As equity markets have rallied sharply over last 1 year, confidence of investors in equity investing is back. The participation of retail investors is also on the upswing. Aiming to take advantage of the upbeat investor’ sentiment, mutual fund houses have launched a number New Fund Offers (NFOs).

Many of the NFOs launched recently, are the close ended funds. Even distributors are promoting them with a great zeal. You must know what makes these schemes more preferred for the distributers and why are fund houses launching so many of them at a time when the markets appear overvalued.

Here are a few reasons why PersonalFN thinks you should avoid investing in close ended schemes:-
 

1. The costs far outweigh the benefits: The reason fund houses and distributers are advocating close ended schemes is because it makes much business sense to them. For example if the fund can charge an expense ratio of 2.5 % and if the duration of the fund is for 5 years the fund house will be guaranteed 12.5% revenue as investors are unable to redeem their units. The bulk of commissions paid by the fund houses to distributers would generally be paid up front. For this reason fund houses would pay distributers upfront commission of around 4-5 % for selling close ended schemes and upto 1 % for open ended schemes.
   
   So, if your mutual fund advisor is insisting you to invest in a close ended fund; it might be only keeping in mind high 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 scheme corpus. It is important to note that most close-ended scheme 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 only meant to be invested into during the NFO and in a lump sum. You can't wait for the track record to be built up and you can't do a systematic investment plan either. 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.
    
4. Lock–in of investment capital: The only form of early exit that is possible is to sell fund units on the stock exchange where they will be listed. The buyer will have to find another investor who is interested in investing in the fund. Based on past experience, one can say confidently that the fund units will generally be sellable only at some discount to the NAV. There are also some other potential problems with close-ended funds. Take this example; suppose you invested in a close ended fund and 1 year later you found that the scheme is failing miserably. Yet, you may not be able to exit that fund for it being a close-ended one. This might work against you in some cases.
    

A few of the close ended funds launched at the peak of 2002-2007 bull market, severely eroded the capital of investors and never recovered thereafter.

Are there any positives?

There are a few benefits of investing in close ended funds. Since the tenure of these funds is fixed, Assets under Management (AUM) Is more stable. This eventually enables the fund manager to build a portfolio keeping a specific time horizon in mind, the comfort not available to open ended mutual funds.

Structurally, closed-ended funds can take concentrated portfolio bets and invest in only a few stocks, about 25-30. That can be an advantage, as it can give you better returns. Although past data has shown that open ended schemes have performed at par, or even better at times, than closed ended schemes.

Hence given the aforesaid, 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, either through a Systematic Investment Plan (SIP) or by putting money in a piecemeal manner.

PersonalFN provides comprehensive and unbiased mutual fund research services.

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