Close-Ended Funds

What are Closed-ended Mutual Funds?

A closed-ended fund is a type of mutual fund with a fixed corpus and a predetermined maturity, typically ranging from 3 to 5 years. Issued only in the New Fund Offer (NFO), the units cannot be bought directly from the fund after the NFO is closed. 

Investors can only get out by selling units through a recognised stock exchange, where the units may trade at a premium or discount to the Net Asset Value (NAV). 

Such a structure permits fund managers to invest without the pressures of having to redeem the fund on a daily basis, allowing fund managers to implement long-term strategies without redemption pressures.

Key Features of Closed-Ended Funds

There are a number of different characteristics to closed-ended funds that distinguish them from open-ended schemes. These include:

• Fixed Term: Closed-ended funds have a fixed maturity, typically between three and seven years; no redemption is allowed before maturity, though units may be traded on NSE or BSE. Units are not redeemed out of the fund before they mature, but they may be sold in the secondary market.

• NFO-Based Investment: Investments are made during the New Fund Offer (NFO). No fresh subscriptions are accepted afterwards.

• Exchange Listing: Units are listed in the known stock markets like NSE or BSE so that the investors can buy or sell units in the secondary market.

• Stable Asset Base: With a locked corpus post-NFO, fund managers can implement long-term investment strategies without redemption pressure.

• Capital Appreciation Potential: The lock-in period gives managers the time to concentrate on assets that might require a long time to yield a higher return.

Types of Closed-Ended Funds

Closed-ended funds are categorised according to their purpose, asset class, and structure. Here are key types you’ll encounter:

1. Debt Closed-Ended Funds

   These are closed-ended debt-oriented funds. Their investment is mostly in fixed-income securities (bonds, corporate debt, government securities), with a maturity date that aligns with the fund’s tenure, ensuring the investment horizon matches the fund term. Due to this correlation, FMPs reduce interest rate risk and lock in yields.

2. Capital Protection Oriented Funds

   The objective of these funds is partial protection of capital by investing a substantial amount of the funds in debt instruments and a smaller amount in equities or derivatives. The point is to maintain principal but have a potential upside.

3. Hybrid Close-Ended Funds

   They provide growth attained through equities and stability as well as through debt, and hence they are appropriate for investors with a moderate risk profile.

How Close-Ended Funds Work?

Close-ended funds operate differently from open-ended schemes because their structure, subscription process, and trading mechanism are all predefined. Here is how they function step by step:

• Fixed Corpus and Duration: A close-ended fund is launched with a fixed investment corpus and a defined tenure, typically between 3 to 7 years.

• New Fund Offer (NFO): The fund opens for subscription through an NFO period that must remain open for at least three working days and not more than 15 days (ELSS schemes may differ as per SEBI rules). After the NFO closes, no new units are issued.

• Deployment of Funds: Once the corpus is collected, the fund manager invests it according to the scheme’s stated objective. This may include equity, debt, or hybrid instruments.

• Listing on Stock Exchanges: After allotment, the fund’s units are listed on recognised stock exchanges. Investors can buy or sell these units in the secondary market through brokers.

• Market-Linked Pricing: The units trade on the exchange at prices influenced by demand and supply. As a result, they may trade above (premium) or below (discount) their Net Asset Value (NAV).

• Redemption at Maturity: Investors cannot redeem units before maturity. At the end of the tenure, the fund is liquidated, and investors receive the final NAV value along with any accumulated returns.

• NAV Disclosure and Regulation: As per SEBI and AMFI guidelines, open-ended schemes disclose NAVs daily, while closed-ended schemes must disclose NAVs at least weekly. All NAVs are available on AMC and AMFI websites for investor access.

Advantages of Closed-Ended Funds

Closed-ended funds have a number of strategic benefits. Some of these are:

• Higher Returns in Debt Funds: Fixed-Maturity Plans (FMPs) align the portfolio maturity with the fund’s tenure, helping lock in yields and reduce reinvestment and interest-rate risk. However, returns are not guaranteed.

• Investor Discipline: The structure discourages frequent withdrawals and market timing, fostering patience and long-term investing.

• Goal-Based Alignment: This tenure is fixed, so these funds are suitable for predetermined financial objectives, including financing education or a house purchase.

• NAV Transparency: Net Asset Value (NAV) will be released on a periodic basis and will give investors an opportunity to monitor the performance of the fund even in the lock-in period.

Difference Between Closed-Ended and Open-Ended Funds

Closed-ended and open-ended funds differ in liquidity, flexibility, and accessibility. The table below highlights the key distinctions between the two:

Why Consider Closed-Ended Funds in Your Portfolio?

Under certain circumstances, closed-ended mutual funds may be helpful strategically, even with all their inherent limitations and risks. The following are reasons why they could be suitable for some investors:

• Goal-Aligned Investing: When you have a specific financial target, such as saving ₹10 lakh in five years for your child’s education or a home down payment, a closed-ended fund with a defined tenure helps align the investment period with your goal.

