Not an Open and Shut Case | Value Research Fund houses are beginning to turn to closed-end equity funds for business reasons and investors must understand the implications of this shift
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Not an Open and Shut Case

Fund houses are beginning to turn to closed-end equity funds for business reasons and investors must understand the implications of this shift

The business model and investment conditions for mutual funds has undergone massive changes over the last four years. The main change in the business model has been the abolition of entry loads that could be charged from investors and paid to distributors to incentivise them to go sell. And of course the investment environment has changed drastically because of the long stagnation of the equity markets so investor interest in equity mutual funds is at a historic low.

One unintended consequence of these two things could well be the return of closed-end funds. ICICI-Prudential Mutual Fund has just concluded a successful NFO of the closed-end ICICI Prudential Value Fund. Axis Mutual Fund is in the midst of the NFO of the 'Axis Small Cap Fund'. Some more are in the works.

Why should fund houses be able to successfully sell closed-end funds when open-ended funds are a problem? They can do so because the business dynamics are different. A fund house can charge 2.5 per cent of the amount managed per year from investors' funds. In an open-ended fund, investors can withdraw their money any time so there is very little basis for paying an intermediary anything more than a small--perhaps half a per cent--commission for attracting investments.

Closed-end funds are different. The investor is locked in for a long time. For a five-year fund, the 2.5 per cent annual charge means that the fund house knows that it is likely to be able to eventually charge around 12.5 per cent of the amount invested, perhaps more if the markets take off. This creates a basis for paying a large sales commission of say, 5 per cent, to attract investments.

To be sure, there is an investment logic for closed-end funds in some types of equities. In the two funds mentioned above, it can be argued that the fund manager can do a better job if he's sure of the tenure for which the money is available. However, for the investor, investing in a closed-end fund is a very different proposition from investing in an open-end fund. Since closed-end funds have a fixed tenure, investors can invest only during the initial issue and withdraw when the tenure ends. Earlier, there have been some funds in which some form of early redemption was permissible but now 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 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, either through a Systematic Investment Plan (SIP) or otherwise. Also, it is never wise to invest in a fund during its NFO (new fund offer) period. The standard warning might say that past performance is no guarantee of future returns, but it is still the most important indicator you have of how good a fund is and there is no past performance for a new funds. Unfortunately, closed-end 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 fund company's track record on similar funds. This is workable, but far from an ideal way to choose a fund.

More than twenty years ago, closed-end funds were the norm in India. However, gradually, the advantages that open-ended funds had for investors won out and there was an almost total shift towards them. In fact, something like this has happened globally and open-ended funds are the norm almost everywhere. It's ironic that closed-end funds are making a comeback in India as a consequence of regulatory changes that were meant to benefit investors.

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