Closed Ended Mutual Funds Should You Invest In Them Now
India is a land of ‘Jugad’ and Indians have mastered this‘art’ in every field, including the complex world of finance. Since the start of this calendar year, we have been seeing many of the mutual fund houses coming up with the closed-ended schemes.
Large players in the asset management industry like Canara Robecco, SBI, Sundaram, Kotak and IDFC have launched closed-ended schemes having lock-in periods,while others are in the process of launching these equity schemes. The reason for the AMCs’ sudden love for the closed-ended schemes can be traced back to one of the circular issued by the market regulator, SEBI, in the month of October 2017. The new norms mentioned in the circular states that fund houses can have only one scheme under each category due to which there were a lot of the mergers of similar schemes to comply with the norms. However, the rules do not apply to the closed-ended funds, so the fund houses are coming up with these funds.
The momentum in the launch of closed-ended equity schemes in the year of 2018 suggests something special in these schemes. The data shows that since January 2018 to June 13, 2018, around 29 closed-ended equity diversified schemes (excluding index, ETFs and RGESS) have been launched by various fund houses. During the same period last year, 21 schemes were launched showing a jump of 38%.
Downpour of Closed-Ended Funds
The closed-ended schemes are older than the open-ended schemes in their origin, however, the open-ended schemes have gained popularity in due course of time due to their various advantages over closed-ended funds. Currently, there are 386 primary open-ended equity dedicated schemes (excluding their variants such as dividend, direct, reinvestment) having assets under management (AUMs) to the tune of Rs 7.11 lakh crore. Compared to this, there are only 289 closed-ended schemes managing assets worth Rs 35,195 crore, which is only five per cent of the AUMs of open-ended equity mutual fund schemes. 
If we take both equity and debt categories, we find the difference in their AUMs narrows down. The open-ended schemes had AUMs of Rs 20,68,453 crore at the end of May 2018 as compared to the closed-ended schemes’ AUMs of Rs 1,84,290 crore, which is nine per cent of the AUMs of open-ended mutual fund schemes. It shows that most of the closed-ended funds are from the debt category, where the fixed maturity plans (FMPs) corner the lion’s share. When asked to explain the reason for their popularity amongst investors, Ashwin Patni, 
Head Products and Fund Manager, Axis Mutual Fund, said that “these are debt funds that have a fixed maturity and typically create a buy and hold debt portfolio that matures in line with the maturity of the scheme. Thus, the investors capture the yield of the portfolio without worrying about the mark-to-market movements.” To ascertain the reasons for the popularity of FMPs,
we analysed a number of closed-ended schemes that have been redeemed or matured between 2014 and 2017, that is, four years of data. Out of the 3,458 schemes, 2,844 schemes or 82% of total schemes were FMPs. We also looked at the performance of all the closed-ended equity schemes, which remains one of the prime filtering criteria for the investors to include them in their portfolios.
Performance: Not Encouraging
The performance of the closed-ended schemes is not quite outstanding. If we compare the data on returns for the last one year between open-ended and closed-ended schemes, the results are a mixed bag. Out of the six categories where data for both types of schemes were available, the average returns of closedended schemes exceeded open-ended schemes only in two categories in the last one year. In the remaining four categories, the closed-ended funds underperformed the open-ended schemes. It is hard for an investor to digest such underperformance. One of the strongest arguments in favour of closed-ended schemes is that the money is locked and the fund manager can take concrete calls with a long-term view without facing any redemption pressure, so the fund manager should be able to generate good returns for the investors in the long run. One of the reasons why the closed-ended funds underperform their open-ended counterpart is the higher expense ratio. For every category of funds, the expense ratio is higher for the closed-ended funds. For example, for open-ended large-cap funds, the average expense ratio has been 1.5 per cent as compared to 2.72 per cent for the closed-ended funds dedicated to large-cap stocks.
Similarly, for the tax saving funds, the closed-ended funds have expense ratio of 2.8 as against 2.24 of the open-ended funds. The argument that goes for higher expense ratio is that the asset size of closed-ended funds is smaller. This is, infact, true as the average size of the open-ended funds is larger by almost 10 times their closed-ended counterparts.
Nonetheless, many of the fund managers will argue that their mandate is to beat the benchmark index rather than their categories in the open-ended schemes. To check that argument, we compared the performance of the closed-ended schemes with their benchmarks. On an average, we found that these funds beat their benchmarks in all the categories.
For example, in the last one year, the large-cap closed-ended funds generated return of 13.2%, while the benchmark represented by Nifty in the same period gave a return of 12.58 per cent. Similarly, 25 small-cap dedicated closed-ended funds on an average have generated return of 6.85 per cent as compared to their benchmark generating return of 5.04 per cent. Hence,in terms of returns, the closed-ended funds have performed upto their expectations.
