Last Updated on May 25, 2022 by Neera Bhardwaj
Mutual funds are one of the most sought-after investment options. The money contributed by individual investors is pooled and used to purchase different types of securities. This is a diverse portfolio of securities and is tailored according to the investment objectives.
On the basis of the subscription period, mutual funds can be classified into two categories – close-ended mutual funds and open-ended mutual funds. In a close-ended mutual fund, a fixed number of units are issued which are traded on the stock exchange. A closed-end fund works like an exchange-traded fund (ETF). In this article, we dive deeper into how a close ended mutual fund works and its pros and cons.
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How does a closed-ended mutual fund work?
According to the SEBI guidelines, a mutual fund is to be launched through a New Fund Offer, which can be open for a maximum of 30 days. The funds are then traded in the open market like shares. The price of the fund is regulated by the demand and supply forces of the market.
With closed-ended mutual funds, only a fixed number of units of the mutual fund are released in the market. The units of such a mutual fund can be purchased only during the NFO period. The units can be redeemed only after the maturity of the fund. This is generally between 3 – 7 yrs. This helps the fund manager to freely use the funds to attain the overall objective of the mutual fund.Units of close-ended mutual funds can be purchased only during the NFO period Click To Tweet
Advantages of a close-ended mutual fund
There are many advantages of investing in a close-ended mutual fund.
Stability: A close-ended fund can be redeemed only on the expiry of the maturity period. This helps the fund managers to build a stable asset base, and employ the right investment strategy. The worry of maintaining liquidity is absent due to the lock-in period.
Demand and supply based market price: Just the way stock price is decided upon by market forces, the NAV of a closed-ended scheme is determined by the demand and supply of the units. So, if the demand for a particular closed-ended scheme goes up and the supply remains low, then the units would fetch a higher price, over and above the NAV of the particular scheme. This helps in compounding money in the investment over time.
Liquidity and flexibility of decision-making: Some close-ended funds provide an option of selling your mutual fund units back to the mutual fund house through periodic repurchase at NAV-related prices. SEBI regulations dictate that fund houses provide at least one of the two exit routes for investors: the repurchase facility or through listing on stock exchanges.The NAV of close-ended schemes depend on the demand and supply of the units Click To Tweet
Disadvantages of a close-ended mutual fund
Some of the disadvantages of investing in a closed-ended mutual fund are as follows.
Lackluster performance: This is one of the biggest disadvantages of investing in closed-ended mutual funds. The returns are not comparable to an open-ended fund. While the fund gets listed on the stock market soon after the NFO, should you require money in the short term, the buyers are so few that you may end up paying a premium over the purchase price, which fails the point of investing at all.
Lump-sum investment amount: Closed-ended funds require you to invest a lump sum at the time of their launch. This means the total amount should be invested in one go. This can be a risky decision regarding your investments. This exposes you to bigger bets than otherwise warranted. Moreover, a huge section of the salaried class of investors is not comfortable with lump sum investments in terms of affordability and risk.
Historical data unavailable: When it comes to open-ended funds, investors can review the performance of the funds over different market cycles because of the availability of historical data. However, in the case of closed-ended funds, the historical record is unavailable. Thus, investment in a closed-ended fund attracts unprecedented risks and uncertainties, and you will have to depend on the fund manager completely for any analysis.
Who should invest in a close-ended mutual fund?
Close-ended funds need a lump sum investment and do not offer a redemption option until maturity. Hence, investors with ready and investable capital and an investment horizon that goes with the maturity date of the scheme can opt for closed-ended mutual funds. Further, the risks and returns should be carefully assessed, based on the asset allocation of the scheme.
Tax on gains from closed-ended funds
Equity and debt funds have different taxation schemes. Therefore, in the case of close-ended mutual funds, the tax rates depend on the percentage of investments made by the scheme in equity and debt.
If the fund has invested 65% or more of its total assets in equity and equity-related instruments, then it is treated as an equity fund for taxation purposes.
If the fund has invested at least 65% of its total assets in debt instruments, then it is treated as a debt fund for taxation purposes.
Make sure to go through the offer document carefully, and check the asset allocation that the scheme holds to understand the tax rates.
List of close-ended funds in India
Based on the performance over the last 5 yrs, here is a small list of some close-ended mutual funds operational in India:
- SBI Tax Advantage Fund – Series III – Regular Plan
- ICICI Prudential Growth Fund – Series 2
- SBI Tax Advantage Fund – Series II
- ICICI Prudential Growth Fund – Series I
- ICICI Prudential R.I.G.H.T. Fund
Note: This is just a short compilation of some of the close-ended funds and is not exhaustive.
The stability that close-ended mutual funds offer are attractive to investors who seek to generate wealth over the long term. Although the returns are lower than open-ended mutual funds, flexibility for the investors is taken care of. It is important to remember that close-ended mutual funds require a lump sum payment which cannot be redeemed until maturity, and so investors should make a decision after assessing if their needs align with the terms, risks and benefits associated with close-ended mutual funds.