What Are Closed Ended Funds & Who Should Invest?

Closed-ended mutual funds are hybrid in nature. They invest in a variety of instruments to maximise the returns. These funds raise capital through a limited period offer. 

Entry to and exit from such a scheme is restricted after the initial launch offer. There is a lock-in period as well that restricts premature redemption.

This blog simplifies the basics of closed-ended schemes, covering what they are, how they operate, pros and cons, and if you should invest in them.

Important: This blog is meant to educate readers and the information furnished here is not to be construed as investment advice from Cube Wealth. 

What Are Closed-Ended Funds?

Closed-ended funds are a type of mutual fund in which a limited number of units are made open to investors for a short period of time. The launch offer is called the NFO or the New Fund Offer. 

After the NFO ends, units of the fund can neither be purchased nor redeemed. Typically, the maturity period for closed-ended mutual funds is 3 to 4 years. 

However, the units of the fund can be traded in the stock exchange soon after the NFO ends. 

But given the above-average lock-in/maturity period, it is important to understand whether closed-ended funds may fit in your portfolio. Speak to a Cube Wealth Coach to find out what investments will suit your needs the best.

Price Determination For Closed-Ended Funds

The trading price of closed-ended funds can be higher or lower than the actual price. It is a function of various factors such as the demand and supply of the units and fund’s future prospects. 

The actual price, on the other hand, is decided by the Net Asset Value of the fund.

Tax Implications Of Closed Ended Mutual Funds

Closed-ended funds allocate their assets between equity and debt funds. Since equity and debt funds are taxed differently, the applicable tax rate for a closed-ended scheme will depend on the ratio of equity to debt investments made by a fund. 

If investment in equity and equity-related instruments is 65% or more, then it is taxed like an equity fund. If the same percentage is concentrated on debt instruments, it is taxed like a debt fund.

Therefore it is important for investors to be aware of the asset allocation of the fund to know how the gains will be taxed. Read this blog to know more about tax saving mistakes to avoid in 2021. 

5 Advantages Of Closed Ended Mutual Funds

#1 Stable Assets

Entry and exit to the fund are closed after the launch period. This means that the number of share units, as well as the capital raised, remains stable for the fund. 

This stability translates to greater freedom for a fund manager to use funds as planned, without worrying about sudden withdrawals from various investors. 

#2 Efficient Management

Unexpected inflow or outflow of funds makes it difficult for the fund manager to manage investments efficiently. In the case of closed-ended funds, the corpus remains fixed. 

#3 Better Returns

Stable assets and efficient corpus management may allow better decision making and thus better yields - for the fund as well as the investors. 

But there are alternative investment options like P2P lending that carry a lower lock-in period and provide healthy returns based on the scheme. Read this blog to know more about P2P lending in India. 

#4 Market Determined Unit Price

The price of closed-ended fund units is affected by market fluctuations. Commonly, the demand and supply of the units determine the trading price. This price can be more or less than the NAV of the scheme.

#5 Moderate Liquidity

Closed-ended fund units cannot be redeemed after the NFO ends but they can be traded in the stock market. At times, the fund itself offers to buy back the units sold in the NFO.

As per SEBI regulations, closed-ended funds must provide at least one of the above-mentioned advantages to investors. Therefore, they are moderately liquid and allow sufficient buying and selling opportunities to investors.

However, these open-ended mutual funds are known to offer higher liquidity and more or less similar returns over 3+ years:

1. Debt funds

2. Liquid funds 

3. Equity funds

4. Arbitrage funds

5. International & global funds

6. Dynamic bond funds

7. Banking & PSU funds

5 Disadvantages Of Closed Ended Mutual Funds

#1 Subject To Market Fluctuations

Trading prices of closed-ended funds are affected by market fluctuations. This could lead to a high trading price even when the actual value of the fund is much lower, or vice versa. 

#2 Lower Liquidity

Closed-ended funds are moderately liquid, yet less liquid than open-ended funds. For investors who prefer higher liquidity, closed-ended funds may not be the best choice.

Explore handpicked open-ended mutual funds on Cube Wealth today

#3 Unavoidable Brokerage Fee

Investors cannot directly trade units of a closed-ended fund in the stock market. They must go through a broker, which means bearing a brokerage fee on the transaction.

#4 Prone To Massive Price Drops

Sometimes, due to market forces, the price of a fund's units may drop below its initial price. If an investor needs to sell the units for quick cash at this time, it will result in a loss on the investment amount.

#5 Risk Of One-Time Investment

Closed-ended schemes are open for a short duration. They demand one single lump sum investment, which is riskier than making small and systematic investments. 

Instead, you can take a risk analysis quiz on the Cube Wealth app to get a curated list of mutual funds and invest using methods that will work for you. 

Who Should Invest In Closed Ended Mutual Fund?

Investors may invest in these schemes if they can afford or want one or more of the following:

• A Long-Term Investment
  

Closed-ended funds have a lock-in period. Investors may or may not be comfortable blocking their money for a long period. Therefore, they need to choose accordingly.  

• Adequate Capital Gains
  

Funds with a lock-in period may or may not ensure adequate gains on investments. However, the fund’s capital remains stable due to limited NFO and therefore fund managers are in a better position to generate returns on investment.

• Make A Lump Sum Investment
  

Closed-ended funds do not give an option of a Systematic Investment Plan (SIP). Instead, they require a lump sum investment. Investors who are comfortable investing a huge amount in one go may opt for closed-ended fund schemes. 

However, carefully assessing the risks and returns associated with such funds is a must. It is recommended to speak to a Cube Wealth Coach before investing in any mutual fund scheme. 

Conclusion

Closed-ended fund schemes may suit investors who can invest a large corpus and let the investment sit for 3-4 years. However, there are more efficient and better options for investors looking for higher gains and higher liquidity. 

Read this blog to know about different types of mutual funds you can invest in India.

Download the Cube Wealth App and speak to a Cube Wealth Coach for expert investment guidance on investment options better than closed-ended mutual fund schemes.

Watch this video to find out how you can avoid the biggest mutual fund investment mistake