• Maximisation of Returns using Debt Markets: Fixed maturity plans may be applied to hedge the yield during the tenure of volatile bond markets or rising movements of interest rates. This can give it more stable returns compared to open-ended debt funds, which must continually reinvest in uncertain market conditions.

• Premium Opportunities: The investors have the ability to exploit market inefficiencies by purchasing units at a price below their Net Asset Value (NAV). If the discount narrows over time, it will bring in an extra gain to the profit, on top of the gains of the assets in the fund.

• Portfolio Diversification: Structural diversification can be increased by the combination of both open-ended and closed-ended funds. Closed-ended funds introduce stability, investment discipline, and a differentiated approach, unlike the normal open-ended schemes.

How to Invest in Closed-Ended?

Investment in closed-ended funds is systematic. Here's a step-by-step guide:

• Check the NFO: Closed-ended funds are open for subscription only during the NFO period. Review the offer information, such as tenure, investment purpose, and investment allocation.

• Full KYC Settlements: You are to ensure your Know Your Customer (KYC) formalities are in place. This is obligatory to invest in any mutual fund within India.

• Subscribe During NFO: The investor must apply to subscribe to units via a bank, mutual fund distributor, financial advisor, or online through the NFO Window.

• Wait for Allotment: Once the NFO has been closed, the investors are allotted units. The fund has a set amount for its entire tenure.

• Trading on Stock Exchange (Optional): In the stock exchange market, once listed, units can be sold or purchased on a recognised stock exchange, where liquidity in the market permits. Prices may trade at a premium or discount.

• Hold Until Maturity: Closed-ended funds are made to have a set term. The investor usually is held till the maturity of the fund to get the final NAV as well as the income or gains.

• Take Early Exit into Account: In case of a sale on the exchange, verify the trading volumes and price against NAV, because the liquidity will be low, and the returns will be influenced.

List of Closed-Ended Funds in India

Below are some closed-ended mutual funds/schemes some closed-ended mutual fund schemes available in India, along with indicative returns:

*Always check current data, scheme documents, and alignment with your goals before making any investment decisions.

Who Should Invest in a Closed-Ended Fund?

Closed-ended funds are not universal- they are appropriate to investors who possess some attributes and inclinations. Here's a quick guide:

1. Best Suitable For:

   • Goal-oriented Investors: Closed-ended tenure can be more suitable in case you have a precise schedule of achieving your financial objective (e.g., provide education to a child in five years).

   • Minimal Liquidity Requirements: It is suitable for investors who do not require short-term access to capital.

   • Patient Long-term Investors: These are the ones who are comfortable remaining invested and are not always watching and responding to the noise in the market.

   • Experienced: A person who is able to discern discount/premium movements and is not afraid of trading in exchanges.

2. Less Suitable For:

   • Investors Seeking High Liquidity: Investors who need quick access to funds may find this option restrictive due to limited liquidity.

   • New or Inexperienced Traders: Beginners or anyone not comfortable with exchange-based trading may struggle to manage this type of investment.

   • SIP-Oriented Investors: Investors who prefer flexible investment approaches like SIP or irregular top-ups may not find this structure suitable.

   • Investors with Uncertain Financial Needs: Anyone who might need to withdraw early because of emergencies or financial stress should avoid this option.

   • Flexibility-Dependent Investors: Investors who rely on the convenience of open-ended funds, where entry and exit are easier, may find this option too rigid.

Key Factors Before Investing in Closed-Ended Mutual Funds

Prior to investing in closed-ended mutual funds, you need to have an understanding of the following key factors:

• Investment Horizon: Closed-ended funds are appropriate in the cases of a medium- to long-term investment horizon of an investor. The premature redemption is prohibited, so make sure that you are able to hold onto the entire tenure.

• Liquidity: The schemes are not liquid on a daily basis as compared to open-ended funds. Leaving before maturity is usually achieved by selling units in the exchange, which may not necessarily be sold at the desired price because of low volumes of trade.

• Performance Potential: The stable approach allows fund managers to pursue long-term, better-risk-adjusted returns without having to concern themselves with day-to-day redemptions. Performance will, however, be dependent on market conditions and fund strategy.

• Costs and Transparency: Closed-ended funds tend to be less expensive in terms of expense ratio, yet the charges and disclosure in the fund offer document must be reviewed by an investor.

• Market Timing and NAV: Timing is of great importance since the investment can be undertaken only in the NFO. The timing of investments can serve to impact returns.

Taxation Implications on Closed-Ended Funds

The taxation of closed-ended mutual funds depends on their asset allocation and the date of investment. These rules are essential for effective financial planning and maximising post-tax returns:

Key Takeaways

Closed-ended mutual funds are organised investment opportunities, which have a set corpus and duration, usually between 3 to 7 years. They best fit the goal-oriented investors who have a specific investment period and can invest their capital until its maturity. Market conditions, tax, trading costs, and investment strategy of the fund are some of the factors that investors should consider carefully before investing. Although closed-ended funds offer discipline, alignment of goals, and availability of niche strategies, they are not suitable for investors requiring frequent liquidity or flexibility. A thorough analysis ensures that closed-ended funds align with your financial goals and risk tolerance.