Closed-end funds give fund managers time to perform

In the absence of redemption pressures, they can pick multi-baggers . But, investors have to reconcile themselves to lower liquidity

Investing in new fund offers (NFOs) is always fraught with risks. So, a fund with a closed-end structure that invests in the micro-cap category is to be viewed carefully.

The new fund offer of Sundaram Long-Term Microcap Tax Advantage Fund Series III, a closed-end scheme, is currently on (closing on November 11). This fund will invest in stocks that rank 301 and below by market cap on the National Stock Exchange. A tax-saver fund, it will allow investors to avail of tax deduction under Section 80C.

The good: The micro-cap space offers scope for identifying multi-baggers. To cite a couple of examples, groceries and garments are purchased in large-format retail stores now, rather than in small shops; movies are watched in multiplexes, rather than in single-screen halls, and so on. Entrepreneurs who can identify such nascent trends and fulfil customer needs stand to grow their businesses manifold within a decade. And, investors in such stock gain from the growth.

Even from an investment standpoint, the micro-cap segment offers opportunities because it is under-researched. Major brokerage houses don't focus on these stocks. “If you have an in-house team that can research this white space, you can earn alpha for your investors,” says S Krishna Kumar, chief investment officer-equity at Sundaram Mutual Fund.

This segment can, however, be volatile. Says Kumar: “Earnings of small companies can fluctuate on a quarterly basis, as it takes time to stabilise a business. Open-ended funds witness a lot of redemption pressure. Managers running a micro-cap fund would find it difficult to perform with such high levels of redemption, since you need at least a three-to-five year investment horizon in such stocks.” Hence the closed-end structure and 10-year tenure of the fund that will allow for a long-term, buy-and-hold approach.

In an open-ended fund, redemption pressure often forces the  manager to sell his better-quality and more liquid stocks. If buyers are hard to come by, he might have to sell these stocks at a discount. This affects the performance and has a negative impact on the returns of those investors who stay put.

As for the disadvantages of closed-end funds, investors have almost zero liquidity in these. While these funds are listed on the stock exchange, trading volumes are thin. “Finding buyers whom you can sell your units to on the stock exchange will be difficult,” says Kaustubh Belapurkar, director, manager research, Morningstar Investment Advisor.

Some experts say that investors should avoid closed-end funds altogether. Says Vidya Bala, head of research, Fundsindia.com: “Regular portfolio review is essential and possible exit, in the case of non-performance in the long term, is needed. Closed-end funds do not give investors that option.” More, the degree of variation in the performance of the best- and the worst-performing fund tends to be higher in mid- and small-cap funds (the micro-cap category is a subset of this category) than in large-cap funds.

Investors who have confidence in the fund manager and prepared that they will not have any access to the corpus for the entire tenure should invest in this fund. Those who want to retain the exit option should stick to an open-ended micro-cap fund.