Some of the pessimists will argue that these funds are yet to mature and hence it will be too early to pass any judgement
What Are Closed-Ended Funds
Closed-ended funds are different in their constitution from the open-ended mutual funds. In the case of open ended fund, if an investor desires to buy the units of the scheme, the asset management company will issue units to him at the prevailing price of the scheme, represented by the net asset value (NAV). However, the close-ended fund issues a fixed number of units that are compulsorily listed on the stock exchanges. The closed-ended funds have a close resemblance with the exchange traded funds (ETFs) than a mutual fund scheme. The funds are launched via IPO to raise the money and traded in the open market just like a stock. The units of closed-end funds can be bought and sold through brokers. These funds have a fixed maturity period. On the contrary, open-ended funds are not traded on the stock exchanges. The investors investing in closed-ended funds are not allowed to redeem their units, except on the maturity date. Due to this, the portfolio manager or fund manager gets a stable asset base which would not change owing to frequent redemptions and purchases.
Ashwin Patni
Head Products and Fund Manager, Axis Mutual Fund
As a fund manager, what in your opinion are the key benefits and risks of investing in closed-ended schemes?
Closed-ended schemes work best when they allow investors to capture some specific opportunity. The best examplesarethe Fixed Maturity Plans (FMPs). These are debt funds that have a fixed maturity and typically create a buy and hold debt portfolio that matures in line with the maturity of the scheme. Thus, the investors capture the yield of the portfolio without worrying about the mark-to-market movements. Similarly, the closed-ended funds in the capital protection space have been used to provide low risk exposure for conservative investors.
In the last one year, the closed-ended schemes have garnered an average return of around 7%.What is your outlook for the coming year?
You cannot club these funds together while looking at returns, since each fund can have a distinct strategy. For equityoriented schemes, their returns should compare with the equity market performance in the comparable period. However, in the case of debt, these funds work very differently due to typically a buy and hold approach. We believe that by and large the funds have delivered in line with the mandate and we expect the same to remain true in the coming year as well.
What are key aspects one should look for while evaluating the closed-ended funds and their performance?
The most important is to understand their mandate. As highlighted earlier, the closed-ended structure allows fund managers to structure distinct strategies that are different from open-ended ones. This is especially true in case of debt and hybrid funds.
At the current juncture, between open-ended and closedended schemes, what should investors prefer?
For most regular long term investors, open-ended funds should form the core part of the portfolio allocation. The closed-ended funds can complement specific allocations for investors that have special requirements, which the openended funds are not able to cater to.
about their performance. To verify whether it is a trend for the closed-ended funds to have consistently beaten their benchmarks in the past, we analysed the performance of all the funds that have matured between 2014 and 2017.
The aggregate figures cannot be generalised as the different schemes had different life span and their benchmarks might have performed differently in those periods. Therefore, we took some specific cases. For example, two tax saving schemes were launched in 2006 and 2007, respectively, for ten years, which matured and were redeemed in 2016 and 2017. These schemes generated an absolute return of around 166 per cent, which gives annualised return of 10.4 per cent. If we take Sensex as the benchmark for these schemes (ELSS normally take large-cap indices as their benchmarks), the returns generated by them has beaten the benchmark during the same period. The Sensex during this period gained at an annualised rate of eight per cent. In another case of a closed-ended index fund, we saw these closely following the benchmarks. Therefore, in most of the cases, the closed-ended schemes match the performance of their benchmarks, but these schemes fail to beat the performance of the open-ended schemes.
Should You Invest In Closed-Ended Schemes?
Looking at the above analysis, should you invest in closedended funds? There are various risks involved in investing in mutual funds,but there are specific risks that are attributable only to closed-ended schemes. First, there are no past performance records of these funds and these can be subscribed only during the NFO period. Although we believe that past performance is not an indicator of the future performance, atleast it can be helpful in knowing the fund management style.
In many cases, you may choose to invest in a closed-ended fund based on the reputation of the fund manager. This can be influenced by the fact that the fund manager managing the closed-ended scheme may have a good track record of managing open-ended schemes which have been performing well over a period. Nevertheless, you cannot do much in case of change of fund manager mid-way. The investors will be stuck with the investment in the closed-ended funds,unlike the open-ended funds, where the investors have a choice to switch over to other funds in case of a change in the fund manager. Other major disadvantage of a closed-ended fund is the lack of liquidity. Even if closed-ended funds are listed on the stock exchange, the liquidity in these funds is extremely low,due to which exiting a fund becomes difficult even if the fund is a poor performer. The trading price of these funds, most of the time, is below their NAVs.
