Close-ended funds: Is it worth investing?

Here are a few points about Close-ended funds showing whether it is worth investing or not:

Close-ended funds: Is it worth investing?

Unlike open-ended funds, Close-ended funds have a limited fund inflow. You may find a specific number of units of close-ended funds being sold in the capital market.

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In order to attract subscriptions from the retail investors, the asset management company (AMC) launches New Fund Offer (NFO). An NFO, just like an IPO, allows you to buy units of the close-ended fund within the given period.

When the subscription period ceases, new investors cannot purchase units of the fund. Similarly, existing investors cannot exit the scheme before the expiry of the term.

Exiting the Scheme

Most of the close-ended funds are listed on the stock-exchange like ETFs. In case any investor needs to exit before maturity of the term, he can sell the units on the exchange.

After getting listed on the exchange, the market price of the units is affected by factors like demand, supply and investors’ future expectations. So, when you want to sell the units, it might not be equal to the NAV.

The units might be trading at a discount or premium. When the market price of units is higher than the NAV, it’s said to be trading at a premium.

When the market price of units is lower than the NAV, it’s said to be trading at a discount.

One point needs to be underscored here.

Also read: When you should exit a mutual-fund

Trading on the stock exchange doesn’t change the number of outstanding units of the fund. In addition to trading on a stock-exchange, there’s one more way to exit the scheme. As per SEBI mandate, the AMC offers to buy back the units of the scheme.

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Ease of administration

Fund managers often find managing close-ended funds easier as compared to open-ended funds.

The close-ended funds don’t face reinvestment risk as there is no issuance of units every day.

You might have heard of open-ended funds swelling to large sizes due to growing popularity. In such situations, administering the fund properly becomes a challenge for the fund manager. To employ the bulk of funds, he may digress from the fund’s investment mandate.

However, close-ended funds are free of such issues. As additional units aren’t issued by the AMC & majority of investors prefer to stay invested in the fund till maturity; there’s no immediate redemption or excessive influx of funds during the existence of the scheme.

Owing to the relatively stable capital base, the fund manager need not hold excess cash to meet unexpected redemptions. The fund manager is at ease to take a holistic view of the fund and develop a robust investment strategy accordingly.

Close-ended funds: A Risk-return approach

Close-ended funds are regarded as relatively riskier than open-ended funds. The source of risk lies in their holdings.

Owing to a stable capital base, the fund manager has greater freedom to take riskier calls. These funds tend to invest in illiquid securities like emerging market stocks which tend to have a higher risk.

Accordingly, the return expectation from close-ended funds is higher than open-ended funds.

Why should you not invest in Close-ended funds?

Close-ended funds strategically enjoy the higher stability of cash flows as compared to open-ended funds. Additionally, the fund manager need not face difficulties similar to that of managing an open-ended fund.

In spite of all this, close-ended funds suffer from certain limitations which you should know before going for one:

Close-ended funds: Is it worth investing?

Poor performance

You, as an investor, expect higher returns when you are thinking about investing in close-ended funds. At why not! After all, there is higher risk-taking involved in close-ended funds as compared to open-ended funds.

But the reality presents a stark contrast.

As compared to open-ended funds, close-ended funds have presented a poor show. The 1 year and 2 year average trailing returns for equity diversified open-ended funds stood at 33.26% and 10.15% respectively.

On the contrary, the 1 year and 2-year average trailing returns for equity diversified close-ended funds was much lower at 28.5% and 5.85% respectively.

It shows the inability of close-ended funds to stand at par with their open-ended peers.

Lumpsum Investment

On the whole, the main advantage of mutual funds over other investment havens is the availability of staggered investment. Especially those investors who belong to lower-income strata can think of investing via SIPs.

But the concept of close-ended funds is anti-thetic to SIPs. As the NFO is open for a limited period, you have to shell out a more significant chunk of money in one go.

Most of the NFOs are launched during a bullish rally when the market is quite expensive. Such kind of more substantial investment in close-ended funds might not give you the advantage of rupee-cost averaging.

No track record

The concept of NFO means that the fund has been introduced in the market for the first time. It implies that past performance of the fund is practically not available.

It’s well-known that past performance doesn’t guarantee future returns. Still, it can give you an idea about the performance of the fund during various market cycles.

Investing in close-ended funds can be riskier from this standpoint as well. All you know is the fund manager who is going to manage the fund. If accessible, you may have a look at his past performance.

But still, it will be highly inadequate to take an informed investing decision. Hence, investing in close-ended funds may seem similar to throwing darts in the dark.

Liquidity issues

Investing in close-ended funds implies money getting locked for a fixed tenure; which can be at least 3 years.

In yet another situation, you may sell the units on the stock exchange for emergency purposes. But, then again it depends on the timing.

It might happen that by the time you decide to redeem the units, the market would have started its downward trajectory. If the market price of the units is lower than the NAV, you will be standing at a loss; even though you might be getting an opportunity to exit the scheme before maturity.

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Final Words

Close-ended funds are more like a double-edged sword. The inherent risk of losing money is higher than the potential of gains. It would be better for you to stay away from them and seek other options.

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