Opening Up to Open-Ended Funds

Many asset managers have made the shift from traditionally closed-ended strategies to establishing open-ended funds. Alter Domus' Greg Myers explains.

When choosing a pooled investment fund, investors are faced with many options. Regional or global? Passive or active? Bonds or equities? An often overlooked choice is the one between open and closed-ended fund structures, but the distinction between the two should not be taken lightly.

Many asset managers, keen to appeal to a larger pool of institutional investors, have begun to adapt their strategies to attractive broader investment pools. They’ve done so by shifting from traditionally closed-ended fund strategies to establishing open-ended funds.

What are the key differences between closed-ended and open-ended funds?

Closed-ended funds, by definition, have fixed terms of life and often prohibit the launch of subsequent funds until certain hurdles are met on the current fund.  The size of the committed capital is fixed at the final close and invested capital is often distributed at the end of the fund’s life. Existing investors who want to exit must sell on the open market to another investor who wants to put money in and requires General Partner Approval.

Open-ended funds, in contrast, are always open to investors with capital accounts being marked more frequently and commitments being offered on a pro rata basis to new entrants. Investors enjoy greater flexibility with more frequent NAV pricing and liquidity options for their interests in the fund, due to the assets’ higher liquidity combined with the fund’s perpetual offerings.

So why are managers making this shift?

The ongoing nature of open-ended funds is a supreme advantage to fund managers. They benefit from the ability to perpetually market to investors. They can capture management fees on an uninterrupted basis and welcome additional investment from investors as their allocation requirements change, without the need to wait for their next fund.

By managing a single fund for specific strategies- rather than a new fund every few years- they’re given a greater deal of marketing simplicity. No sunset provisions apply as they often do with most closed-ended funds, making the management of open-ended fund structures more straight-forward.

There are also favorable conditions for institutional and pension plan investors investing in open-ended funds. The ease of entry and exit provides a convenient investment vehicle for those looking to invest cash, yet retain their liquidity. They also benefit from readily available historical data about the fund’s performance over various market cycles, which helps them to make well-informed decisions. And unlike their closed-ended counterparts, open-ended funds do not require large, risky, lump sum investments at the time of the fund’s launch on the part of the Manager and investors.

What risks should be considered?

While the open-ended structure provides undeniable benefits to both investor and manager, they don’t come without risk. The advantage of having highly liquid investments also creates risk for the fund manager and other investors of the fund.

Although redemptions are pegged to each investor’s risk appetite, the threat of high-volume redemptions presents an undesirable scenario. Investors who maintain their capital in the fund risk losing value. However, most deals cap the redemption threshold at 5% to help mitigate this risk.

What are the operational differences to keep in mind?

When managing an open-ended fund, there are several operational discrepancies for managers to be aware of. Open-ended funds require either internal infrastructure or an outsourced provider in order to manage the NAV-per-unit calculations and various reporting requirements that are synonymous with these fund structures.

Alter Domus Director Greg Myers explains, “The complex nature of the system’s setup also involves moving allocations of investor accounts. Most managers are not set up to support this high frequency activity, and oftentimes benefit from outsourcing these types of administrative tasks to third-parties. Fund administrators have the systems, infrastructure and staff to manage these complexities, preventing the fund manager from having to build this costly middle and back-office ecosystem themselves.”