There are a variety of ways in which mutual funds are created to accommodate varied risk and return requirements of investors. Depending on the investment portfolio that is created and the segments of the various markets in which funds are invested, there is a choice of funds to investors. Mutual funds can offer further broad choices to the investors in terms of:
- Nature of participation: Open and close-end funds.
- Nature of income distribution: Dividend, growth and reinvestment of dividends.
Mutual Fund Products based on the Nature of Participation
1. Open-Ended Mutual Funds
An open-ended mutual fund remains open for issue and redemption of its shares throughout its unlimited duration. As an open-ended mutual fund is required to redeem its shares any time the investors wish to liquidate their holdings, a relatively higher portion of its assets need to be highly liquid. There are two ways in which investor participation in a mutual fund can be structured. In an open-ended fund, the investors can buy and sell units of the fund, at Net Asset Value (NAV) related prices, at any time, directly from the fund. This is called open-ended fund because the pool of funds is open for additional sales and repurchases. Therefore, both the amount of funds that the mutual fund manages and the number of units vary everyday. The price at which the investors buy or sell units is linked to the NAV. Open-ended funds have to balance the interests of investors who come in, invested who go out and the investors who stay invested. Open-ended funds are offered for sale at a pre- specified price, say Rs.10 in the initial offer period. After a pre-specified period the fund is declared open for sales and repurchases. These transactions happen at the computed NAV related price. An investor in an open-ended fund can liquidate his investments by repurchasing the units from the fund. An investor in an open-ended fund receives an account statement of his holdings periodically.
2. Close-Ended Mutual Funds
A close-ended mutual fund can issue shares only in the beginning and cannot redeem them or reissue them till the end of their fixed investment duration. A close-ended fund is open for sale to investors for a specific period, after which further sales are closed. Any further transaction for buying the units or repurchasing them, happen in the secondary markets, where close-ended funds are listed. Therefore, new investors buy from the existing investors and the existing investors can liquidate their units by selling them to other willing buyers. In the close-ended funds, the pool of funds can technically be kept constant. However, the Asset Management Company can buy the units in the secondary markets from the investors thus reducing the amount of funds held by outside investors. The price at which the units can be sold or redeemed depends on the market prices, which are fundamentally linked to the NAV. Investors in close-end funds receive either certificates or depository receipts for their holdings in a closed-end mutual fund. A close-end fund does not face the problem of investing substantial amounts marketable securities as it does not require to redeem its shares before the maturity of the fund. The shares of the close-end fund generally quote at a discount, for which investments in less marketable securities are partly responsible.
In the earlier days of the mutual fund industry in India, most mutual funds were close-ended, and were listed in the stock exchange. One of the reasons why the fund managers chose to have close-ended funds was the apprehension that underlying markets may not be liquid enough to support frequent changes in the size of the investment portfolio. However, closed-end funds presented a set of other problems. Investors perceived mutual fund to be a kin to equity shares, because the issue process was similar to that of equity shares: a limited initial offer period and subsequent listing on stock exchange. The perception created impractical return expectations for mutual funds. The next problem was the discount at which the mutual funds were priced, to the NAV, in the secondary markets. Most mutual funds were priced at precipitous discounts, ranging from 15% to 45%. Since the mid ’90s mutual funds have been offering repurchase at NAV linked prices for their close-end funds; many closed-end funds have also been converted into open- ended funds.