Investment companies or investment trusts obtain funds from large number of investors through sale of units. The funds collected from the investors are placed under professional management for the benefit of the investors. 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.
Mutual Fund Products based on the Nature of Income Distribution
Mutual funds offer a variety of options to investors, in the manner in which the returns from their investments are structured. At a broad level, the investors have three options: Dividend Option and Growth Option & Reinvestment option.
1. Dividend Option
Investors, who choose a dividend option on their investments, will receive dividends from the mutual fund, as and when such dividends are declared. Dividends are paid in the form of warrants or are directly credited to the investors, bank accounts. There are further choices in the distribution of dividend. In a normal dividend plan, periodicity of dividends is left to the fund managers, who may pay annual or an interim dividend. Though investors know that they would earn a dividend income from their investment, the timing of the pay-out is decided by fund managers. The variants to the normal dividend plan are pre-specified distribution schedules. Mutual funds provide the option of receiving dividends at pre-determined frequencies, which can vary from daily, weekly, monthly, quarterly, half-yearly and annual. Investors can choose the frequency of dividend distribution that suits their requirements. Not all mutual funds provide all of these frequencies as choices, though. Investors can choose from income distribution frequency from the choices available in a particular mutual fund product. Investors choosing this option have a fixed number of units invested in the fund and earn incomes on this investment. The NAV of these investors’ holdings will vary with changes in the value of the portfolio and the impact of the proportion of income earned by the fund to what is actually distributed as dividend.
2. Growth Option
Investors who do not require periodic income distribution can choose the growth option, where the incomes earned are retained in the investment portfolio, and allowed to grow, rather than being distributed to the investors. Investors with longer investment horizons and limited requirements for income choose this option. The return to the investor who chooses a growth option is the rate at which – his initial investment has grown over a period for which he has invested in the fund. The investor choosing this option will vary the NAV with the value of the investment portfolio, while the number of units held will remain constant.
3. Reinvestment Option
Mutual funds also provide another option to investors in the form of reinvestment. Investors reinvest the dividends that are declared by the mutual fund, back into the fund itself at NAV that is prevalent at the time of reinvestment. In this option, the number of units held by the investor will change with every reinvestment. The value of units will be similar to that under the dividend option. The choice of options depends not only on the investors requirements for income and growth, but also on his tax status. The different tax treatment of dividends and capital gains will also impact the choice made by the investor.