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The Unfortunate Revival of Closed-end Funds

Closed-end funds are making a comeback, but unfortunately the reasons are rooted less in investors' interests and more in the business logic of AMCs

Consider the numbers: From October 2013 till now, 33 closed-end equity funds have been launched. Out of these, collection data is available for 28 and these 28 have managed to gather ₹4,300 crore between them. Compare this to open-end funds. Over the same period, ₹50,369 crore has flown into open-end equity funds but ₹46,642 crore has flown out, leaving a net positive investment of ₹3,727 crore. Thus, 54 per cent of the equity fund investments over this period have flown into closed-end funds. This is a far cry from the situation a few years ago when closed-end equity funds were basically extinct. During the 6 years from 2003 to 2008, there were a total of 328 equity NFOs, out of which a paltry 22 were closed-end funds. This was understandable. After all, closed-end funds have a long list of disadvantages over open-end funds. You have to invest all the money in a lump-sum and can't take advantage of SIPs. You have to invest at the start so there is no track record to judge a fund by. And effectively, there is no liquidity so you have to commit for the entire period of the fund. Even if you need your money half way there is no way of redeeming it without suffering a loss over the NAV.

So why have investors suddenly become so fond of closed-end funds? Don't they understand that open-end funds are a far better option? The answer is simple-this is an unintended (and harmful) side effect of the regulatory changes that SEBI has brought about over the last five years. The fact is that closed-end funds make much more business sense for AMCs and they are willing to pay distributors handsomely to push these to investors.

They can do so because the business dynamics are different. No entry load can be charged so all the money to incentivise sales and marketing must come from the 2.5-2.75 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.

This money that an AMC can spend on marketing and the high level of commission it can pay for sales is the sole reason for the revival of this decidedly inferior type of fund.