No SIP, tough midway exits and now LTCG tax take shine off Closed-end funds

Long-term investors should opt for an open-ended fund where they have to pay 10% LTCG tax only once when they are close to their goal

Closed-end funds have always been a less attractive investment category for investors than open-ended funds. The imposition of long-term capital gains tax of 10 per cent is set to make this category even more unattractive.

Closed-end funds are open for subscription to investors for a limited period at the time of their new fund offer (NFO). Unlike open-ended funds, investors can't enter them once this period gets over. In recent times, the number of closed-end funds being launched by fund houses has far exceeded the new fund launches of open-ended schemes.

When marketing closed-end schemes, fund houses highlight the following advantages of these funds. One, exiting these funds in the middle of their tenure is very difficult. Though they are listed on the exchanges, the investor usually has to sell them at a steep discount. This, they say, deters investors who lack the will power to stay invested in open-ended funds for the long term, from exiting. And two, they say, fund managers can invest the money gathered from investors for the longer tenure, without worrying about redemption pressures.

Closed-end funds, however,  have a number of disadvantages. Investors are subject to timing risk in these funds. They can't do a systematic investment plan (SIP) at entry as they are open for only a limited period. They could end up investing a lump sum when equities are trading at high valuations, as is the case now. Investors also have to withdraw money at a particular time, when the tenure ends, irrespective of market conditions. This has the potential to affect their returns from these funds.

In India, fund houses have to charge expense ratio depending on corpus size. Since the corpus size of these funds typically tends to be limited, their expense ratios, on an average, tend to be higher than that of open-end funds.

With the introduction of LTCG tax at 10 per cent, an additional negative has been added to these funds. An investor's goal may be 10 years away. If he's sold a three-year closed-end fund, he will end up paying the 10 per cent LTCG three times. His returns will be hit much more than that of an investor who invests in an open-end fund and pays LTCG only once, at the end of, say, nine years, when he is close to his goal. Thus, investors having a longer investment horizon will be better off investing in an open-ended fund.