Open-ended vs. Closed-ended funds


Funds are an increasingly popular choice for investors looking to build their portfolio. They offer a simple way to pool capital with other investors, giving quick and straightforward access to diversification and the services of professional asset managers.

When researching funds, it won’t be long before the terms ‘open-ended’ and ‘closed-ended’ crop up. For many people, these terms might not seem as important as other considerations, such as selecting a particular fund manager, asset class, industry sector and so on. However, they are two fundamentally different ways of structuring funds, which should be borne in mind when investors are making their choices.

What is an open-ended fund?

Open-ended funds are collective investments that do not have a fixed size or number of units. Instead, an open-ended fund will grow or shrink in line with investor demand. This means that when investors purchase an open-ended fund, new units are created; when investors sell their holdings, these units are cancelled.

Open-ended funds have two important features:

  • Investors have the right to sell their units on demand, directly back to the fund manager. This means that an open-ended fund will ensure a certain level of liquidity for investors. Dealing can normally be done daily but this varies on a fund-by-fund basis. Due to this requirement for daily dealing, it is commonly thought that open-ended vehicles are most suited for holding the most liquid types of investments which fund managers can sell quickly to meet demand.
  • The price of units is determined by the net asset value (often known by the abbreviation NAV) of the underlying portfolio of assets held by the fund. This value will vary in line with the portfolio’s performance and the level of investor inflow and outflow.

There are various types of open-ended investment funds in the UK. The two most popular are:

  • Authorised Unit Trust (AUT) – a type of collective investment where the assets of the fund are held in trust for investors – known as unitholders - by a designated trustee.
  • Open-Ended Investment Company (OEIC) – these funds are sometimes referred to as Investment Companies with Variable Capital (ICVCs). They are companies rather than trusts, so instead of a trustee, an OEIC has an Authorised Corporate Director (ACD) who is responsible for its day-to-day running and administration. Investment management is usually delegated by the ACD to a specialist fund manager.

What is a closed-ended fund?

In contrast, a closed-ended fund has a fixed number of shares, issued via an Initial Public Offering (IPO). These shares are issued in accordance with company law. Investors are not entitled to redeem their holdings on demand. Rather than trading directly with the fund manager, as with an open-ended fund, investors in closed-ended vehicles trade amongst themselves on the secondary market in a similar way to a standard company share – this is why holdings of closed-ended funds are usually known as shares rather than units.

This means that the prices of shares in a closed-ended fund are determined by market demand and supply factors, rather than with strict reference to the net asset value of the underlying portfolio of assets in the fund. Therefore, a closed-ended vehicle can trade at a discount (below net asset value) or premium (above net asset value).

Closed-ended funds are not currently as prevalent as open-ended vehicles in the UK, even though they have a much longer heritage – the world’s first collective investment fund was a closed-ended scheme launched in 1868! They are however steadily growing in popularity.

The most widespread type of closed-ended fund is the investment trust. ‘Trust’ is somewhat of a misnomer here, as the structure technically is not a trust at all, but legally is established as a company.

Two key features of investment trusts often make them attractive to investors:

  • The manager of an investment trust has the ability to borrow in order to finance the purchase of assets within the fund’s portfolio – this is known as “gearing”. Gearing allows the manager to increase the size of the investment trust’s assets beyond the amount initially raised from investors. This can significantly amplify returns but can also cause greater losses depending on investment performance.
  • Investment trusts can retain earnings (up to 15% in each accounting period), which open-ended funds cannot do. This means that an investment trust can smooth income payments by retaining earnings during better years, in order to make up payments in weaker times.

Comparing the approaches – which is better?

Open-ended and closed-ended funds have different characteristics and neither is intrinsically better than the other – rather, it is a question of ‘horses for courses’ and the most appropriate vehicle will depend on an individual’s investment view and personal circumstances.

Open-ended funds are one of the most widely available types of investment vehicle in the UK. As we have seen, they generally offer daily dealing, but to support this the assets in the fund’s portfolio may need to be sold quickly, which could prove extremely difficult if they are illiquid. Therefore it is important to understand not just the overall fund structure, but the nature of the underlying investments.

Closed-ended funds are often more suitable for holding illiquid investments, and have the ability to smooth income payments. They can also add gearing to amplify returns, but this can add risk. Prices are set by market supply and demand, so it is possible that a closed-ended fund may be priced at a significant discount or premium to the underlying value of the assets in the portfolio, unlike an open-ended vehicle.

The key differences between open- and closed-ended funds are summarised in the table below.

Factor Open-Ended Closed-Ended
Borrowing Powers Fund managers cannot use gearing. Gearing can be used to increase the amount of money available for the fund manager.
Dealing Investors can purchase and sell on demand by dealing with the fund manager directly; this can typically be done daily. Shares cannot be bought or sold on demand – they are dealt between investors on the secondary market between matched buyers and sellers.
Income All income must be distributed to investors in each accounting period. Up to 15% of income can be retained in each accounting period to smooth distributions.
Fund Capital Capital will vary according to investor purchases and sales. The capital of the fund is fixed.
Investment Liquidity Assets must be liquid enough so that investments can be redeemed on demand. Assets can be longer-term and illiquid as investments cannot be sold on demand.
Net Asset Value The fund’s net asset value is typically published daily. The fund’s net asset value can be published daily, but is often more infrequent than this.
Pricing The fund price is based on the net asset value of the underlying portfolio. The fund price is based on market supply and demand factors, so shares can trade a premium or discount to the fund’s net asset value.
Trading Directly with fund manager. Traded on a regulated exchange, such as the London Stock Exchange.

In isolation, these and other differences are not necessarily advantages or disadvantages, but should be considered in the context of an investment strategy and as one part of any rigorous fund selection process. Perhaps the most important fact is that an investor does not need to choose one approach for their entire portfolio - it may well be that a mixture of the two types of vehicle is the optimal choice.

These articles are for information purposes only and are not a personal recommendation or advice.

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Written by:
Mark Gillan

Mark is Head of Operations at AJ Bell. He studied Economics at Liverpool University, and has a master’s degree in International Banking & Finance from Liverpool John Moores University. Qualified to CISI Diploma level in Investment Operations, Mark came to AJ Bell with nine years’ experience in operations at a custodian and an investment management firm.