FundsIndia explains : What are Closed-ended mutual funds

Most mutual funds are open-ended, that is, you can invest in that fund any time you please and also exit when you wish to. But some funds are classified as closed-ended. How are these different and what are their pros and cons? This article deals with it.

What is an Open-ended mutual fund
Open-ended mutual funds allow you to invest in them at any point in time apart from the ‘new fund offer’ period. The funds therefore receive ongoing inflows and redemptions. The AUM of the fund goes up or down not only by the virtue of the market but due to such inflows and outflows as well. The subscription for these funds happen at the NAV prevailing at the time of investment.

What is a Closed-ended mutual fund
On the contrary, closed-ended mutual funds are those in which the investors can subscribe to, only during the new fund offer period. They have a fixed period post which you will get the investment value back or in some cases, the fund becomes open ended.

Closed-ended funds must be listed on the exchange. They can be purchased from the exchange only through a Demat account outside of the NFO period, subject to liquidity in the units in the exchange.

As these funds are closed-ended, they do not get fresh inflows nor redemptions on an on-going basis. The number of units in the fund remains constant and the AUM of the fund moves up or down only by way of market movement.

Types of closed-ended funds
As in an open-ended mutual fund, there are closed-ended funds in both debt and equity. We will be looking into the types of closed-ended debt funds their risks and advantages in the subsequent week. Fund houses come up with various types of closed-ended equity funds. The funds could be, thematic, value fund, growth funds, market-cap based funds or tax saving funds.

Pros and cons in closed-ended funds
Before we look at some of the risks of investing in closed-ended funds. Closed-ended funds do help the fund managers in managing the money more efficiently. One of the key advantage in closed-ended fund is that since the money over the period of the fund is locked in, it helps the fund manager to take concrete calls with long term view on some of the stocks without facing any redemption pressure. This allows the fund manager to take positions in stocks that may be otherwise illiquid. This helps keep the churn low and holds potential to deliver higher returns in the stock and consequently the fund as well.

There are various risks involved in investing in equity funds. But there are specific risks that are attributable only to closed ended funds. Let us look at some of them.

No past record: Closed-ended funds can be subscribed to only during the NFO period. Hence there is no track record for the investor to rely on at the time of purchase. Unlike an open ended fund, where the investors can follow a wait and watch approach, track the fund for a couple of quarters or even years before deciding to invest, closed-ended funds have no such track record to showcase.

Change of Fund manager mid way: With very limited option to purchase a closed-ended fund after its NFO period, some investors may decide to purchase the fund based on the reputation of the fund manager. This may be influenced by the fact that the fund manager managing the closed-ended fund may have successfully managed many open-ended funds which have been performing well over a considerable period of time. But the status quo with respect to the fund manager may not remain. If a fund manager quits half way through the period of the fund, you will be stuck with the fund unlike an open-ended where you can choose to monitor the performance of the new fund manager and choose to exit in case you are not satisfied with the performance.

Low liquidity: Though closed-ended funds are listed on the stock exchange, their liquidity is extremely low. As a result, exiting a fund when in need of money or because the fund is a poor performer,will be difficult. And the low liquidity means that the market price of these closed ended funds on the exchange, mostly trade below or above their actual NAV based on demand and supply.

No SIPs/STPs: During volatile markets, when SIPs and STPs are the best mode of investing, since these help average investment cost by providing entry points at various levels of the market. In a closed-ended fund, SIPs and STPs are not possible and investments have to be made in lumpsum irrespective of the market condition. In the same light, partial redemptions and additional purchases are literally impossible making asset allocation difficult during various market cycles.

High degree of uncertainty: Just as there is a risk of ill-timing the entry, the exit point too may be writ with risks when a closed-ended fund matures. A single black swan event right before the maturity of the fund can wipe out some or all of the gains. It would not give an option to the investor to even wait it out as the fund would have matured.

Closed-ended funds can be risky options for the above reasons. One needs to have a high tolerance for risk and a very clear outlook of the markets for the foreseeable future before venturing into closed-ended funds. Or they may have to understand a theme and believe that it will do well, to invest in themes in certain market conditions. Having said that some closed-ended funds have delivered returns for the investors in the past. But for majority of retail investors, not wanting to take calls on the market. STPs and SIPs in open-ended funds hold good for all seasons.