Closed-end funds have been in the news recently and not in a good way. One newspaper story has predicted the doom of these funds as the capital market regulator clamps down on mis-selling through this route. Closed-end funds have had a bad history in India and have been repeatedly used by the industry to mis-sell. My introduction to these funds happened more than a decade ago. In 2006, armed with an upgrade in the knowledge of using excel sheets and the workings of mutual funds, I did a series of stories in The Indian Express on the big mutual fund churn where mutual funds and agents were harvesting the high upfront commissions. You can read one of the stories here, the others seem to be lost online. You are being churned if your adviser or agent makes you sell a financial product only to buy something else, with an aim to earn commission on a new sale. The agent wins at your cost. It's the oldest trick in retail finance. Churning is an industry practice that global regulators frown upon because it hurts investors.

The incentives for churning mutual funds were far higher in 2006 than today. Mutual funds carried a sales commission of 2.25% and could charge investors 6% of the amount they collected from new fund offers (NFOs). Agents were harvesting up to 8-9% of the investment by making the funds hand over the 6% NFO charge upfront and churning investors again and again to harvest this cost. The 6% NFO charge led to the great NFO rush from 2005 to 2008, with over 73% of the inflows in mutual funds in 2005-06 coming from NFOs. The then market regulator, M. Damodaran, banned the 6% NFO charge on open-ended funds on 4 April 2006, but allowed closed-end funds to charge this. I remember a phone call with him soon after this decision during which I protested and said, why not shut off the charge totally; it was not in investor interest. He said: We’ll let mutual funds show that they know how to behave. I remember saying: They won’t. Sebi will have to switch it off sooner or later.

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The industry at once switched to closed-end funds to harvest the higher charge. In 2006-07, the number of closed-end NFOs went up to 21 and then 31 in the subsequent year, up from just three in 2004-05. Open-ended NFOs dropped from 51 to 18 in 2006-07. It took until 31 January 2008 for Sebi to shut the door on closed-end funds as well by taking away the 6% carrot. The number of closed-end NFOs dropped to three in 2008-09. For almost a two-year period, there was an arbitrage in the mutual fund market where two similar product categories had different rewards. This cost investors $500 million in extra fees over the 22-month period that this arbitrage existed, says a paper by Anagol and Kim (2012). This is money you and I lost due to higher costs. You can read the paper here.

The closed-end products have been back on the market for a few years because some fund houses have found a way to keep new products coming. Why are they so keen to launch new products? It allows them to incentivise agents with upfronting a three-year trail commission at the time of sale. Remember that C.B. Bhave took away the 2.25% front load on a mutual fund in 2009 making them a very investor friendly product. The industry then began to upfront trail commissions to give an incentive to the agent. So far so good, but then with the closed-end fund, the fund house could pass on 3-5 years of trail commissions in the first year, allowing agents to hard sell these products. Once in, the investors were largely left with poorly performing products. There are stories of poorly performing stocks being dumped from open-ended into closed-end funds of the same fund house. Because once in, the investor cannot exit except on the secondary market. That is not a viable option due to the big discount closed-end funds trade at.

With the introduction of new categories of mutual funds and the rule that funds can have just one product in every category, the closed-end product launch is now reaching another level of loophole searching. One particular fund house is now known as a ‘serial killer’. It kills investors with its fund series. Unfortunately, it has been the largest firms in the mutual fund business that have sniffed out regulatory loopholes and rushed to slide products through them for years. A mix of regulatory capture and drowning out the smaller voices allowed the practices to continue. But a newly energized Sebi is looking at evidence and data based regulatory interventions.

From media reports and the speeches of the chairman Ajay Tyagi in the past two weeks, it’s clear that the regulatory loophole around closed-end funds will shut down soon. It has taken more than 12 years for this to happen. The only suggestion to investors around closed-end funds is this: do not buy any equity closed-end funds. Remember that equity-linked savings scheme (ELSS) is not a closed-end fund; it’s an open-ended fund with a lock-in of 3 years for the tax benefit. But fixed maturity plans are closed-end funds—use them the way you use a fixed deposit but without the guaranteed return.

Just as even experienced drivers cannot take their eyes off the road, experienced investors too need to watch their fund managers and fund houses because some fund houses believe in the letter of the law and not the spirit.

Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation.

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