The rate at which closed-end funds have been flooding the market gives the illusion that they are in the bargain bin.
No matter which fund or fund house, the rhetoric is consistent: Fund managers can do a better job simply because the closed-end structure allows them to work with a stable pool of capital. Huge inflows would lead to the issue of cash deployment, a problem if valuations are steep. Sudden outflows may result in the manager disposing off stocks he would rather hold. As a result, a fund manager in an open-end fund is sometimes forced to buy or sell securities at inopportune times.
In a closed-end fund, since the investment horizon of the investor and fund manager are in sync, the fund manager will not have to contend with such a situation.
In theory that argument is solid, but the reality does not bear this out. At the recent Morningstar Investment Conference, Prashant Jain, CIO of HDFC Mutual Fund, noted that in terms of performance, closed-end funds have not done better than open-end funds. He went on to point out that since open-end funds are the more visible part of the business and under constant scrutiny, they are probably managed by more experienced managers. His verdict: “I don't think it is right to say that the fund managers of closed-end funds have any advantage in managing those funds.”
In fact, the very argument proposed by proponents of closed-end funds works against it. When stocks are available at great bargains, there are no inflows which will allow the fund managers to pick them up, unless they sell some of their existing holdings.
To add to it is the dimension of timing. Anoop Bhaskar, Head of Equities at UTI Mutual Fund, commented on this aspect during the Morningstar Investment Conference. “Because the launch and the closure of such funds are all pre-fixed, investors must be a bit more careful about that aspect,” he cautioned. In other words, there is a significant element of timing in these products which can have a huge impact on overall returns. A fund that collects money and invests when the market is on a roll will not be in a good place if redemption takes place a few years later during a market downturn.
Closed-end funds operate on the reasoning that the structure ties up the investor so that he does not flee in panic should the market take a turn for the worse. After all it is no surprise that investors redeem when the market drops and flock to funds when the market is on an upturn. To counter such behavioural tendencies, we don’t recommend closed-end funds but that investors invest systematically via a SIP in a reputed open-end fund. (Read: Are SIPs overrated?) And refrain from having an outlook of just three years but a long-term view. Investing systematically over market cycles is the way to approach equity investing.
Closed-end funds by design can only accept money during the launch period and that too at one go. So while investors in an open-end fund would check the fund’s mandate and performance track record before opting for a SIP, they do not have that leeway with a closed-end fund. I am not suggesting that investors buy funds simply because the performance numbers are good. I am saying that while the predictive power of past performance is limited, it can be remarkably informative when used in the right context. (Read: Does past performance matter?) Unfortunately, when opting for a closed-end fund, the investor only has the pedigree of the fund house and its track record with other schemes to fall back on. This is a far cry from an optimal situation.
And finally we have the issue of liquidity. Investors do not get the chance to exit during the tenure of the fund, which is a minimum of 3 years. Should they desperately need the money, they can sell on the stock exchange where the fund is listed. But this is not a viable exit route since the selling price is most often lower than its net asset value, or NAV. Ditto if the fund manager changes and they want out.
So what is the lure of a closed-end fund?
It is ultimately a business call by asset management companies, or AMCs.
In the case of an open-end fund, the AMC has to justify to the Securities and Exchange Board of India, or SEBI, why it is different proposition from the existing open-end schemes. Not so in the case of closed-end funds. Then there is the added benefit of not having to put in seed capital, as is required in an open-end scheme.
In a closed-end fund, investors cannot pull out their money as and when they choose to. As a result, the AMC finds it more beneficial to pay distributors a high upfront commission for attracting investments since they are fairly certain of how much they will garner as expense ratio over the next few years. The collateral damage could be mis-selling. A distributor chasing those high commissions could push this product. The investor has to be responsible enough not to fall for the sales pitch blindly. As the CIO of one of the largest fund houses commented, “no one is putting a gun to the head of the investor.”
So remember dear investor, the buck stops with you.
