Effective 22 March, HSBC Unique Opportunities Fund (HUOF), an erstwhile closed-end fund that was launched in February 2007, became open-ended. A mid- and small-cap-oriented fund, HUOF was a three-year closed-end fund that had the option to convert into an open-ended type, after three years. In these three years, the scheme barely managed to return your principal; it returned just 0.13%, against open-ended mid-cap funds that returned 10.88%.
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When the capital market regulator, the Securities and Exchange Board of India banned open-ended mutual fund (MF) schemes from amortizing their initial issue expenses in April 2006, fund houses started launching closed-end funds. They claimed that on account of the lock-in, closed-end funds would not allow premature withdrawals. This would result in a stable corpus and closed-end funds would, therefore, outperform open-ended funds in the long run. But did they live up to their promise?
Things did not go as planned. Over the past one, two and three years, open-ended large-cap, mid-cap and equity-linked saving schemes (ELSS) funds have outperformed their closed-end peers. Open-ended funds, on average, also outperformed their closed-end peers in the falling markets of 2008 and the rising markets of 2009. For instance, in the large-cap space, the best performing closed-end fund in 2009 was Birla Sun Life Pure Value Fund that returned 91%, against Principal Large Cap (an open-ended fund) that topped the large-cap open-ended space with returns of 110%.
The NFO game
Here’s why fund houses went on a spree to launch closed-end funds. Earlier, MF schemes were allowed to spend as much as 6% of amount they raised from the investors as initial issue expenses. A Rs1,000 crore new fund offer (NFO) would allow a fund to deduct Rs60 crore their initial issue expenses. Funds were allowed to amortize (write-off) this amount over a maximum period of five years.
Some high net worth investors and companies began to extract their share of pie too. They would often invest in these NFOs purely for listing gains that came with a bull run and make a hasty exit soon after the scheme reopens for subscription. Long term investors who stayed in the fund paid heavily due to higher costs.
Between April and December 2006, 10 closed-end funds were launched that garnered Rs7,764.25 crore against six open-ended funds that garnered Rs1,521 crore. In 2007, 32 closed-end funds were launched against 28 open-ended funds.
Apart from the amortization of the NFO expenses, one of the reasons why closed-end funds suffered was their premature withdrawals. Many closed-end funds offered quarterly redemption window. Some, such as Tata Indo-Global Infrastructure Fund, offered monthly redemptions, defeating the purpose of a proper closed-end fund. Although premature withdrawals were penalized, investors withdrew systematically. For instance, Franklin India Smaller Companies Fund (FISCF), a five-year closed-end mid-cap fund, collected around Rs1,200 crore when it opened. On account of its half-yearly redemption window, investors withdrew money when markets started to fall. “Our experience has been that the liquidity windows did lead to redemptions and impact performance to some extent along with our stock picks”, says Sivasubramanian K.N., head of Franklin Equity Portfolio Management, Franklin Templeton Investments. As per its February-end factsheet, FISCF’s corpus is Rs585 crore. A rush for redemptions forces fund managers to sell liquid stocks. What remains are, typically, illiquid stocks that take time to recover. Says Nikhil Johri, managing director, Fortis Investment Management (India) Pvt. Ltd: “The problem with closed-end funds is that premature redemptions happen but no new money is allowed to enter the fund. Hence, many times, it tends to sit on far more cash than he ought to.”
Is closed-end structure bad?
Experts are divided on whether or not the structure of a closed-end fund works. In the initial years of funds in india, when public sector banks launched their mutual fund houses, they launched closed-end funds, especially tax-saving funds, which matured after 5-10 years. Open-ended funds were not heard of in those days. Even private sector firm that entered the MF space in 1993 launched closed-end funds to begin with. Franklin India Bluechip Fund, one of Franklin Templeton India MF’s most successful funds, was launched as a three-year closed-end fund in December 1993. It became open-ended in January 1997 and did very well across market cycles. “The performance of the closed-end funds is also dependent on the structure, whether it is a pure closed-end one or with redemption windows”, adds Sivasubramanian.
“Closed-end funds like fixed maturity plans work very well since the present regulations do not allow premature withdrawals. The fund manager is therefore assured that panic selling—to meet premature redemptions—will not be necessary,” says Johri.
Not all agree though. Some experts feel that fund managers of closed-end funds tend to get lazy. Says Rakesh Goyal, senior vice-president, Bonanza Portfolio Ltd, a Mumbai-based financial services company: “Most fund managers of closed-end funds typically get money for a three-year period. They, however, take it for granted that this money is going to stick around for three years and markets would also keep rising. Hence, these funds are seldom actively managed against open-ended funds that are actively managed funds.” Goyal added that in 2006 and 2007, most MFs got “easy money” from investors as they paid high commission to distributors who convinced investors that equity markets would continue to rise.
Lack of monitoring can also affect closed-end funds. “Fund managers did not pay attention to their closed-end funds once money came in. They are usually told to pay more attention and hence actively manage open-ended funds as they can be constantly sold to investors and attract money”, says a chief executive officer of a fund house who did not want to be identified.
Money Matters take
The monetary benefit for MFs and distributors to launch closed-end equity funds is almost gone. Unless a closed-end fund offers something unique that no other successful open-ended scheme offers, avoid closed-end funds.
Graphic by Yogesh Kumar/Mint