Think hard before opting for Close-ended funds

The almost-dead close-ended equity funds are making a comeback in the Indian market.

The mutual fund industry did begin its innings in India with close-ended equity funds. But after the initial euphoria, almost all of them ended as unmitigated disasters. As a result, the MF industry remained inconsequential for a long time.

The first sign of the industry’s revival came with the introduction of open-ended funds. Since then the industry has grown quite admirably. In fact a lot of the earlier close-ended funds have since been converted into open-ended ones.

Given the fact that things were going so well for the industry with the open-ended funds, why this sudden about turn. Why is the MF industry suddenly launching mainly close-ended funds, which were earlier resoundingly rejected by investors?

The reason is not far to seek. The answer lies in the recent changes brought in by Sebi as regards the appropriation of the issue expenses of a New Fund Offer. (Also read - Check out the dos & don'ts of MF investing)

Before the Sebi circular came in, the MFs were allowed to write-off issue expenses of a New Fund Offer, from the fund, over a period of 5 years. Therefore, marketing expenses on new funds, usually about 6% of the corpus raised, were incurred and written-off from the fund over the next five years.

Since, these expenses were written-off over a period, the NFOs could open at par. Also, quite a few of them were introduced with no up-front entry load.

With the new guidelines, this has been stopped. Now in an open-ended NFO, all the expenses have to be either met out of the entry-loads or netted off from the fund on day 1. It is difficult to assume that anyone would be willing to pay 6% entry load, especially after being used to the so-called no-load funds. As a result, an open-ended NFO will always open at NAV below Rs.10. This will attract the ire of the investors and they will, over a period of time, stop investing in NFOs. Or alternatively, the AMCs would have to bear such expenses, eating into their profits.

Since the rules of the game have not changed for close-ended funds, there is a sudden newfound love for such close-ended NFOs.

A part of the blame, of course, lies with the investors too. They have all along believed that an NFO at Rs.10 NAV is cheaper than an existing fund with an NAV of say Rs 100. (Also read - Demystifying NAV myths)

As a result, they have been willing to invest thousands of crores in an NFO, but will not invest even Rs 1000 in an existing fund with a proven-track record. Hence, the only avenue available to the MFs to increase their AUMs was to come out with NFOs, similar to the ones they were already having. And as a marketing strategy, some of them were introduced with fancy names to attract investors.

As it is, investing in NFOs makes little sense, unless they have something different to offer from the existing funds. Without the benefit of a known track record, one cannot make an informed judgment.  And to compound the problems, in a close-ended fund you can’t even get out and rectify your mistake in case the fund does not perform well. (Also read - Invest, but choose the right mutual fund)

SIP is the best way of investing in equity markets, especially in today’s volatile markets. Close-ended funds, by their very nature, do not facilitate SIPs, thus taking away a very important risk-mitigating strategy.

One small advantage of a close-ended fund is that it makes the investor take a long-term view of the markets.

But all the other negatives far outweigh this benefit. Moreover, a smart and well-informed investor can derive this benefit by staying invested in an open-ended fund too.

As regards the fund manager being able to take a long-term view instead of having to manage short-term performance, fund managers have done a commendable job in the past in managing open-ended funds and there is no reason why they cannot continue with the same performance in future too.

All in all, there is a need to look at the close-ended funds really hard before putting in one’s hard earned money.

The solution lies in investor education and MF distributors have to play a very important role. Instead of looking at short-term profits at the cost of the investors, whose interests they are supposedly serving, they must work towards building a strong and ethical MF industry. This is in everyone's interest– MFs, investors and distributors.

- Sanjay Matai

The author is an investment advisor and can be reached at sanjay.matai@moneycontrol.com.

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