At least once a week, I get e-mails regarding launch of closed-end funds. In the past 18 months, 40-45 such funds have been launched. Given their nature—invest today and remain invested till a specified day, after three or five years—these mimic fixed maturity plans (FMPs) but invest in equity. The increasing popularity of closed-end funds indicates that investors are timing the market; the very trap that Mint Money warns against.

While three years is a reasonably long time, long-term investing is not about putting in money now and redeeming exactly three years later. It is not even about whether fund managers think this is a great time for investing and India is poised for structurally higher growth, which can drive equity markets higher in the next few years. Long-term investing is about selecting good quality companies at a reasonable price, no matter what the market environment may be, and staying invested for at least 8-10 years.

The recently launched closed-end funds come with mainly three-year maturities; some with five. The aim is to capture the anticipated market upside in the next 3-5 years, as corporate earnings are expected to grow faster thanks to the reforms that the new government may bring in. But how can we know this with utmost surety? And then package this opportunity into an exact time frame? Rather than basing decisions on macro expectations, we should focus on companies’ future earnings and sustainable growth.

There are some good arguments in favour of these funds. Firstly, the idea is to give investors a good equity experience. Assuming that the next three years are actually going to be positive for the economy and hence, for corporate earnings and the equity market, if investors remain invested during this period, they should benefit. The fear is that investors sometimes tend to redeem too soon or panic if there is an interim correction. Thanks to this indecisive investor behaviour, it is often assumed that open-ended funds aren’t placed well to capture this opportunity. In fact, according to Association of Mutual Funds in India (Amfi), as of September 2014, at least 64% retail folios were invested for more than 24 months; it was 61.5% in March 2012. This shows that retail investors’ approach to investing isn’t short-term; many seem to hold on for at least two years. If they do, then open-ended funds, too, can give them a ‘good’ experience.

Another problem with this argument is that the closed-end funds have been launched in different months over the past year. So, the three-year period will be different for all, spreading from November 2016 to November 2018 or 2019. So, are we saying that through all these months, when the funds are set to be redeemed, there won’t be any period of sharp correction to disrupt returns?

Fund managers argue that knowing the redemption date is a boon as the exits can be planned and any event-risk can be safeguarded against. Corrections can last longer than a month or two. And even then, selling because the fund needs liquidity (it has to pay back investors) has never attracted the best price. You get optimal value by selling when you think the stock doesn’t have any meaningful upside, or there is a better stock to replace it.

Another argument made in favour of closed-end schemes is that of penetration. Chief executives of fund houses have repeatedly pointed out that the number of new folios being opened for these schemes are coming from the beyond (top) 15 cities, which helps popularize mutual funds. Today, it is presumed that a new equity investor will become a ‘happy’ investor three years later through these equity-FMPs. The penetration argument is probably better supported due to the commission structure of these products—distributors get the entire three years’ commission upfront at the time of sale (as no redemption can happen), which is in the 3.5-7% range, versus 1.25-1.5% in open-ended funds. The incentive to get new investors is indeed high.

It’s unlikely that the popularity is due to product design. Else, open-ended funds, too, would be selling as much. But that’s not the case. Amfi data shows that in the November 2013-March 2014 period, 16 closed-end funds were launched, which collected around 2,400 crore, while open-ended funds saw net outflow of 1,570 crore. In June 2014, four closed-end new fund offerings (NFOs) collected 764 crore; four open-ended NFOs collected 350 crore.

Recognizing that high upfronts can potentially be misused or lead to mis-selling, on the capital market regulator’s nudge, Amfi proposed the idea of abolishing upfront commission. This was done nearly two months ago and a final decision is pending.

Now, let us go back to my argument about how can we know for sure that these funds will get the expected return or even a positive return for the said period? Aren’t we creating a risky precedent for the new investor, who may not be well versed with equity and is probably shifting fixed deposit money into this? There is also a risk of under delivering. Recently, a trigger fund that had a 30% or three years trigger for redemption (which ever is sooner), saw the target net asset value getting hit in eight months; investors could have gained more if they had remained invested as markets rose further.

These days, in a closed-end fund application form, you can select a switch option to move funds into an open-ended equity fund at maturity. But why create a complicated new structure for something that already exists—an open ended fund?

Open-ended funds have delivered compounded average returns of 13-18% over periods of 10, 15 and 20 years, regardless of the market capitalization of the stocks. A fund house that already has, say, 30-35 open-ended schemes across market caps, and still launches 10 closed-end schemes, is essentially attempting to dissect the market in 40-45 different ways. Only time will tell whether the experience through closed-end funds will be positive. In the meantime, we are distorting the perception of equity risk by telling investors that it is acceptable to time the market as ‘good times’ are here.

Closed-end products work against the basic grain of equity investing and it only takes a few of these funds to under-deliver to lose that ‘new’ investor forever.

Sadly, as long as product applications are approved, these funds will keep getting launched.

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