Should You Avoid Mutual Funds With a Lock-In Period?
May 28, 2019

Author: Divya Grover

(Image source: Image by mohamed Hassan from Pixabay)

Liquidity is one of the main advantages of investing in mutual funds, which means you can buy and sell them as per your convenience. This can be a real boon when you have an urgent financial need.

Most mutual funds, especially open-ended ones do not have a lock-in period. The only exception is Equity-linked saving scheme (ELSS), with a lock-in period of three years and solution-oriented plans like Children fund and Retirement fund that have a lock-in period of five years.

Some close-ended funds come with a lock-in period of 3-5 years. As a result, the fund manager does not have to worry about redemption and can select instruments even with low liquidity.

But should you invest in mutual funds with lock-in period or would you be better off investing in schemes without a lock-in period?

Let's find out...

Close-ended mutual funds

Close-ended funds are the funds that are available for subscription only during a specific period, i.e. during the new fund offer (NFO) period. Thereafter, investors can buy or sell the units of close-ended funds only on the stock exchange in which they are listed.

Mutual funds houses have always promoted close-ended funds citing that since an exit option isn't available, investors will be encouraged to stay invested for a longer time and as a result build wealth.

In reality, recent performances of close-ended funds show that they have not been on par with that of open-ended schemes. Most NFOs are launched during a market rally in a race to garner more Asset under management (AUM) growth, while market valuations remain overlooked. However, this strategy has not benefited investors with regards to wealth creation.

As these schemes can only be bought during the NFO period; there is no track record of performance that can be used to compare performance of schemes. The ultimate downside is that the lock-in period will not allow you to exit in case of consistent underperformance of the scheme, or if there is change in your financial objective, or if a better alternative is available.

Additionally, since the market regulator's restriction of limiting one scheme per category is only applicable to open-ended schemes, mutual funds continued to launch close-ended funds to grow their AUM.

Though investors have the option to sell their units on the stock exchange in which it is listed, there isn't enough market for close-ended schemes, making it difficult to find a buyer.

Unlike open-ended funds, close-ended funds do not have the option to invest via Systematic investment plan (SIP). SIP is the ideal way to invest in mutual funds as it helps in rupee-cost averaging and grows your wealth through the power of compounding.

The disadvantages of close-ended scheme far outweigh its advantages and it should therefore be avoided.

[Read: 5 Reasons To Avoid Close-ended Mutual Funds]

Solution-oriented schemes

Mutual funds have launched open-ended solution-oriented schemes that aim to help you achieve specific goals like retirement, children's education/marriage. Designed to cater to your long-term goals, these funds generally invest in equity and equity-related instruments. The schemes come with a lock-in period of 5 years.

Since every investor's requirement is different, a dedicated scheme may not be enough to achieve the goal. Instead, your portfolio should consist of different asset classes and categories of products selected based on your age, income, expenses, risk profile, and time horizon.

[Read: Type of Mutual Funds for Your Child's Higher Education Needs]

With solution-oriented scheme, the lock-in period will prevent you from exiting if it consistently underperforms. The past performances of the solution-oriented funds show that the returns have not been impressive enough.

You can achieve the financial objectives like retirement, children's education/marriage without a dedicated solution-oriented fund. Instead begin by building a research-backed portfolio based on your needs. A carefully designed portfolio will also give you the flexibility to review and rebalance the portfolio whenever necessary.

[Read: Can You Solely Depend On 'Retirement Funds' For Your Retirement?]

Equity-linked saving scheme (ELSS)

Equity-linked saving scheme (ELSS) is an equity-oriented scheme that comes with a lock-in period of three years and tax benefits. These funds invest minimum 80% of their assets in equity and equity-related instruments. The high equity exposure makes it ideal for moderate to high risk-takers.

Many ELSS have clocked impressive returns in medium to long-term and therefore, it can form part of your tax-planning portfolio. Investments in ELSS entitle you to tax deduction under Section 80C of the Income Tax Act. It can thus help you achieve your financial goals and efficient tax planning.

[Read: Should You Be Investing in ELSS At The Beginning Of The Financial Year?]

As mentioned earlier, ELSS come with a lock-in period, so you must be careful while selecting a suitable fund. You should select the funds that have performed consistently well over different market phases and has an appealing risk-reward ratio. Invest through the SIP route for long-term to reduce the volatility due to the high equity component.

To conclude

You should avoid close-ended funds because-

  1. The costs outweigh the benefits

  2. Launched when the markets are doing well

  3. No assessable track record

  4. Lock-in of capital

  5. No option for regular investment (SIP)

Solution-oriented funds on the other hand are not bad, but they are not ideal either. If you decide to invest in solution-oriented schemes then you must approach very carefully. Select the fund based on its performance over different time periods. Also determine if the fund will be suitable for you to achieve your goals or should you rather create a well-diversified portfolio consisting of different asset classes and product category.

Here are some solution-oriented scheme related myths you should be aware of before you decide to invest in solution-oriented schemes-

Myth-1

The lock-in period gives the fund manager more leeway in managing schemes and taking long-term investment calls, without fearing redemption pressure.

Myth-2

Solution-oriented funds offer you wide array of choices depending on your needs.

Myth-3

It helps you do away with the need to draw a personalized allocation plan.

Myth-4

It gives you more flexibility in deciding how to utilise your investments.

Speaking of ELSS, the scheme's benefits as part of your tax-planning portfolio should not be missed. However, make sure to select the right fund after evaluating it on quantitative and qualitative parameters.

If you have already invested in mutual funds with lock-in period like close-ended funds or solution-oriented funds, your only option will be to stick with it until you can exit.

Once the lock-in period is complete, do not rush to redeem the fund. Instead, analyse how the fund has performed over different time frames and compare its performance with benchmark and peers. If the funds have performed well, you can continue with the investment. Consult with your investment adviser if you need clarity about the suitability of scheme for your portfolio.

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