Close-end funds: What is close-ended Mutual Fund and how it works

Mutual funds are one of the most preferred investment options these days. A mutual fund is an investment fund that is managed by a fund manager. The money invested by individual investors is pooled in to purchase different kinds of securities. The portfolio of securities is diverse and is tailored as per the investment goals of the investors. Mutual funds are considered to be a less risky investment option.

On the basis of the subscription period, mutual funds can be classified into two categories – close-ended mutual fund and open-ended mutual fund. In a close-ended mutual fund, a fixed number of units are issued which are traded on the stock exchange. A closed-end fund functions like an exchange-traded fund.

 

How does closed-end fund work?

As per the guidelines of the securities market regulator SEBI, a mutual fund is 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 demand and supply as it is possible to trade the fund at a price that is above or below its real value.

Units of a close-ended mutual fund can be purchased only during the NFO period. They can be traded at premiums or discounts to their NAVs.  The units can be redeemed only after the maturity of the fund which is typically between 3 to 7 years.

Does that mean that an investor cannot opt-out of a close-end fund prior to the expiry period? SEBI allows redemption before maturity if the funds are listed on a stock exchange or the fund house allows the investor to sell the units to the fund house through periodic repurchase at the Net Asset Value related prices.

 

What are the advantages of a closed-end fund?

There are numerous advantages of investing in a close-ended mutual fund:

Stability: Redemption of the fund is only allowed on the expiry of the maturity period. This helps the portfolio managers to build a steady asset base and devise the right investment strategy. Investment in a close-ended mutual fund means that there is no unexpected inflow outflow of investment due to the stable asset base.

Enhanced flexibility: These funds can be liquidated as per the norms of the fund house. The investors are allowed to sell these units based on the real-time prices available during the trading day.

Maximum possible returns: An investor of a close-ended mutual fund is bound by the lock-in period. This helps investors the temptation to fall prey to risky investments. By staying committed to the mutual fund, they enhance their chances of taking home the maximum possible returns offered by the fund.

Unique Portfolio: These funds allow the fund manager to create a unique portfolio that can give great returns. Due to the extended lock-in period, the fund manager can explore undervalued equity and debt instruments which would otherwise not feature in the portfolio.

 

Who should invest in a closed-end fund?

Investment in any type of mutual fund depends on the investment objectives of the investor. Given the relatively longer lock-in period, close-ended mutual funds are best suited for investors who are looking at a long investment horizon. These funds are also great for an investor who is looking to diversify his or her investment portfolio.

Investors should also bear in mind that closed-end funds require lump sum investment which may not be suited for all investors. The performance of a close-ended mutual fund depends on the investment style and skills of the fund manager, the sector in which the investment is made, and the prevailing market conditions. An investor looking to invest in a close-ended mutual fund should be prepared to undertake these risks.

In addition to the above, the investor should also meet the standard eligibility criteria laid down by SEBI. As per SEBI, an investor of a mutual fund can be Indian residents above the age of 18, Non-resident Indians (NRIs) and Persons of Indian Origin (PIOs) residing abroad,  Companies (including public sector undertakings), corporate bodies, trusts (through trustees) and cooperative societies, religious and charitable trusts (through trustees), and private trusts authorized to invest in mutual fund schemes under their trust deeds, foreign institutional investors registered with SEBI, and other individuals or institutions, as approved by asset management companies, so long they conform to SEBI regulations.

 

How to invest in close-ended mutual funds?

Investors can invest directly or contact the agents and distributors of mutual funds for necessary information and application forms. Investors must ensure that they invest through the Association of Mutual Funds in India (AMFI) registered distributors and that the distributor has a valid AMFI Registration Number (ARN).

For investments through the direct plan, the investor needs a financial adviser but does not have to pay any commissions to the distributors. This maximizes the returns from the close-ended mutual funds. If the investment is done through a distributor, they are required to disclose all the commissions (in the form of trail commission or any other mode) payable to them for the different competing schemes of various mutual funds out of which the scheme is being recommended to the investor.

Investors also have the option to invest directly with the mutual fund either by visiting the mutual fund branch or online through mutual fund website. Forms can be deposited with mutual funds through the agents and distributors who provide such services.

