratio: Compare the expense ratios of different funds to ensure they are reasonable. Lower expense ratios can significantly impact your overall returns over the long term.
- Fund Manager’s Track Record: Research the experience and track record of the fund manager. A skilled and experienced manager is more likely to navigate various market conditions effectively.
- Taxation: Mutual funds are subject to taxation, and it’s important to note that debt and equity funds have distinct tax rules and rates.
Consequently, for open-ended mutual funds, the tax regulations and rates differ based on the proportion of investments in debt and equity by the scheme.
If the fund allocates 65% or more of its total assets to debt instruments, it is classified as a debt fund for tax purposes.
On the other hand, if the fund invests at least 65% of its total assets in equity, it is treated as an equity fund for tax purposes. To ascertain the applicable tax rates, it is crucial to carefully review the offer document and assess the planned asset allocation of the scheme.
Frequently Asked Questions (FAQs)
How do you invest in open-ended mutual funds?
You can invest in open-ended mutual funds by approaching a fund house or a distributor, completing the necessary documentation, and investing the desired amount.
Can you redeem my investment from an open-ended mutual fund at any time?
Yes, open-ended mutual funds allow investors to redeem their investments at any time, providing liquidity and flexibility.
What are Closed-ended mutual funds?
Closed-ended mutual funds have a fixed number of units issued through an initial public offering (IPO). These funds are listed on stock exchanges and trade like regular stocks.
How do we distinguish between open and Closed-ended funds?
The key difference lies in their liquidity and availability. Open-ended funds allow investors to enter or exit at any time, while closed-ended funds have a specific maturity period and are traded on stock exchanges like stocks.
