Have closed-end funds delivered?

In November 2015, IDFC Equity Opportunity–Series 3 (IEO3) quietly matured. This was a 21-month closed-end diversified equity scheme that was launched in February 2014. It returned close to 14% since its inception.

This was the first of the closed-end funds that were launched in 2013, to have redeemed. Let’s call them closed-end funds version 2 (v2). Very few topics have dominated the Indian mutual funds (MF) industry these past two years more than its obsession with closed-end equity schemes. In 2014, 55 closed-end equity funds were launched and collected little over 10,000 crore. In 2015, 30 closed-end funds were launched and collected about 5,100 crore. Much has been written about commissions that most of these funds paid, which hit the roof. But the biggest concerns were these: Do we need closed-end funds when many open-ended schemes are available? How would these funds pay their investors come redemption time if markets are volatile?

Mint Money decided to do a health check on the four closed-end funds that are coming up for maturity in 2016, and one in early 2017. These are IDFC Equity Opportunities Fund–Series 1 (IEO1; maturing in April 2016), IDFC Equity Opportunities Fund–Series 2 (IEO2; maturing in January 2017), L&T Emerging Businesses Fund (LTEB; maturing and getting converted into an open-ended fund in May 2016), ICICI Prudential Value Fund–Series 1 (IPVF1; maturing in October 2016) and ICICI Prudential Value Fund–Series 2 (IPVF2; maturing in December 2016). The purpose of this exercise was to see if these funds are on track to deliver what they promised and whether they’ve added value to investors’ portfolios.

Varied performance

It’s wrong to compare all closed-end equity funds together, because while many focused on small- and mid-sized companies, some tilted towards large-sized companies. But we kept our focus on small- and mid-cap funds. This is because this is where a bulk of these closed-end funds focused. While open-ended small- and mid-cap funds returned 8% in 2015, closed-end funds returned 7%. In 2014 when the equity market was rising, open-ended small- and mid-cap funds returned 74%, closed-end funds 69%. On an average, equity-oriented funds returned 49% in 2014 and just 3% in 2015.

Broadly, it seems that open-ended have outperformed closed-end funds, so far. “Closed-end funds can’t receive fresh inflows, which hurts them during market volatility. The market has been reasonably volatile since May 2014. Open-ended funds have received regular and sizeable quantum of inflows since then. This has helped fund managers deploy funds during market dips, and thus have performed better than the close-ended funds,” said Kaustubh Belapurkar, director, fund research, Morningstar India, a US-headquartered MF tracking and research firm.

But if you dig deeper, closed-end funds haven’t done all that badly. In fact, the funds that were launched roughly before May 2014 did exceedingly well. IEO1—the first such closed-end scheme launched among the current crop—has returned 43.42% on a compounded basis since its launch in April 2013. LTEB has returned about 32% so far since its launch in May 2014. However, many closed-end funds launched after May 2014 are lagging behind.

Timing was key

Contrary to what conventional wisdom say about the dangers of trying to time the markets, the most successful closed-end funds v2 were launched at just the right time. By the end of 2012, equity had become a dreaded investment. Up until then, diversified equity funds had returned just 1.31% over a 5-year period, and just under 6% over a 3-year period on a compounded basis. As per an analysis that IDFC Asset Management Co. Ltd had done on the S&P BSE 500 companies at the time, profit after tax margin of these companies had dropped to 5.83%, from a high of about 10% in 2007, and return on equity (a measure on how efficiently a company uses shareholder’s money) had dropped to 12.46% from a high of about 19-21% they sported between 2004 and 2007.

“In 2013, the macro construct in India was quite challenging. Incrementally, in a troubled world post the Lehman crisis in 2008, market biases had been towards large-sized companies where perceived risk was low. Disproportionate money had moved towards companies in the large-cap universe,” said Punam Sharma, associate director-fund management, IDFC Asset Management Co. Ltd. She adds that the way investors shunned small- and mid-cap companies in favour of large-cap ones, ensured that many small-sized companies were available at an attractive price.

Shyam Sekhar, founder of ithought, a Chennai-based MF advisory firm agrees. “The sheer value of the market and the target (investment) segment for some of the early launched new small- and mid-cap funds was a screaming one. For fund managers who understood value investing, the opportunity that existed was a no-brainer.

And fund managers who saw this opportunity and seized it, got their timing right.

