A mutual fund is an investment option that pools money from various investors and invests in underlying securities. These securities can be stocks, bonds, and short-term debt. The profits and losses on mutual funds are shared by the investors in the proportion of their investment. Based on structure, the mutual funds are divided into two categories- open-ended and close-ended mutual funds.
Open-Ended mutual funds
Open-ended mutual funds are open for investment after the NFO (New Fund Offering) period. There is no limit on the number of units of the fund that can be issued. Unlike close-ended mutual funds, these are not traded on the stock exchange. The units of these funds can be purchased or sold on-demand at the net asset value (NAV) of the fund from or to the AMC.
Moreover, there is no set maturity period for these funds. The NAV of these funds fluctuates due to the changes in the prices of the underlying securities.
Difference between Open-ended and Close-ended mutual funds
There is no restriction on the entry and exit of open-ended funds after the NFO but the entry and exit on close-ended funds are restricted to NFO. The units of open-ended funds can be bought and sold on demand at NAV in open-ended funds though the exit from close-ended funds is not possible until the specified period of usually 4-5 years.
The stocks of open-ended funds are not traded through the stock exchange though, these are traded on the stock exchange for close-ended funds. Open-ended funds provide an option of systematic plans but there is no such option in close-ended funds. There has to be a one-shot lumpsum investment into a close-ended fund.
How does an Open-ended fund work?
An open-ended fund can issue units as long as the buyers want to buy them. These units are purchased and sold on demand at their NAV. The NAV is based on the value of the underlying assets and is calculated at the end of each trading day. Sometimes, if the fund’s total assets become too large and do not serve the stated purpose, these are closed for investment to new investors. These funds are the most commonly invested and are used mostly synonymous with mutual funds.
As long as there is buying, more units of the fund are created. And, if there is redemption these are taken out from circulation. There is no restriction on the number of units sold by the funds of open-ended mutual funds though, the fund must buy back all the units redeemed by the investors.
The open-ended mutual fund is open to investment after the closure of NFO. The investment in these funds can be made through systematic plans or in lump sum.
Taxability on gains of Open-ended mutual funds
The gains on mutual funds are not tax-deductible. The tax rules and rates are different for equity and debt funds. The tax on the gains depends on the percentage of investment of the fund in equity and debt instruments.
- If the fund invests 65% or more of its total assets in equity, then the tax on gains is calculated treating it as an equity fund.
- If the fund invests 65% or more out of its total assets in debt instruments then the tax on gains is calculated treating it as a debt fund
Advantages of Open-ended mutual fund
There are many advantages of these funds, the primary objectives of it being:
- Liquidity access
The investor has no restriction on the redemption of the units of the funds. It provides a quick liquidity option. And, these units can be redeemed at NAV on the day of redemption.
- Availability of past performance
Since the net asset value is calculated at the end of each trading day, investors can keep track of the performance of these funds and make the decision accordingly.
- Systematic plans
These funds can be accessed for investment and withdrawal through systematic plans. The investors have the option of a Systematic Investment Plan (SIP), Systematic Withdrawal Plan (SWP), and Systematic Transfer Plan (STP). These can help to invest a fixed amount in the scheme continuously.
- Diversified portfolio
Open-ended funds are invested in a wide range of assets that belong to a variety of companies and industries. This diversification of the portfolio helps in reducing the risk of the investment.
- Low investment
Open-ended funds do not require a huge amount of investment. The investor can start with a small amount of systematic investment plan.
Apart, from these advantages, the open-ended funds are exposed to high volatility that is a disadvantage. The NAV of these funds keeps fluctuating based on the performance of the underlying securities, and hence are prone to market risks. Though, the risks can be reduced by diversifying the portfolio yet there remains a certain degree of risk.
Also, the open-ended funds can have exit loads. The exit loads are charges that have to be paid by the investor if they exit from the fund before a predetermined period, which is usually a year.
The volume of inflow and outflow in the case of open-ended funds is larger than the close-ended funds and hence a sudden outflow can cause the fund manager to sell holdings at the lowest possible level causing loss for all the investors.
Who can invest in an open-ended mutual fund?
- Liquidity access
- The investment by an individual depends on the objectives that he/she wants to achieve through the investment. The objectives that you should take into account are
- The amount of risk that you are willing to take (high, medium, low).
- The amount of investment that you are willing to invest.
- The investment horizon that you are aiming for.
- The returns expectations from the investment.
- Liquidity expectations of the investment
The open-ended mutual funds are suitable for investors who aim for high liquidity without any period restrictions and are willing to take up risk and require good returns.
Apart from these objectives of the investors, they also need to primarily meet the eligibility criteria laid down by SEBI to invest in any instrument.