Open ended Scheme Vs Close ended Schemes

A mutual fund scheme may be a closed ended or an open ended scheme. What are the salient differences between these schemes?

The key differences between the closed ended and open ended schemes are as follows:

1) The subscription to a closed ended scheme is kept open only for a limited period usually one month to three months. Whereas an open ended scheme accepts funds from investors by offering its units or shares on a continuing basis.
2) A closed ended scheme does not allow investors to withdraw funds as and when they like, whereas on open ended scheme permits investors to withdraw funds on a continuing basis under a re-purchase arrangement.
3) A closed ended scheme has a fixed maturity period (usually 5 to 15 years) whereas an open ended scheme has no maturity period.
4) The closed ended schemes are listed on the secondary market, whereas the open ended schemes are ordinarily not listed.

In general, the pros and cons of the closed ended and open ended schemes areas are as follows:

1) In the secondary market, the shares of closed ended schemes sell at a discount (often varying between 10 and 30 percent) over their net asset value. Hence, a subscriber to such a scheme does not realize a fair value. As against this, the subscriber to an open ended scheme gets a value close to the net asset value (typically, it is 0 to 2 percent less than the net asset value).
2) At the time of redemption the entire investment in a closed ended scheme is liquidated and the proceeds are distributed among the subscriber. This has two, somewhat unfavorable, implications; (1) the full value of the investment may not be realized because of an averse market impact and (2) the tax liability of the subscriber ends to be greater as the entire capital appreciation is realized in one go. The open ended schemes, on the other hand, do not suffer from these drawbacks.
3) The fund manager of a closed ended scheme can manage the investments better because the corpus fund is available for the entire duration of the scheme and he is not required to maintain liquidity to take care of redemption demands during its life. As against this, the fund manager of an open ended scheme has to wrestle with a volatile fund corpus. He may have to cope with a sharp outflow in a declining market or with a speculative inflow in a buoyant market and also maintain some liquidity to meet the redemption demands. All this can mar the overall performance of an open ended scheme vis-à-vis a closed ended scheme.

Exchange Traded funds:

An exchange traded fund (ETF) is a hybrid of a closed ended index fund and an open ended index fund. Like a closed ended index fund, it is listed on the stock exchange and like an open ended fund it creates and redeems Units inline with the rise and fall in demand. Benchmark Mutual Fund’s Nifty Benchmark Exchange Traded Scheme (BeES) which tracks the S&P CNX Nifty and Prudential ICICI Mutual Fund’s SPICE (Sensex Prudential ICICI ETF) which tracks the BSE Sensex are examples of exchange traded funds.

The manner in which an exchange traded fund is structured. The key features of traded funds:

The open end side of an ETF is restricted to a limited set of participants called Authorized participants and a certain minimum size is prescribed for the creation / redemption of units.

The creation / redemption of units happen in kind. Authorized Participants who want new ETF units have to pay in the form f a basket of stocks that mirrors the underlying index. Likewise, when authorized Participants want he ETF units to be redeemed they are paid in the form of a basket of stocks mirroring the underlying index.

As ETF units are listed on the secondary market (like NSE) investors can buy and sell ETF units in cash.

In the secondary market ETF units tend to trade very near tot their fair value (NAV) If the market price of ETF units exceeds their NAV, Authorized Participants would sell ETF units from their inventory, buy the underlying basket of stocks from the exchange, and deliver the basket of stocks to the EFT to replenish their inventory of ETF units and make an arbitrage profit. Likewise, if the market price of ETF units is less than their NAV, Authorized Participants would buy ETF units from the market redeem the units with the ETF get the underlying basket of stocks sell the same in the market and make an arbitrage profit.

That is the advantage of an ETF over an index fund, closed ended or open ended? An ETF is better than a close ended index fund because ETYF units trade near their fair value (NAV) whereas the units of a close ended index fund typically sell at a discount. An ETF is better than an open ended index fund because an ETF requires minimal cash balance, thanks to in-kind creation and redemption of units. This reduces the tracking error.