“People say don’t time the market. But these experts got the timing right by being constantly attentive and responsive to market trends taking advantage of the deep correction and almost the cyclical bottom of the mid-and small-cap index,” said Ravi Kumar T.V., founder, Gaining Ground Investment Services, a Bengaluru-based MF distribution firm.

Soumendra Nath Lahiri, chief investment officer, L&T Investment Management Ltd was one such fund manager who tasted success with LTEB by picking companies when their stock prices were quite low.

Staying liquid...

Most of these v2 closed-end funds attempted to differentiate themselves from the earlier version on two counts primarily. First, the small-and mid-cap focused schemes said that although they will invest a significant chunk in small-sized companies, they’ll move towards a combination of large-sized companies and cash as they near maturity. Second, some mid-cap closed-end funds, such as those from IDFC AMC and some from ICICI Prudential Asset Management Co. Ltd came out with only dividend plans and not growth.

IEO3 paid two dividends in its 21 months of existence. IPVF 1 and IPVF 2 also paid dividends. “What investors liked in these funds is that some of them paid good dividends,” said Kumar.

Additionally, schemes like IEO1—which is coming up for maturity in three months—have started to shift to large-caps; the more liquid lot. Till February 2015; it did not invest in large-cap companies. Thereon, it has brought up its holdings in large companies, gradually, to around 40% now, according to Value Research data.

...while being true to label

Some fund managers, like Lahiri, have stayed away from large-caps. “We stick to our mandate. One way to make the most in this area (small- and mid-sized companies) is to invest in a graded fashion. The portfolio has now ripened. Hence, a closed-end structure is important for these of funds,” he said. Schemes like LTEB and all of Sundaram Asset Management Co. Ltd’s micro-cap funds have stayed true to label till now.

As per data provided by Value Research, the weighted average market capitalisation of LTEB and all of the eight Sundaram Micro Cap funds launched in the past two years, have been at the bottom of the heap of the 321 diversified equity funds, as they selected companies with low market capitalisations. In fact, the eight Sundaram schemes are the bottom eight in this list. Weighted average market capitalisation of a fund is a statistical tool that measures the market capitalisation of a scheme’s underlying holdings in context of its corpus size and holdings.

S.Krishnakumar, chief investment officer-equity, Sundaram AMC says he has time on his side and that he will shift to large-sized firms and cash holdings as his schemes near redemption. And to be fair, closed-end funds, like those from IDFC AMC, ICICI Prudential AMC and Sundaram AMC stated at the time of their launches about their intention to shift when nearing maturity.

Mint Money take

Not all closed-end funds have tasted resounding success. Sharma of IDFC AMC says that she would have liked IOE3 to return more. She says that the scheme was designed to perform in a market “where economic environment was benign, risk appetite was fairly low and equity was kind of untouchable. The product was designed to cater to investors with low-risk appetite and deliver positive return even in the risk averse market we were seeing then.” But after the Narendra Modi-led government assumed office in May 2014, the equity market shot up, less on fundamentals, but more on speculation and hope. This, she says, didn’t bode as well for IOE3; that followed a dividend yield strategy. But she’s not complaining.

Schemes from ICICI Prudential AMC, though ahead of the curve, have given decent returns, though not great unlike few other closed-end funds. In the past two years, IPVF1 and IPVF2 returned 30% and 29%, respectively. A superlative performance in 2014 was followed by a tame one in 2015. This is also partly because the fund increased its allocation to large-cap companies throughout 2015. But S. Naren, chief investment officer, ICICI Prudential AMC is not fazed. “Just because a scheme makes money, the investor may not withdraw it at the right time, so she doesn’t necessarily see those gains. People don’t redeem their funds when they are at their peak. The experience that investors have got from the new-age closed-end funds, especially those that have only dividend plans, is good as they have got a chunk of their money back and by the time these will redeem, hopefully they would have made good capital gains.”

Quite a few open-ended schemes have done just as well. However, apart from IEO1 and the Sundaram series of micro-cap schemes, most of the other small- and mid-cap funds haven’t really managed to significantly outshine their open-ended counterparts, till date.

For them though, there’s still time for redemption. Others like IEO3, that was recently redeemed, and IPV1 and IPV2, that have given dividends, have appealed to a set of investors who were happy to see gains, say distributors like Kumar and Sekhar. “Rarely have fund houses launched products that were timely and the odds of losing were low,” said Sekhar referring to some of the earliest of the v2 closed-end funds.