Cost of closed-end schemes

They're multiplying and have a plus for those lacking investment discipline but you cannot do an SIP in these

It’s difficult to resist the temptation to enter the market now. With global and domestic brokerages predicting new highs for the benchmark indices in the coming months and years, investors would feel enthused. Even mutual funds (MFs) are aggressively launching equity schemes to ensure more participation.

However, there is a catch. Most of these schemes are closed-end ones. According to data from Value Research, 33 closed-end equity schemes have been launched since October 2013. In comparison, between 2003 and 2008, there were 328 equity new fund offers (NFOs) but only 22 closed-end schemes.

Closed-end MF schemes are where the investor can’t exit for a certain period, such as three or five years. Though these are listed on the exchanges to provide an exit route, the absence of liquidity makes it difficult to sell units. If desperate, one might have to exit at a discount.

This is why financial planners like Gaurav Mashruwala aren’t very comfortable with these. “There is no empirical evidence that closed-end equity schemes will perform better than open-end schemes. So, from that perspective, why should one get into a scheme that will not allow an easy exit route?” he asks.

There is an important drawback of closed-end funds; you cannot do a Systematic Investment Plan (SIP) in these. As a result, both fund managers and investors can get stuck. Investors are forced to commit a lump sum because once the scheme closes, there cannot be any fresh collection. This can hurt the scheme’s performance as well, since the fund manager does not get any fresh money to average out costs if the stock he favours falls sharply.

Says the chief executive officer (CEO) of an MF: “In products like fixed maturity plans, getting locked in works because the fund manager can buy debt instruments matching the scheme’s tenure. But in the case of equities, the case is different.” Financial planners feel if someone is a lazy investor or has a tendency to churn or move money, such schemes work because they are forced to stay invested. But the price to be paid for the absence of discipline can be high. If the market tanks before maturity, there could be serious losses staring at you. Once you have invested in such a scheme, there is no way to review its performance, an important thing for NFOs, and exit if the performance is not up to the mark.

What explains the sudden spurt in closed-end schemes? Says Dhirendra Kumar, CEO, Value Research: “The investor is locked in for a long time in closed-end schemes. For a five-year fund, the 2.5 per cent annual charge means the fund house knows it is likely to be able to eventually charge around 12.5 per cent of the amount invested, perhaps more if the markets take off. This creates a basis for paying a large sales commission, say of five per cent, to attract investments.”

In an open-end scheme, there isn’t any surety that investors would stay in a scheme for a long term. The advice: There are enough good open-end schemes with a good record. If you can maintain discipline, invest through the SIP route.

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