When many investors come together with a common interest, they constitute a big pool of money referred to as a fund. Consequently, there are two types of funds – a closed-ended fund and an open end fund. The rest of this article deals with the latter. It is also referred to as a mutual fund in the United States or a unit trust in the United Kingdom. It details the concept of this investment scheme, its structure and its merits and demerits. The aim is to provide useful information to a prospective investor. So, what is an open end fund?
The Concept of an Open End Fund
What is an open end fund? Open end or mutual funds represent a collective investment scheme. It sells shares directly to its investors. Moreover, the investors can sell the shares. In this case, the fund buys back the shares, in a process known as redemption. The key aspect of this investment scheme is this. It issues an unlimited number of shares, providing more flexibility for its investors.
Here’s another thing you need to know when learning what is an open end fund. When an investor buys shares in this fund, it creates an additional number of shares. Conversely, when an investor sells shares to the fund, the number of shares in circulation reduces by the same amount of shares sold. This is the origin of the “open-end” concept. Buying increases the number of unit shares and selling shrinks it. Now you know the basis of the question what is an open end fund.
Each share price in this type of fund has a net asset value (NAV). The NAV, or unit price, is calculated daily. One works out the value of all assets held by the fund. He or she subtracts any liabilities and divides the result by the total number of outstanding shares as illustrated below.
Net Asset Value (NAV) = (Total Asset Value – Total Liabilities) / Number of Outstanding Shares
This type of fund invests in assets in line with the investors’ objectives. These could be stocks or bonds. To mitigate investment risks, a professional manager runs the fund’s portfolio with the assistance of analysts. The aim is to grow the total asset value. When the collective asset value appreciates, the investors earn an amount referred to as return on investment (ROI).
American investors turn to mutual funds to save for retirement among other financial goals. The Securities Exchange Commission (SEC) registers and regulates the actions of these investment vehicles. It can also guide investors. The Investment Company Institute (ICI) reports that by end of 2015, US mutual funds had over $15.6 trillion in assets.
Advantages and disadvantages of Open End Funds
Some merits of these funds include their simplicity and flexibility. Purchase of shares takes place in the open market.
There is no need for lengthy procedures and a stockbroker, as is the case with close ended funds. Moreover, the concept of net asset value means that the share price is always the market value. On the other hand, these funds attract taxation, specifically the capital gains tax (CGT). This can hurt investors’ earnings. Furthermore, forward pricing forces the investor to wait for the regular share pricing time in order to know at which to buy or sell shares.
Now that you know what is an open end fund, let’s take a look at their pros and cons.
Advantages of Open End Funds
Mutual funds constitute a less risk investment as opposed to trading in stocks at a formal exchange. This owes to the fact that they are less volatile in terms of pricing due to the net asset value principle. Therefore, an investor does not have to worry about overpaying for the shares or selling for less than is worth.
Moreover, investors can buy and sell their shares freely, with a guarantee of a complete transaction in 24 hours. This is because the fund management prices the shares on a daily basis. It happens after analyzing the day’s trading. This allows investors to make regular purchases and sales as they wish.
This kind of investment option enjoys economies of scale. Essentially, the fund pools together a number of different investors who have a similar objective. This way, the investment and operating costs spread over a large number of investors. In a sense, this leads to very low expenses of managing each investor’s money.
Perhaps the overriding advantage of these funds is the existence of very few restrictions. Unless the fund manager has closed buying or selling for any approved reason, an investor can buy any amount of shares. Similarly, there are no restrictions on the number of investors and the duration of the investment.
Additionally, this kind of fund requires less money for initial investment compared to other investment schemes. This owes to the fact that there are few restrictions to the amount of investment to make. Therefore, most people can easily access them at low cost. This explains the widespread acceptance of mutual funds and unit trusts in many markets across the globe.
Recommended read – What Are Closed Ended Funds?
Disadvantages of Open Ended Funds
Once you know what are open end funds, you will come to realize they have some drawbacks as well. Here they are.
The fund management has to maintain cash reserves to handle redemptions. This blocks open end funds from investing in illiquid investment schemes. The reason is that their assets should easily convert into cash. This challenge magnifies when a large amount of shares are sold (redeemed).
In addition, these funds must sell some assets they have invested in to buy back shares investors redeem. This presents a unique challenge. As every redemption request can generate capital gains on which all investors have to pay capital gain tax. This poses a risk of eroding earnings, a situation which forces most investors to postpone their redemption to defer taxation.
Due to the nature of these funds, the managers restrict themselves from investing in illiquid assets that they cannot easily convert into cash. They do so to manage redemptions. This makes these funds earn the investors very little. The more illiquid an investment is, the bigger returns it will earn. Therefore, open-end funds are outperformed by closed-ended funds in terms of returns on investment.
Moreover, owing to the nature of their operations, open end funds can liquidate if all investors decide to pull out their investment by selling their shares. This happens when there is a financial crisis, as panic grips investors. This susceptibility leads to the formulation of strict regulations. They govern the funds’ establishment, operation, and regulation the SEC and other laws.
Open end funds are prone to abuse and risks to some degree. They require round the clock monitoring by authorities. This is to prevent any cases of fraud or money laundering.
Additionally, they have to comply with transparency requirements taking care not to engage insider dealing which can lead to market abuse. Additionally, these funds face risks ranging from market, liquidity, credit, operational, system failures, and compliance-related risks. Risks and potential abuse can be costly to a clueless investor.
However, the rules and regulations, if followed to the letter, provide a formidable shield.
Overall, open end funds provide good opportunities for investment and are easily understood. More so now that you know what is an open end fund. You do not have to be a complicated investor to put your money in a mutual fund. In addition, you can never run the risk of selling your shares below market value. According to Practical Law Company, multiple laws and regulatory bodies such as the SEC, FINRA, and the CFTC protect investors in these schemes. Kindly share your thoughts and experiences and ask any questions you may have.
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