5 Reasons To Avoid Close-ended Mutual Funds
Dec 11, 2017

Author: PersonalFN Content & Research Team


Mutual Funds love launching close-ended schemes for a variety of reasons.

Unfortunately, the reasons may not always be in your best interest.

It is common to see fund houses come out with New Fund Offers (NFOs) when the market is hot. This is the time investors are attracted by the supernormal returns generated by equity mutual funds.

Asset managers strike when the iron is hot and launch new schemes with similar objectives, in order to garner more funds and increase their asset base.

For example, in the balanced fund category, a few fund houses have launched multiple schemes. The mutual fund regulator, the Securities and Exchange Board of India (SEBI), has often chided mutual fund houses for launching open-ended schemes with similar investment objectives. This has led to scheme mergers and reduced frequency of open-ended NFOs.

But, money managers found a way out. They soon began to launch close-ended funds. Here there is no restriction on overlapping investment objectives and the money is locked-in for 3-5 years, depending on the maturity period of the scheme. Being new funds with a small asset base, the expense ratio too is higher than most established open-ended funds.

Has this strategy helped mutual fund houses? Absolutely!

Over the past one year, fund houses launched as many as 36 close-ended funds garnering an asset size of nearly Rs 11,000 crore. In comparison, only 13 open-ended schemes were launched, picking up about Rs 6,000 crore.

With the regulator introducing a categorisation for open-ended schemes, keeping a limit of one scheme per category, the number of close-ended NFOs may shoot up in the coming months.

Distributors aggressively push close-ended schemes as the trail-commission, which is a monthly commission to the distributor, is paid up front as a one-time payment. This is in addition to the upfront commission paid, which is limited to 1%.

While fund houses benefit with a strong inflow of assets and higher fees, there are several reasons why you should avoid NFOs of close-ended funds.

PersonalFN highlights five reasons why you should avoid close-ended schemes:

  1. The costs outweigh the benefits

    Fund houses and distributors advocate NFOs of close-ended schemes because it makes better business sense.

    For example, if the fund can charge an expense ratio of up to 3% and if the duration of the fund is for five years, then the fund house receives guaranteed revenue of 15% of the assets, as investors cannot redeem their units. The bulk of commissions paid by the fund houses to distributors is up front.

    So, if your mutual fund advisor is insisting you to invest in a close-ended fund; it might be only keeping in mind the commissions. The fund may not be suitable to you at all. 
  2. Timing of launch

    Most close-ended NFOs are launched during times when the market is doing well, which leads to much better collections and a larger scheme corpus. It is important to note that most close-ended NFOs launched in 2007, just before the financial crisis of 2008, have not created wealth for investors. During such times, construction of portfolio could be a challenging task as valuations are stretched at a broader level.

    Under such market conditions, the margin of safety is often low. The rush of close-ended schemes, even in the current bull phase, exposes the tendency of fund houses to launch NFOs with an aim of growing AUM ignoring market valuations. 
  3. No assessable track record

    It is never wise to invest in a fund during its NFO period. Past performance is the most important indicator you have of how good a fund is and there is no past performance for new funds. Unfortunately, close-ended funds by design are open for investments only during the NFO period. There is no track-record. That leaves the investor in the uncomfortable position of having to invest based entirely on the track record of the fund house on similar funds.

    This is workable, but far from an ideal way to choose a fund. This is mainly because the underlying portfolios may differ drastically depending on the investment strategy and fund manager style.
  4. Lock–in of capital

    The only mode to sell close-ended fund units, before maturity, is on the stock exchange, provided you bought the units in demat form. On the exchange, you will have to find another investor who is interested in buying units of the fund.

    Based on experience, there is hardly a market for close-ended funds. And even if there are buyers, units will generally be sellable at some discount to the NAV.

    There are also some other potential problems with a lock-in period for close-ended funds. Take this example, you found that the scheme is performing miserably or you had a financial emergency. You may be unable to exit that fund before maturity for lack of liquidity. This might work against you in some cases.
  5. No option for regular investments

    Under close-ended NFOs, there is no option to invest regularly through a Systematic Investment Plan (SIP), which is the ideal way to invest in equities. Even if you do invest in a close-ended mutual fund schemes when the market is high, there will be no way to average out your cost if the market heads lower. Therefore, before investing, take a long-term view on the direction of the market. It will be difficult to fit in close-ended funds with your long-term financial goals that require a regular contribution.

Structurally, given their limited corpus size, closed-ended funds take concentrated portfolio bets with only about 25-30 stocks in the portfolio. As there is no inflows and outflows from the scheme, portfolio churn too, is limited. That can be an advantage, as it can give you better returns. But, stock picking skills and costs, too, have an important role to play.

Past data shows that open-ended schemes have performed at par, or even better at times, than closed-ended NFOs.

Hence, PersonalFN believes that investors would be better-off avoid investing in close-ended funds. You should instead prefer investing in existing open-ended diversified equity mutual funds having a consistent and dependable performance track record. The best way to invest in such funds is to do so gradually, by investing through a SIP.

Those who are unsure about which mutual fund schemes to invest in may try PersonalFN’s unbiased mutual fund research services. Along with quantitative parameters such as performance, PersonalFN also considers qualitative parameters such as portfolio characteristics while analysing mutual fund schemes.

One such service of PersonalFN is FundSelect. This service helps you identify the top-performing funds across varying market caps and investment styles—be it largecap, midcap, multicap, value-based or balanced funds—highlighting the underperforming or average performing ones too.

FundSelect will assist you in discovering the "best of the best" equity funds as well as debt funds in the market. It will help you build a solid mutual fund portfolio through disciplined investing. So, you have an opportunity to benefit from market beating returns generated by quality mutual funds. 

You will get access to NFO Reviews, in addition to access to other premium research reports.

So don't hesitate... give FundSelect a try Now.


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