Parag's Views

Markets are known to create fads and fancies from time to time depending upon the psychology of the investors.

The latest fad is Close Ended Funds. Is it not surprising that all of a sudden these have become fancies and big fund houses have been lining up to launch close ended funds. One fund house after an initial success has immediately launched series 2 to gather as much money before the others get in and the fancy ends. Herd mentality is at work.After a long time the distributors have got active. Close ended funds offer attractive commissions to the distributors. This is how it works:

A fund can charge 2.5% as expenses per year. Say for instance a fund is close ended for 5 years, it can have 12.5% as expenses. The AMC of such a fund would offer anywhere between 7 to 8% to the distributors. Their job is to get an investor who would be locked in for 5 years. And for getting that money for five years he is rewarded for an upfront commission. This has got the distributors active. Imagine getting paid for 5 years work today itself. They will sell anything to anybody.

This practice can be adopted only by AMC’s having deep pockets and very high net worth as the AMC would be financing the upfront commissions to be paid to the distributors. The scheme would get its 2.5% every year for the next five years. Say for instance a fund collects Rs.500 crores. Distributor commission at say 7% works out to be Rs.35 crores. The scheme will earn only 2.5% on Rs.500 crores amounting to Rs.12.5 crores in the first year. The rest will come from the AMC. These Fund houses don’t realize that with these high upfront commissions they are only encouraging distributors to seek redemptions from their other schemes in order to invest in to close ended funds. This reminds me of the old saying “ A fool and his money are soon parted”.

We have seen the fickle minded behavior of the investors and also their short term approach when it comes to long term investing. So why are they investing in these schemes? Why are they locking up their funds for 5 years? Greed is the driver. Firstly there would be pass offs given by the distributors from the heavy commissions they get. Greedy investors fall for such baits. Secondly the investors are misled in to believing that the exit will always be there as the close ended funds would be listed. But they are not told that the fund would be listed and quote at a huge discount to the NAV. Maybe the distributors are also not aware of it. All close ended funds when listed quote at a huge discount to the NAV.

We are aware that stock markets are inefficient and the investors are irrational. That is the reason that close ended funds always quote at a huge discount to the NAV. This discount can be viewed as an expensive monument erected to the inertia and the stupidity of the share holders. It is interesting to understand the behavioral interpretation of Close end Fund pricing: Investors sentiment varies through time. When noise traders are optimistic the price of close ended fund rise and the discount to NAV narrows. When noise traders are pessimistic the price of close ended funds fall and the discount widens. But the discount is always there because of the time lag to the redemption date.

Investors in Close Ended Funds are subjected to two types of risk:

• The Fundamental risk of NAV going down.
• The noise trader risk of widening the discount due to pessimism.