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  • Why closed-end mutual fund schemes are a risky investment

    Quote by Jayant Pai in The Economic Times Wealth, February 13, 2017

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    Why closed-end mutual fund schemes are a risky investment
    Even though the lock-in period ensures that investors ride out the volatility, their poor performance, no track record make closed-end schemes a risky choice.

    Closed-end equity mutual fund launches have been declining since the Association of Mutual Funds in India (AMFI) asked fund houses to cap up-front commissions at 1%. In the 12 months preceding AMFI's decision (April 2015), 58 closed-end schemes were launched.

    In the 20 months since the cap, the launches fell to 29. The Securities Exchange Board of India restricting the launch of new schemes, also contributed to the fall in their launches. But investors should not be worried. There are several reasons why you are better off without closed-end schemes.

    Underperforming peers across categories
    Returns of most closed-end funds are markedly lower than that of open-ended peers.



    *Belonging to the same category as the closed-end scheme. ICICI Pru Growth Fund AUM is as on 31 Jan 2017, others as on 31 Dec 2016. Returns as on 6 Feb 2017. Data source: Value Research

    Poor show

    Closed-end schemes have under-performed their open-ended peers across time periods. Closed-end diversified multi-cap funds' one and two-year average trailing returns stand at 28.5% and 5.85% respectively. The same for open-ended diversified multi-cap funds stand at 33.26% and 10.15% respectively.

    The three year lock-in period of closed-end funds, meant to provide fund managers the flexibility to steer their funds without the fear of outflows, has not helped generate better returns either. The three-year average trailing return of closed-end diversified multi-cap funds stands at 26.74% while the same for open-ended category peers is 27.67%.

    Even when we look at the annualised performance of open-ended equity funds, it has been mostly superior to that of closed-end schemes. Staying locked-in, clearly, hasn't led to higher returns. "There is no type of investor for whom closed-end funds score over open-ended ones," says Jayant Pai, CFP and Head, Marketing, PPFAS Mutual Fund.

    Lump sum investment

    A large number of investors, especially the salaried class, do not have a lump sum amount to invest in equity funds. They prefer staggered investments, such as through systematic investment plans (SIP) which can be started with as little as ₹ 500. Closed-end funds do not offer this flexibility.

    You need to invest a lump sum into these schemes when they are launched. Even if you have the funds to invest, experts say, SIP should be the preferred route to invest in equities as SIPs lower the risks arising out of market volatility. With no SIP possibility in a closed-end fund, you risk investing when the market is expensive and maybe forced to exit when they are tanking. "Investors stand to lose out as very few closed-end schemes offer the option to extending the tenure," says Dhaval Kapadia, Director, Portfolio Specialist, Morningstar.

    Since the funds are listed on stock exchanges, investors do have the option of selling their holdings but usually at a discount to their existing NAV (net asset value). So, whether you wait out the lock-in period or sell the units in the secondary market, closed-end funds come with a greater risk compared to open ended schemes.

    Some experts, however, offer the counter perspective: The lock-in period ensures that investors ride out the volatility without making redemptions. "The compulsion to stay invested can make these funds a good choice," says S. Naren, Executive Director and Chief Investment Officer, ICICI Mutual Fund. ICICI Pru Growth Series I closed-end scheme has fared better than its open-ended peers. It is, however, an exception.

    No track record

    It is true that past performance does not guarantee future returns, but it still remains an important indicator when selecting a fund. With an open-ended equity fund, you can see how it has performed over different market cycles before you invest in it. But investing in a closed-end fund is akin to throwing a dart in the dark. "You're basically betting on the fund manager, rather than the track record of the fund," says Kunal Bajaj, Co-founder and CEO, Clearfunds. com. There is the performance of the fund series to look at, but it cannot be used as an indicator because different funds within the same series are often managed differently.

    The original article could be seen here.

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