Closed and open-ended funds, what is the difference?
Funds are a popular and convenient way to invest on a diversified basis. They allow individuals to pool their wealth with others in order to buy combinations of different assets, creating diversified portfolios run by expert managers or tracking specific indices.
Choosing the right type of fund is a matter of understanding the underlying assets, the strategy of the fund manager, and the risk tolerance of the individual who wishes to purchase it. However, it is also important to understand the general type of a fund, as this can make a difference to the returns that are made.
One of the major differences between types of funds is whether a fund is ‘open-ended’ or ‘closed-ended’. These two types of funds have different characteristics and can be suitable for different types of investors and their objectives and goals.
Here are the main characteristics of each type of fund:
Most funds offered in the UK are open-ended. They are called this because they usually allow investors to buy as many ‘units’ of a given fund as they wish. The fund grows or shrinks depending on investor demand, with units created or cancelled when individuals sell or buy them.
The two most popular types of open-ended funds are authorised unit trusts (AUTs) and open-ended investment trusts (OEICs). The difference between the two is that the former is governed by trust law and the latter by company law, but this makes little difference to investors.
The value of a unit in an OEIC or AUT is linked to the net asset value (NAV) of the underlying assets held in the fund. If the value of these assets moves, so does the value of an individual unit versus the original unit purchasing price.
Investors in OEICs and AUTs can sell their units back to the fund manager when they want to, usually on a daily basis. This is convenient, but means that the manager may need to sell underlying assets in order to give the money back to investors. If the assets are illiquid (difficult to sell) this can be a problem.
If an OEIC or AUT makes income, it must distribute all of it to investors in an accounting period.
Compared to a closed-ended fund, an open-ended fund cannot borrow money (known as gearing) to take on further investments if it sees an opportunity.
Closed-ended funds have a fixed number of shares, so that if you want to buy into them you have to buy as part of the IPO (known as an initial public offering or IPO) or, following that, from someone else who is selling. This is easy, as these funds, which are also known as investment trusts, are bought and sold on the stock exchange like other shares. The difference is that, while most shares that are being bought or sold are representing a slice of ownership of a given company, each share in an investment trust buys a slice of that trust’s portfolio of diversified assets.
The price of each share in an investment trust moves in line with supply and demand, like the price of any other share. Although a closed-ended fund also has a net asset value (NAV) representing the price of the underlying assets, it does not always trade at this value, and may be at a significant discount or premium to the NAV.
One thing that makes closed-ended funds very different from open-ended ones is the fact that they can borrow money, known as gearing, to make additional investments. Adding gearing to a fund can give a fund manager greater leeway to buy when they see a good investment opportunity, amplifying potential gains, but it can also amplify losses if things go wrong.
Unlike OEICS and AUTs, closed-ended funds are allowed to hold back up to 15 per cent of the income they receive in a good year and distribute it in a less good year. Investors therefore find that income payments are smoother in many cases, with some investment trusts going for decades increasing their dividend payments every year.
How to choose
Neither closed- or open-ended funds are intrinsically a better vehicle for investments. Instead, it is important to understand, and discuss with an expert if needed, how they can help achieve one’s financial objectives and best fit into a given investment strategy and portfolio.