Considering all the above mentioned reasons, we see that investment in a closed-ended schemes is a risky affair. Nevertheless, closed-ended schemes are not to be shunned and these are suitable for investors who are prone to fall into the trap of fear and greed,that is, they sell when the market is on a decline and buy when the market is on a high. The closedended schemes help them behave in a rational manner. Besides, the closed-ended funds can form part of your portfolio to take specific exposure which is not available through
S Naren
ED & CIO, ICICI Prudential AMC
What in your opinion are the key benefits and risks of investing in the closed-ended schemes?
We are positive on closed-ended schemes and had recently launched one on the consumption theme. It is generally seen that inflow accelerates at market tops and tends to peter out as market bottoms, which is the inverse of what should ideally happen. Therefore, by investing in a closed-ended fund, the investor is aware that the money is locked away for the specified duration and hence won’t succumb to the greed and fear psychosis. This gives the fund manager the opportunity to deploy large sums whenever there is a market dislocation, thereby creating the opportunity to make outsized gains. For example: Warren Buffett, the most successful fund manager over the last 50 years, has been running a closed-ended fund (Berkshire Hathway). Also, a closed-ended fund is most likely launched when a fund manager spots an attractive pocket of opportunity in the market (mostly based on themes). However, at that point in time, there is no way to access the inflow into a scheme for large deployment. At such a time, the close-ended structure helps because the fund manager has the leeway to deploy the raised capital by taking concentrated bets in that particular theme, which is likely to play out over the duration of the scheme.
In the last one year, the closed-ended schemes have garnered an average return of around 7%.What is your outlook for the coming year?
It would be ideal if one could look at the investment experience open-ended schemes. Or else, investors need to understand a theme and have confidence that the theme will do well to invest in themes in certain market conditions. For example, closedended schemes need lumpsum investment and if market is over the full term of the scheme. Thus far, the investment experience of the schemes which were launched in the second half of 2013 and have matured has been good. Same is the case with investment experience of ICICI Prudential R.I.G.H.T. (Rewards of Investing & Generation of Healthy Tax Savings) Fund, a ten-year close-ended equity-linked savings scheme which was launched in September 2009 has thus far delivered 18% returns in CAGR terms since inception (as on May 31, 2018)
What are key aspects one should look for while evaluating the closed-ended funds and their performance?
For a closed-ended fund, it would not be appropriate to look at returns on a year-on-year basis. The best way to analyse would be when a market cycle is over. Globally, it has been proved that it is only over a market cycle that measuring any closeended fund is logical.
At the current juncture, between open-ended and closedended schemes, what should investors prefer?
For those with the ability to stay invested for the lock-in duration should opt for closed-ended fund. Whenever the funds make sizeable gains, it is generally seen that dividends are declared such that the gains are returned to the investors periodically. For those looking to invest in open-ended schemes now can go for large-cap oriented funds and balanced advantage scheme in order to make the most of the volatile market conditions.
trading at higher valuation, lumpsum investment may not give you the desired returns. As against this, if the market is trading at lower valuation, lumpsum investment may give you better returns.
Closed Ended Funds Available at Discount: Is it a bargain buy
Closed ended funds are listed on the stock exchanges. Normally, they are available at a discount to their NAVs and sometimes at a deep discount. Hence, if a closed-ended fund is available at a discount of 20%, this means you are getting Rs 100 worth of product at Rs 80. Should you buy them? A case in the point is ICICI Prudential Bharat Consumption Fund, which was available at Rs 9.05 on June 15, 2018. However, its NAV was 9.95 for the same day, which means it was available at discount of 10 per cent to its actual NAV. There are other cases where the discount is even steeper. Normally, further away is the maturity period of the fund, higher is the discount. This sounds like a good bargain and you should pounce on it. But wait.
These closed-ended fund's NAV do not consider the future cost of all fees and other fund expenses, in other words expense ratio. They will remain as a liability for the funds irrespective of how they perform and who owns them. Currently, the closed-ended funds on an average have expense ratio of 2.71 per cent. Therefore, it is natural for closed-ended funds to trade at discount.
But what is the ideal discount at which the closed-ended funds are an attractive buy? Depending upon the remaining maturity period and an expense ratio of the fund, any discount above 20 per cent can be a good bargain buy. However, there are a couple of things that you should consider. First and foremost is the liquidity issue. You may not get any buyer when you want to sell your funds and it may happen that you have to sell at a discount, which actually cancels any benefit you got while buying the fund. Second, the fund should not be bought only because it is available at a deep discount. The fund should also fit into your entire scheme of things such as a sector fund, where currently you do not have much exposure.