Even five years ago, everyone associated with the Indian mutual fund industry - AMCs included - was convinced that open-ended mutual funds are the future of the industry and that closed-end funds are dinosaurs of the past. But closed-end funds have risen phoenix like from the ashes to make a comeback in the last three years. If you look at the line up of new fund offers this month, closed-end funds easily outnumber open-ended funds, with over eight new schemes set to tap the market in the next couple of months.
What AMCs say
If you ask AMCs why they've gone back to closed-end equity funds, they have many pat explanations to offer.
By locking in your money for three years, closed-end funds make sure that you stay invested long enough for equities to pay off. As retail investors are behaviourally inclined to jump into equities in bull markets and pull out in panic during market dips, closed-end funds save investors from such wealth-destroying behaviour.
Without the distractions of inflows and outflows, the fund manager gets to buy and own long-term picks in his portfolio without worrying about short-term performance.
Lately, there's also the argument that closed-end equity funds allow managers to own concentrated positions in high-conviction bets, a strategy which is getting harder to implement in many of the jumbo-sized open-ended schemes.
But if all these arguments are tempting you to apply for some of the recent closed-end NFOs, you should first be aware of the following aspects of closed-end funds, which AMCs and advisors may not like to talk about.
Most fund houses in India warn that timing the market is a dangerous sport. Not only do most AMCs refuse to time the market in their own schemes, they also persuade investors to take the SIP route so that they aren't hurt by bad timing.
But closed-end funds, by offering you only a limited window of opportunity, force you to make a lump-sum investment and not an SIP. If you lack the flexibility to take the systematic route while investing in closed-end funds, you also have the same problem when the units are redeemed.
As closed-end funds are not permitted to automatically convert into open-ended schemes at maturity, both your investment and your exit from the fund are timed to a specific market level. Your returns will heavily depend on point-to-point performance between the fund's opening and closing dates.
Steep expense ratio
If their small size helps closed-end funds hold concentrated portfolios, the flip side of a tiny size is a high expense ratio. While SEBI sets clear limits on the maximum expense ratio that funds may charge from their investors, its slab structure allows AMCs to charge their highest expense ratios to their smallest funds, with the expense limit shrinking as fund size increases.
Given that closed-end funds often collect very small sums in relation to their open-ended peers, they often end up with high expense ratios. Sifting through the expense ratios of closed-end funds on the Value Research database, the average ratio worked out to a steep 2.62 per cent, with over half a dozen schemes easily topping the 3 per cent mark.
Levying these high costs helps AMCs in two ways. One, they can offer high upfront commissions to distributors to market their closed-end funds. Two, the AMC gets to pocket a much larger fee by managing 10 closed-end funds of Rs 100 crore each than one Rs 1,000 crore open-end scheme!
No skin in the game
Three years ago, SEBI ushered in an important new rule to ensure that AMCs and fund sponsors had a sufficient stake in the schemes they managed. It required all AMCs or sponsor companies to invest either 1 per cent of the assets or Rs 50 lakh in every fund that they launched. This very sensible rule was designed to make sure that sponsors and AMCs had their own skin in the game when they sold any fancy new schemes to investors.
For some reason though, this rule was made applicable only to open-ended funds and not closed-end funds. Ever since the skin-in-the-game norms have come into force, closed-end scheme launches have really picked up in number vis-a-vis open-end schemes.
With open-ended funds, you can do a real-time comparison of any scheme with its peers and benchmarks and exit it if it fails to deliver the goods. Closed-end funds are constrained on both. Given that closed-end funds are not open to investors after their initial offer period, most independent ranking agencies do not include them in their rating exercises. Sporadic disclosures from closed-end funds also make analysis of their metrics difficult. Because most closed-end funds have a definite start date, they don't lend themselves to a rolling-return or trailing-return analysis. This lack of scrutiny can lead to complacency for the managers of closed-end schemes.
Worst of all, while investor pressure and frenetic competition have forced AMCs to clearly define their mandates and investment strategies for their open-ended schemes and to stick more closely to their labels, closed-end schemes enjoy a free hand both in naming and loosely defining their mandates. In fact, with vague names like 'Equity Opportunities', 'Focused Equity', 'Capital Builder', 'Long-Term Advantage' and so on, you are hard pressed to gauge a closed-end fund's mandate from its name. The presence of multiple schemes under a series from the same AMC also compounds the confusion on mandate and performance.
No SEBI clean-up
SEBI has recently mooted a very important set of rules to tighten the labelling norms for mutual funds, enforcing truth in labelling and simplifying the roster of schemes by consolidating similar ones. But as these norms don't apply to closed-end schemes, they may continue with their black-box style of working!