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

Is it beneficial for an investor to invest in a mutual fund NFO?

Here is my article published in Mumbai edition of Mid-day Gujarati today. The paper is attached herewith. Below that, the English translation is given:

Is it beneficial to an investor to invest in a mutual fund NFO?

“Fund houses happy as NFOs get speedy nod from SEBI” – this was the news headline some time back. The news also added that there is a surge in the NFOs from fund houses.

At some stage, SEBI took a view that the fund houses were launching too many similar schemes and they started reforms, including a declaration from the trustees that the proposed scheme (if open-ended) is different from any of the existing schemes. It also cut down the time of the launch as well as the time for allotment of units after the closure of the NFO. However, it still took quite long to clear the offer documents. This process has now been streamlined as the news referred.

Well, that is as far as the news is concerned, but what is in it for the investors? What should an investor do if the number of NFOs goes up?

Before that, let us first understand what an NFO is. NFO means a New Fund Offer – this is the time when a new mutual fund scheme is offered to public for investment for the first time, whether the scheme is open-ended or close-ended. This is similar to equity share IPO, where the company offers subscription to its shares to public for the first time.

The NFO matters to an investor only in certain cases:

1.     In case of a close-ended fund, where the units are not available for subscription directly from the fund on an on-going basis after the NFO period

2.     Recently, there was a new scheme launched – CPSE ETF, to help the Government of India’s disinvestment program. In this case, the NFO investors were given two incentives

                         i.         There was a 5% discount to NFO investors,

                       ii.         The NFO investors, who stay invested for a year, would be allotted bonus units in the ratio of 1 unit for every 15 held in the account

In the first of the above cases, since the investor does not get a chance to invest in the scheme, one may consider investment during the NFO period. In case of a close-ended scheme, thought the units are listed on the stock exchanges, there is hardly any trading activity. In that case, NFO could be the last chance to buy into the scheme for an investor.

In the second case, there would be a market-making mechanism that provides liquidity. This would allow an investor to buy ETF units from the stock market after the NFO is over. However, the additional incentive is available only if the investment is made during the NFO period.

In all the other cases, there is no compelling reason to buy during the NFO period, since one can invest anytime after the scheme becomes open.

At the same time, this discussion should not be construed as recommendation to invest or not invest in any mutual fund scheme – either during the NFO or thereafter. An investor is advised to consider one’s own situation before taking any decision. Just because a new scheme is being launched, one does not have to jump to invest.

A new launch cannot be the reason of one’s investment. Can someone imagine going for dialysis just because a new kidney hospital has opened next door and one has been invited for the inauguration function? At the same time, nobody would wait for a new hospital to open when there is a need for dialysis.

Treat a new launch in an exactly the same manner. Identify your own objectives and then decide what kind of investment portfolio you want to build. After that comes the decision of scheme selection. It does not matter whether it is an existing or a new scheme. However, an existing scheme would allow an investor to analyse the past performance to take an informed investment decision.

Happy investing!

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.