Close-ended mutual funds do not have any track record and aren't open to investors post their initial offer period
Ever since the Securities and Exchange Board of India (SEBI) announced re-categorisation of open-ended mutual funds in October 2017 into 36 schemes under equity, debt, hybrid etc, funds houses have been restricted from having more than one scheme under each category, subject to certain exceptions. As per a report by The Association of Mutual Funds in India (AMFI), fund houses have launched 12 new close-ended equity schemes in the January to March quarter, leading to growing eagerness among investors to invest in them.
But before you decide to invest in a close-ended mutual fund, here are some important points to keep in mind before arriving at any such investment decision:
Lack of past records and real time comparisonClose-ended mutual funds do not have any track record and aren't open to investors after their initial offer period. Most agencies do not rank them in their rating exercises. Lack of a track record implies that past performance cannot be reviewed or scrutinised. Such schemes can neither be compared with their peer schemes and benchmarks, nor can their performance be tracked or compared real time. Moreover, sporadic disclosures also make analysis of close-ended funds difficult and lack of scrutiny often leads to complacency for close-ended fund managers.
Unlike open-ended schemes where the performance of the fund is traceable over different market cycles, investors may have to rely on the fund manager's past performance and experience when it comes to investing in close-ended schemes.
Concentrated portfolio and high expense ratioClose-ended mutual funds involve small sized portfolios. This leads to higher expense ratio for even the smallest of funds, which usually rises to 3 percent per annum. Majority of close-ended schemes have a relatively higher expense ratio than open-ended funds. Although SEBI has placed a limit on the maximum expense ratio chargeable from investors, the slab structure of close-ended fund allows them to charge the highest expense ratio from their smallest sized funds. As the fund size increases, this expense ratio decreases.
Levying high expense ratio on close-ended funds means fund houses can offer higher commissions to distributors and therefore maximize the income of both asset management companies and distributors.
Low liquidityClose-ended schemes do not provide the option to exit funds in case of non-/underperformance of funds in the portfolio. Funds invested in these cannot be redeemed or sold when such a need arises. Due to lack of past records and absence of a facility to exit the fund, the working of close-ended schemes is sometimes referred to as black box as it lacks scrutiny.
Before maturity, the only mode to sell a close-ended scheme bought in demat form is on the stock exchange. On the latter, your fund units would be bought by another investor who is interested in purchasing units of that fund. Moreover, absence of portfolio rebalancing or an asset allocation option adds to the rigidity of close-ended schemes.
Absence of an SIP investment optionMany investors, especially the salaried class, usually prefer regular investments (in the form of systematic investment plans) over lump sum equity investments. This ultimately leads them to investing in open-ended schemes, since close-ended ones don't offer the flexibility of regular investments. Even if a lump sum amount is invested in a close-ended scheme, the concept of rupee cost averaging isn't present if the market trends lower. Performance of close-ended schemes and investor returns are therefore solely dependent on timing of the investment, i.e. the opening and closing dates.
Benefits of investing in close-ended mutual funds
Investors don't sell in panic: Since close ended equity schemes have a specified term such as 36 months, 5 years etc, those aiming to build a corpus without worrying about day-to-day market fluctuation can invest in these schemes. Investors cannot exit whenever the market turns unfavourable. This provides a more stable asset base to fund managers to manage the fund throughout the term.
Moreover, only the opening and closing date of scheme affects returns which an investor would earn.
With a closed-ended fund, the fund manager has the advantage of managing the money pooled without any redemption pressure during the lock-in period. Although investors cannot redeem or sell their schemes, they can exchange them on stock exchange, by selling to a buyer who seems interested in the close-ended fund.
Invest in funds which offer differentiated income/objectives: Another benefit of investing in close-ended funds is that investors are able to invest in funds that offer differentiated objectives/income, which may not be offered in open-market funds or schemes. Close-ended funds can be unique and possess niche strategies which require a finite life and hence need to be properly timed. The strategy could be for a new or different idea meant only for select investors who are willing to look at a different risk profile and invest accordingly in such funds.
How much to invest in close-ended funds?Ideally, investor should invest 5-10 percent of the desired corpus amount in each close-ended scheme, keeping in mind the risk of timing the investment properly for generating adequate returns on the closing date. Since close-ended funds require lump sum investment, investors should invest small sums in different schemes of close-ended funds, instead of putting the lump sum into a single scheme. But before investing in close-ended schemes, ensure that they offer something unique, when compared to the flexibility and benefits of open-ended funds.
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