Can closed-end funds choke your portfolio? All you need to know

However, one category which stands out is fixed maturity plans due to its tax benefits

Closed-end funds have been in the news for the wrong reasons. According to media reports, the market regulator, the Securities and Exchange Board of India (Sebi), will not give approval to the launch of closed-end equity schemes easily in the future as it fears that these schemes have been mis-sold to investors. The regulator also feels that fund houses have not paid adequate attention to the performance of these schemes, since investors get locked in and can't exit them after having put in their money during the new fund offer (NFO). 

A closed-end fund accepts money only at the time of its NFO. Once invested, investors can't redeem the units of these schemes by selling them back to the fund house. These funds are called closed-end because their corpus remains fixed during their tenure. 

Closed-end funds are listed on the exchanges. While in theory investors have the option to sell them on the exchanges if they want an exit, in reality liquidity is poor, and investors are forced to sell them at a steep discount. 

Let us first examine some of the positives of these schemes.

No redemption pressure: In open-end funds, fund managers always face redemption pressures. Especially when markets turn turbulent, investors begin to withdraw money from them. This forces fund managers to always keep a portion of the total corpus in cash. This non-deployment of a part of the corpus affects returns. When redemption levels are high, fund managers are even forced to sell some of their stock holdings, especially in smaller funds. This again affects an open-end fund's performance. 

Due to the lock-in in closed-end schemes, their fund managers do not face redemption pressures. This allows them to take longer-term calls, that is, they can invest in stocks where it may take a while for the value to be realised, without worrying about having to sell them.

No panic selling: Closed-end funds may also suit novice investors in equities, who tend to panic during market downturns. In an open-end fund, these investors have the option to sell and exit. They can't do so in a closed-end fund owing to the lock-in and the low liquidity on exchanges. By staying invested for a longer tenure, investors can reap the benefit of higher returns from equities. This is one advantage of closed-end funds that is heavily touted by the mutual fund industry when selling these funds.

Against these advantages, closed-end funds suffer from several shortcomings, which we shall turn to next.

Timing risk: Investments in closed-end funds can only be made at the start of their tenure. That may or may not be a good time to make a one-time investment in an equity fund. If market valuations are low, investors have a high probability of earning sound returns from their one-time investment in these funds. But if they enter them at a time when valuations are high, their chances of earning good returns are poor. Thus, these funds subject investors to timing risk.

A related shortcoming of these funds is that one can't invest via the systematic investment plan (SIP) route in them. Investors cannot average out their cost of purchase, something that plays a major part in helping them earn high returns from their equity funds irrespective of interim market conditions, provided they stay invested for long enough (at least seven years).

Lack of liquidity: In life, emergencies come unannounced. Since these instruments have a lock-in, and suffer from poor liquidity on the exchanges, investors face a major liquidity issue in these funds. It is, therefore, advisable not to invest a large portion of your net worth in them.

Performance gap vis-a-vis open-end funds: To validate whether the regulator's apprehensions about the performance of closed-end funds are correct, we carried out an internal study. We found that across asset management companies (AMCs), a large proportion of closed-fund are currently underperforming their benchmarks and also the top-quartile of open-end funds in their respective categories.

In an open-end fund, investors can evaluate its past track record. Seasoned investors can also evaluate the quality of stocks and bonds that the fund manager has invested in. None of this is possible in the case of a closed-end fund, where you have neither a track record nor a portfolio that you can examine (the portfolio gets created only after the NFO ends). And if you notice during the fund's tenure that it is underperforming, it is nearly impossible to exit the  fund before maturity.

Most investors, therefore, will be better off opting for open-end equity funds that have a track record of consistent performance. These funds score in terms of returns, transparency and liquidity over their closed-end counterparts. If an agent pushes you to buy these schemes, it is because he stands to earn a hefty front-ended commission from their sale.   

Fixed maturity plans (FMPs), a type of closed-end debt funds, however, do offer a few real advantages to investors. 

Lock-in returns and beat market volatility: In a rising interest rate scenario, most open-end debt funds (and more so the ones having a longer duration) suffer mark-to-market losses. FMPs become an attractive product category in such an environment because they allow investors to circumvent debt market volatility. They also enable investors to lock-in returns at current yields. Based on the credit quality of the bonds that the fund will invest in, and their current yield to maturity, investors can estimate, right at the time of investing, the return they will get from these funds on maturity. The FMP fund manager buys and holds the bond portfolio and does not engage in trading or churning.

Tax indexation benefit: FMPs having a tenure of three years or more are the most popular among investors. This is because capital gains from debt funds become entitled to indexation benefit when held for three years or more. FMPs having a three-year plus tenure are able to generate better post-tax returns compared to bank fixed deposits, as the interest income from the latter is taxed at the investor's marginal income tax rate, which is usually higher.

Hence, investors may opt for closed-end debt funds. However, they should study the FMP's scheme information document and learn the credit quality of the bonds that the fund manager intends to invest in. Lower rated FMPs, which invest in papers below double-A plus rating, should be avoided.

In the table given above, we have compared the post-tax return of a 1,100-day (three years and five days), 8 per cent debt FMP with an 8 per cent fixed deposit starting on March 29, 2015, and maturing on April 2, 2018. The inflation index was at 240 and 280 in financial years 2014-15 and 2018-19 respectively. As we can see from the table, an FMP faces a net tax of only 7 per cent versus 30 per cent (if the investor belongs to the highest tax bracket) in the case of a fixed deposit. The FMP also gets the benefit of four indexations because the investment tenure straddles four financial years. Thus, FMPs can be a good substitute for long-term fixed deposits, especially in a rising interest rate environment.

The writer is CEO and company-co-founder, Upwardly.in