Understanding close-ended mutual funds

My article published in Mid-day Gujarati, Mumbai edition today.

The English translation is as under:

“Should I invest in this new mutual fund scheme?” Someone asked me the other day. This person was referring to the launch of a New Fund Offer (NFO) of a close-ended mutual fund scheme. This is not unusual. So many investors worry about investment decisions and tend to check on the schemes being heavily advertised. This may result into them missing out on some good schemes only since these are not advertised enough and information may not be easily available.

Let us come back to the NFO of this scheme. We have dealt with NFOs in one of our earlier articles. However, this time we are looking at NFO of a particular category of mutual funds, the close-ended funds.

To make it simple to understand, let us start with the difference between the terms (tenure) of these two categories of funds – open-ended funds and close-ended funds. The open-ended funds do not have a specific date of maturity, whereas the close-ended funds have. This means, these funds are wound up after a particular date (the maturity date) and the money is returned to the fund’s investors. On the other hand, the open-ended funds continue to operate perpetually.

Close-ended funds differ from the open-ended funds in offering liquidity to the investor. In case of open-ended funds, an investor has the facility to get out of the scheme on any business day. This can be done through submission of a redemption request with the fund house. Close-ended fund do not offer such a redemption facility. However, SEBI has made it mandatory to offer an exit route for the investors through the stock exchanges. This means, the units of close-ended funds have to be compulsorily listed on a recognized stock exchange. At this stage, it must be clarified that listing on a stock exchange does not mean liquidity, which is a function of the trading activity in the units of a specific fund on the stock exchange. Experience suggests that there is hardly any liquidity in the units of close-ended funds.

Where do these funds invest? Well, the mutual fund companies have launched various kinds of close-ended funds – equity funds, debt funds and hybrid funds (those that invest in both equity and debt).

The close-ended funds investing in debt are popularly known as FMPs or Fixed Maturity Plans. These funds are often used in lieu of fixed deposits simply as the mutual fund schemes have a slight advantage over fixed deposits – the returns are more tax-efficient. Though the last budget reduced some of the tax advantages to these schemes, these are still better if the investment is for more than 3 years.

The hybrid funds come in mainly in the “capital protection oriented” structure. In such funds, the primary objective is to protect the investor’s capital over the term of the fund. The second objective is to generate returns higher than traditional fixed income products. However, since these are close-ended funds, the equity component must generate superior returns exactly matching the term of the scheme for the secondary objective to be fulfilled.

The equity funds need more attention. Many investors prefer to invest in these schemes with certain assumptions: (1) this is an NFO, and (2) a close-ended fund offers better flexibility to the fund manager since there would be no redemptions. Distributors prefer to sell these schemes due to high commission income. All these reasons may not be correct. An NFO does not mean better investment performance. History does not support the argument that close-ended funds are able to outperform their open-ended counter-parts.

On the whole, it is always advisable to avoid these schemes considering the lack of liquidity. The funds with equity exposure – equity funds or hybrid funds – suffer from the fact that one does not know exactly over what period the equity would generate good returns. Equity, as an asset class, is always unpredictable – this must never be forgotten.

- Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions. He can be reached at amit@karmayog-knowledge.com