What are Closed End Funds?
Mutual fund investments have become an investor-favourite. Some advantages of mutual funds include a diversified portfolio, professional management, flexibility, accessibility, safety, etc., making them suitable for novice investors, too. Mutual Fund are classified based on asset class, risk, investment goals structure, and other factors. Based on structure, mutual funds are classified as open-end funds and closed-end funds.
This article focuses on what are closed-end funds, the pros and cons of closed-end funds, and examples of closed-end funds in India.
A closed-end fund pools money from various investors through a New Fund Offer (NFO) and invests it across various securities. New Fund Offer is for funds, similar to IPO for stocks. This is a way by which investors can subscribe to mutual fund units. The Net Asset Value (NAV) of the fund is determined, thereafter, depending on the number of units and the total value of underlying assets.
A unique attribute of close-ended funds is their fixed number of units. After the end of the NFO subscription period, neither new units of the fund are issued, nor investors can redeem the units until maturity. But, investors can buy or sell units from the stock exchanges.
However, the unit prices depend on their demand and supply and differ from their NAV. If the demand is higher than supply, the fund unit is traded above its NAV i.e. at a premium. In contrast, if the demand is lower, fund units tend to trade at a discount.
Various closed-ended funds differ based on securities invested, investment strategy, distribution policy, risk structure, etc. The closed-end fund can be categorized as equity or debt funds based on the weightage of kinds of security in the portfolio, for taxation. If the fund constitutes 65% or more of equity investment, the fund is treated as an equity fund from a tax perspective. On the contrary, if the fund invests 65% or more in debt securities, the fund is treated as a debt fund.
When the NFO subscription is open, investors can invest directly in a closed-end fund with the asset management company, via agents or distributors. However, investing through agents or distributors is expensive due to commission and charges.
An investor can get dividend income, interest income, capital gains, and principal repayment based on the structure of a close-ended fund.
Pros of Closed-End Fund
The benefits of closed-end funds include:
Well-diversified Portfolio: Closed-end funds save investors from putting all their money in a single security or stock. A key benefit of a well-diversified portfolio is that even if one security performs poorly, the investor’s portfolio would be less impacted due to other well-performing securities.
Professional management: The closed-ended funds are managed by professional fund managers. Owing to their skills, knowledge, and experience in the market, they can make sound investment decisions. A wise investment decision ultimately drives healthy returns.
Comprehensive strategy: In a closed-end fund, neither the new units will be issued, nor the investors can redeem their units until maturity. Therefore, a fund manager can make a comprehensive investment strategy considering a steady asset base. This increases the chances of attaining investment objectives.
Liquidity: When close-ended funds seem illiquid at first, they are not. Although these funds don’t allow investors to redeem their units, they are traded on the stock exchanges. When demands for a close-ended scheme exceed its supply, investors can sell the units at a higher price on the stock exchange.
Cons of Closed-End Fund
Here is the negative side of a closed-end fund.
Lump-sum investment: As closed-end funds enable investors to buy units during the New Fund Offer period, they need to invest a lump sum amount. Therefore, these funds are less suitable for investors that prefer SIPs. Moreover, they cannot redeem the units before maturity. Therefore, making a lump-sum investment is riskier.
Unavailability of performance data: Investors tend to make investment decisions by looking at the past performance of the funds in different market cycle phases. In the case of closed-ended funds, assessing their performance in phases is not possible. Therefore, investors cannot get a clearer picture of how their investment performed or can perform throughout the market cycle.
Returns depend on the fund manager’s skills: When professional management can be a benefit, too much dependency can also be a drawback for your investment. The return from an investment greatly depends on the fund manager’s judgment and decision-making skills. If the fund's manager is not capable enough, you may not get targeted returns.
Examples of Closed-End Funds
For instance, if a closed-end fund acquired Rs. 50,00,000 through a New Fund Offer. After the NFO, the fund issued 5,00,000 units. Therefore, the NAV per unit is Rs. 10. However, as per the demand and supply for different schemes, their market value may vary.
Some of the closed-ended funds available in India are ICICI Prudential Growth Fund, ICICI Prudential R.I.G.H.T Fund, SBI Tax Advantage Fund, Mirae Asset Emerging Bluechip Fund, Canara Robeco Emerging Equities Fund, Axis Strategic Bond Fund, Kotak Emerging Equity Scheme, Nippon India Small Cap Fund and many more.
To wrap up, a closed-end fund is a type of mutual fund that is open for subscription only during the NFO period and held till maturity. Therefore, if the investor has a longer investment horizon and enough disposable income to invest, closed-end funds may be the ideal choice. However, they are traded on the stock exchange and thus provide a way to step out of the fund before maturity. As the number of units is fixed, a fund manager can make a better strategy.
Frequently Asked Questions Expand All
Ans. Suppose an investor’s investment horizon matches the maturity date of the fund and they have enough disposable income to invest in a lump sum. In that case, closed-end funds are good investment options to consider.
Ans. Unlike open-end funds, closed-end funds have lock-in periods. Therefore, the fund managers of closed-end funds can devise a stable investment strategy till maturity, which is difficult in open-end funds. However, open-end funds are liquid, and closed-end funds are relatively less liquid. Additionally, the performance of open-end funds can be tracked during various phases of market cycles which is not possible for closed-end funds.