Closed-ended funds are mutual funds that have a fixed and limited number of units and are offered during the New Fund Offer (NFO) period. Once the NFO ends, there cannot be any new units of this mutual fund that can be issued. They are closed for subscription and sale after the NFO. According to Securities and Exchange Board of India (SEBI) guidelines, an NFO can stay open for 30 days.
Closed-ended funds also have a fixed maturity period and generally one can only redeem them only on that date. This maturity period is usually between 3 and 7 years. This raises the question: What happens if one wants to sell such funds due to some financial requirement? SEBI has mandated that the fund company provide buyers with one of the two options during the purchase: one is that of a repurchase by the fund company and the other is a sale by listing on the stock exchange.
To understand this, let us use a banking analogy. Open-ended funds are a bit like your regular bank account where you can both deposit and withdraw periodically, whereas a closed-ended fund is more like a fixed deposit, where you park your money for a fixed period of time. If you want to deposit more, then you will have to start another fixed deposit account, you cannot just add money into the existing account (in most cases).
Taking the banking analogy further, if you decide to withdraw from the fixed deposit before maturity, then you have to forfeit some of the amount. Similarly, if you sell a closed-ended fund after the NFO, via the stock exchange, you may end up having to sell it at a discount, as there are usually fewer takers for such funds on the stock exchange. Fund managers therefore, recommend closed-ended funds in cases where the investor wants to put money away for a longer period of time and might not need to withdraw them for any use in the near term.
The other way of redeeming closed-ended funds is when the fund company repurchases them. SEBI mandates that if the funds are listed on the stock exchange after the NFO, the company can repurchase them at periodic intervals at NAV-related prices, that is, the market value of securities at the given point of time. This is why closed-ended funds are said to be governed by demand and supply. The fact that after the NFO, they are listed in the stock market and bought and sold only on stock exchanges, makes them similar in nature to exchange traded funds (ETFs).
The choice of going for an open-ended or a closed-ended fund depends on various factors. Closed-ended funds typically require a lump-sum investment, which will be locked till the date of maturity. This is not affordable for some investors. Secondly, the investor’s purpose of investment will dictate which of the two types of funds he/she wishes to go for. Overall, being a longer term fund, closed-ended funds are seen to perform better on maturity. However, this may not always be the case as existing market conditions and the skills of the fund manager come into play when it comes to the profit the investor may make. Generally, fund managers are able to work with more flexibility as this is a longer term fund. And lastly, the investor should research the overall performance of the fund management company and other terms and conditions of the NFO, before going for a closed-ended fund.