In the wake of the launch of a number of closed-end equity schemes over the past few months, I have been asked about the merits of investing in such schemes. In this post, I put down my thoughts.
Many years ago, when I was first introduced to the concept of mutual funds, I was told that it was more likely for closed-end equity schemes to deliver better returns than open-end schemes. The reason, I was told, was that in a closed-end scheme, the fund manager could invest without the need to keep cash in the portfolio for ongoing redemptions by investors, and without the worry of being impacted by large, unexpected redemptions.
With the passage of time, I have revised my understanding. As things turned out, over the years, I noticed that a number of closed-end equity schemes delivered performances that belied their abovementioned advantage. In all fairness, I did come to realize that there can never be an apples-to-apples comparison between closed-end schemes and open-end schemes. Even so, the performance of a number of closed-end schemes was clearly questionable. For instance, there were some tax-saving schemes with a tenure of 10 years and which, at the end of the tenure, generated returns that were less than what one could have achieved by investing in a bank deposit. In fact, at least a couple of these schemes returned to their investors, an amount that was less than what they had invested.
More than this, I have come to realize that by virtue of their structure, closed-end schemes are more likely to leave investors unhappy than open-end schemes. Understanding why I say so requires an understanding of psychology and I will refrain from delving into any details for now. For the moment, let me say this: unless there is something more than the aforesaid advantage that a closed-end scheme offers, an investor would most likely be better off in an open-end scheme.
For anyone still contemplating investing in a closed-end scheme, I give below a checklist of things to consider before doing so:
The fund house and the fund manager
Irrespective of whether a scheme is open-ended or closed-ended, I believe it is crucial that an investor have confidence in the fund house that has launched the scheme and in the fund manager who will be managing the investments under the scheme. In my homegrown analysis of the performance of closed-end schemes, I have come to conclude that the single most common factor across schemes that have underperformed is the inexperience and/or lack of competence of the fund manager.
The objective of the scheme
Again, irrespective of whether a scheme is open-ended or closed-ended, it is important to be familiar and comfortable with the investment objective of a scheme that one is considering investing into.
When is the scheme launched
Far too often, new schemes are launched during bull phases. In effect, everything that a closed-end equity scheme mobilizes from the investors will necessarily have to be invested around the peak (such schemes do not even offer Systematic Investment Plans). As I pointed out in my previous post, doing so is highly likely to result in mediocre returns.
Your exit plans and options
In my understanding, the two most common reasons for exiting a closed-end scheme before its tenure are a.lack of faith in the scheme’s future prospects and b.the desire to cash in one’s gains (or book profits, as it is often known). Some investors also consider exiting because they need the money.
Before completion of a closed-end scheme’s tenure, usually the only way to exit such a scheme is by selling one’s units on a stock exchange. That brings with it two challenges. Firstly, there may not be any buyers and hence the sale may never go through. Secondly, there is a high likelihood that the sale would happen at a discount to the NAV i.e. you may get less (possibly, far less) than what your investment is worth. Yes, there have been schemes where the fund houses have offered to buy back one’s units on specific dates, before the completion of the scheme’s tenure. If the dates match with one’s planned exit, that is a far better option. Some schemes have also offered a trigger option i.e. an option to buy back when the investment has grown to a certain value (or at a pre-defined rate). If the intent is to cash in one’s gains, that is, by far, the best option to exercise.
The possibility of the scheme ending during a bear phase
It is difficult, if not impossible, to predict whether the tenure of a scheme will end during a bear phase or a bull phase. If it does end during a bear phase, the performance will, quite likely, appear disappointing. If one had invested instead in an open-end equity scheme and exited during a bear phase, the results would be quite similar. However, in an open-end scheme, there being no need to exit during a bear phase, that may not happen. In a closed-end scheme, effectively, there is no choice but to exit at the end of the scheme’s tenure. The reason I make this point is that I have met many investors who were unhappy with their investment for this very reason. Such unhappiness, while understandable, is not justifiable, if I may say so. Yet, my understanding of psychology tells me it is highly likely.
Worldwide, and in India, open-end equity schemes outnumber and outsize closed-end schemes. While it may be difficult to list all the reasons for that, I would feel safe to say that the disadvantages of closed-end schemes far outweigh the advantages. Some might say that the fact that these schemes exist is proof that these schemes meet some need. I can see the truth of that in a country such as the USA where closed-end funds score over open-end schemes on at least one count: the extent to which a scheme can be leveraged. In India, I see no compelling reasons whatsoever.
