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Mutual Funds Look Back to Move Forward

The no loads era may have created the quite unwelcome setting for the return of close-end funds

One of the unintended consequences of the abolition of entry loads on mutual funds could well be the return of closed-end funds. Investors need to be aware of this and have a clear idea of the pros and cons involved. Of the small handful of equity funds that are currently in the pipeline, at least one (Birla Sun Life’s T-20 Fund) is closed-end. For fund companies, the business logic of closed-end funds has been that much stronger in the post entry-load world and others in the business are planning the same.

The reason is simple. Without entry loads, funds will have to pay fund distributors out of their own pockets rather than out of the entry load deducted from the investors’ money. Now, the fund company’s as well as the distributor’s revenues must come out of the 2.5 per cent annual expenses that are deducted from the funds managed. Therefore, to improve the commercial viability of running a fund, it is important that investors stay with a fund for a reasonably long period.

However, for the investor, investing in a closed-end fund is a very different proposition from investing in an open-end fund. Closed-end funds have a fixed tenure and investors can invest only during the initial issue. Also, the fund company will redeem their investment at the end of the fixed tenure. Earlier, there have been some funds in which some form of early redemption was permissible, but from now on I expect that the only form of early exit that is possible is to sell the fund units on the stock exchange where they will be listed. The buyer will obviously have to be 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 net asset value (NAV).

There are also some other potential problems with closed-end funds. The best way to invest in a fund is to do so gradually, through a Systematic Investment Plan (SIP). Also, it is never wise to invest in a fund during its new fund offer (NFO) period. As the standard warning says, past performance is no guarantee of future returns, but it is still the most important indicator you have of how good a fund is.

Unfortunately, closed-end funds by design are only meant to be invested in during the NFO and that too with a lump sum payment. You can’t wait for the track record to be built up and you can’t do a SIP either. That leaves the investor in the uncomfortable position of having to invest based entirely on the fund company’s track record on similar funds. This is workable, but not an ideal way to choose a fund.

Interestingly, closed-end funds that are listed on the stock markets offer a unique opportunity to savvy fund investors. Since these funds are generally traded at a discount, it is possible to buy them gradually from the stock market with a sort of a guaranteed outperformance built into the price, provided you are willing to hold it to maturity. If the fund is a reasonably competently-run large-cap fund, you can be sure of getting excellent returns. While low trading volumes can be a limitation, I know some investors who employed this strategy with great success in the past and bought funds at discounts of 20 to 35 per cent. That would be like buying the Sensex at perhaps 12,000 today.

However, none of this can disguise the fact that closed-end funds are less desirable than open-end ones and if the abolition of entry load leads to an increase in such funds then that’s a step backwards.