Ever since SEBI announced re-categorization 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 AMFI report, fund houses have launched 12 new close ended equity schemes during the past quarter of January to March 2018, leading to growing eagerness amongst investors to invest in them.
But, before you decide to invest in close ended mutual funds, we explain you important points to keep in mind before arriving at any such investment decision.
Lack of past records and real time comparison
Since close ended mutual funds are mostly launched with New fund offers (NFOs) which do not have any track record, and aren’t open to investors post their initial offer period; most agencies do not rank them in their rating exercises. Lack of track record implies that the past performance cannot be reviewed or scrutinized. Such schemes can neither be compared with their peer schemes and benchmarks, nor can their performance be tracked/ 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’s managers.
Therefore, 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 ratio
Close ended mutual funds involve small sized portfolios which remain concentrated to only a few stocks. This leads to higher expense ratio for even the smallest of funds, which usually goes up to 3% p.a. Majority of close ended schemes, therefore, have a relatively higher expense ratio than open ended funds. Although SEBI has put a limit on maximum expense ratio chargeable from investors, close ended fund’s slab structure allows them to charge 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 the fund houses can offer higher commissions to distributors and therefore, maximize the income of both AMC and distributors.
Close ended schemes does not provide the option to exit the funds in case of non-/underperformance of funds in the portfolio. Funds invested in these cannot be redeemed or sold when such need arises. Due to lack of past records and absence of facility to exit the fund, close ended schemes’ working is sometimes referred to as black box working, which lacks scrutiny.
Before maturity, the only mode to sell close ended schemes bought in demat form, is on the stock exchange. On the stock exchange, your fund units would be bought by another investor who is interested in purchasing units of that fund. Moreover, absence of portfolio rebalancing or asset allocation option adds to the rigidity of close ended schemes.
Absence of SIP investment option
Many investors, especially the salaried class, usually prefer regular investments (in the form of SIP) over lump sum investing in equities, which ultimately leads them to investing in open ended schemes, since close ended ones don’t have offer the flexibility of regular investments. Even if a lump sum amount is invested in close ended schemes, the concept of rupee cost averaging isn’t present, even if the market falls down lower. Performance of close ended schemes and investor’s returns are therefore, solely dependent on the timing of the investment, i.e. the opening and closing dates. Moreover, close ended schemes do not cover the concept of rupee cost averaging, implying that the scheme’s investment should be perfectly timed to reduce risk at maturity.
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 corpus without worrying about day to day market fluctuation, can invest in these schemes. Investors cannot exit whenever the market turns unfavorable, and 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 affect the returns which 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 your close ended funds.
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. 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% of 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.
<<The article was originally published in Moneycontrol.com>>