Why You Should Avoid Closed-End Mutual Funds

I have written about Debt Funds and Equity-Linked Savings Funds in the past. Now, let’s take a closer look at Closed-End Mutual Funds.

avoid closed ended fundsClosed-ended funds, by definition, refer to funds where the investor can subscribe only during the launch period and cannot withdraw money until the tenure of the scheme is completed. It is important that you don’t get confused between closed-end funds and funds with a lock-in period like ELSS.

Closed-end funds sell a specific number of units and their NAV is fixed. The investor can’t purchase the units of this scheme once the initial offer period is over and those who have bought the units cannot redeem it until the scheme matures, which could take anywhere from 3  to 10 years. This restriction means that there are no new inflows and no redemption from the scheme resulting in the scheme’s portfolio corpus remaining the same throughout the period of the said scheme.

Since, there is no exit route for the investor, it is mandatory to list the units of these closed-end funds on a stock exchange after the offer period closes. This allows the investor to sell their units on the exchange if they want to exit the scheme before its maturity.

Drawbacks of Closed-End Funds

  • No track record
    Whenever one selects a mutual fund scheme for their investment, it is always advisable that they check the past performance record. Although, past performance is no guarantee of future performance, one can gain great insights from these records. Details like how the fund has performed in comparison to its peers, or how frequently has the fund outperformed its set benchmarks can help you decide which scheme to select. But such information is not available in case of closed-end funds. One can only decide based on the fund house and fund manager of the scheme. Also, what if the fund manager was replaced midway?
  • Liquidity Issue
    It is difficult for an investor to find an exit from these schemes if they are not satisfied with the performance or if they want their money on an urgent basis and money from their contingency savings is not enough. There is a stock exchange route but it is not easy to find a buyer for these units. Moreover, even if you get lucky and find a buyer, most of the trades that take place on exchanges are done at a steep discount compared to the actual NAV.
  • High Level of Uncertainty
    Closed-end funds are for a long duration & the element of timing the market plays a big role. What kind of returns one will get depends on the market at the time of entry and exit. Since there is no systematic investment option and you have to park a lump sum, market timing comes into play. If the market tanks right before the fund matures, it could decrease all or some of your returns. Unlike open-end funds one cannot “wait it out” because once the fund has matured you have to redeem.

So you don’t know what you are getting yourself into, you are blocking a huge chunk of your cash & you are at the mercy of the market. It’s the complete antithesis of all things that make mutual fund investments sensible.

But many such funds are launched frequently. The argument given in favour of closed-end funds is that since there is no fear of unforeseen redemption, the fund manager can do a better job. They can deploy funds for long-term properly and earn higher returns for the investor. Also, it prevents the investor from being governed by emotions as he cannot flee the scheme in panic if the market falls.

All this is good in theory but in reality even with this stable capital, closed-ended funds have not been able to beat returns given by open ended funds.

If you are in the market for investing in a mutual fund scheme ask your investment advisor about open-end schemes and tell them you want to stay away from closed-end ones. Some unscrupulous advisors may tell you about an exciting new fund offer (NFO, used when a new closed-end fund is launched) & how successful it is going to be & why you should invest in it. Avoid it like a plague. Most likely, he/she is getting a higher commission on it.

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