Before making an investment, the investor should take into account the track record of the mutual fund/scheme. Investors should also refer to the product labelling of the scheme. As per SEBI regulations, all the mutual funds are required to label their schemes on the following parameters:

1. a)  Nature of scheme – whether the aim is to create wealth or provide regular income in an indicative time horizon (short/ medium/ long term).
2. b)  A brief about the investment objective (in a single line sentence) followed by kind of product in which investor is investing (equity/debt).
3. c)  Level of risk depicted by a pictorial meter as under:

• Low - principal at low risk
• Moderately Low - principal at moderately low risk
• Moderate - principal at moderate risk
• Moderately High - principal at moderately high risk
• High - principal at high risk

Product labeling should be disclosed in:

1. Front page of initial offering application forms, Key Information Memorandum (KIM) and

Scheme Information Documents (SIDs).

1. Common application form – along with the information about the scheme.
2. Scheme advertisements.

 

FAQs

 

What is the Net Asset Value of a mutual fund scheme?

The performance of a particular scheme of a mutual fund is indicated by the Net Asset Value (NAV).

NAV represents the market value of the securities held by the scheme. Since the market value of securities changes every day, NAV of the same scheme varies on a day to day basis. The NAV per unit is the market value of securities of a scheme divided by the total number of units of the scheme on any particular date. For instance, if the market value of securities of a mutual fund scheme is INR 200 lakh and the mutual fund has issued 10 lakh units of INR 10 each to the investors, then the NAV per unit of the fund is INR 20 (i.e.200 lakh/10 lakh). NAV is required to be disclosed by the mutual funds on a daily basis.

 

Can I choose a periodic investment plan to invest in a mutual fund?

Most private-sector funds allow investors to invest through a Systematic Investment Plan. Regular monthly investments can help you to build a long-term portfolio and add discipline to your investment process.

 

What are Exchange Traded Funds?

ETFs are mutual fund units that investors can buy or sell at the stock exchange. In a regular mutual fund, the investor buys or sells the unit of a fund the Asset Management Company (directly or through a distributor). However, in the case of ETFs, the AMC does not deal directly with investors or distributors. Units are issued to a few designated large participants called Authorised Participants. The APs provide buy and sell quotes for the ETFs on the stock exchange, which allows investors to buy and sell the ETFs at any given point of time on the stock market.

 

What is the frequency of declaring NAV?

NAV has to be disclosed by the mutual funds on a regular basis. Depending on the type of the scheme, the declaration can be on all business days or on a weekly basis.  As per SEBI Regulations, the NAV of a scheme shall be calculated and published at least in two daily newspapers at intervals not exceeding one week. The NAVs should also be made available on the websites of mutual funds. Fund houses are also required to put their NAVs on the website of Association of Mutual Funds in India (AMFI) www.amfiindia.com. This allows investors to access the NAVs of all mutual funds at one place.

 

What is the expense ratio of a mutual fund?

The expense ratio refers to the annual fund operating expenses of a scheme, which is expressed as a percentage of the fund’s daily net assets. Operating expenses of a scheme include the administration, management, advertising related expenses, etc. If the expense ratio of a mutual fund is 1% per annum, it means that each year 1% of the fund’s total assets will be used to cover expenses. Information on expense ratios that may be applicable to a scheme is mentioned in the offer document. As per the present regulations, there is no limit on any particular type of allowed expense as long as the total expense ratio is within the prescribed limits by SEBI.

 

Can I invest in a mutual fund directly without a distributor or agent?

From 2013, SEBI has mandated mutual funds to launch a direct plan for direct investments, which allows investors to invest directly without routing it through a distributor. Direct plans have a lower expense ratio excluding distribution expenses, commission, etc., and no commission is to be paid from such plans. The plan also has a separate NAV. The investor has a choice to make the investment either a lump sum amount, i.e. a onetime payment, or through a Systematic Investment Plan (SIP).

 

What is a Systematic Investment Plan (SIP)?

SIP is a mode of making an investment to your mutual fund. A SIP allows an investor to invest regularly. You can put in a small amount every month that is invested in a mutual fund. A SIP allows one to take part in the stock market without trying to second-guess its movements. It works best for a novice investor.