Pros & cons of investing in close-ended funds

Mutual fund houses launch new fund offers (NFOs) that are either open-ended or close-ended. The open-ended schemes do not have any tenure and can continue till perpetuity unless the fund house decides to wind up the scheme. The units of these schemes can be purchased from the fund house or sold back (redeemed) to the fund house on an ongoing basis. In contrast, the close-ended schemes are for a specified period of say 3-5 years or more, after which the scheme is dissolved and the net proceeds realised after the sale of all investments are distributed amongst investors.

Now, the crucial question is: should the investors opt for an open-ended or a close-ended scheme? The answer to this question will depend on the needs and objectives of the investor. To have a better idea, let us look at the pros and cons of investing in a close-ended scheme.

Timing of launch: If the mutual fund scheme is an equity-oriented scheme launched during a bull market, the fund house will be forced to enter the market at higher valuations. This poses a downside risk and loss of capital if the market goes into a bearish phase after the fund house invests the corpus of the fund. Since the aim of an equity-oriented scheme is to provide capital appreciation over the specified period, the purpose will be defeated if the market continues in a bearish phase over the specified period of the scheme.

However, if the scheme is launched during the bearish phase of the market and the market turns around and goes into a bullish phase after the fund house fully invests the fund corpus, the performance of the scheme may turn out to be quite impressive as the value of investments will soar during the bull phase and the fund house can book profits on the investments and generate good returns for the investors. So, the timing of launch is crucial for the performance of the fund.

Low liquidity: The units of close-ended scheme cannot be redeemed during the tenure of the scheme. However, if the units are listed on the stock exchanges, these can be bought and sold on the exchanges. But since the fund house does not buy or sell any units, there are hardly any takers for the units in the market. Hence, there is very little, if any, liquidity in the units of the scheme due to which the amount of capital invested by the investor remains locked in for the specified tenure of the scheme. Also, since the fund house does not buy or sell units during the specified period, investors do not have the option of buying more units from the fund house, although they can purchase the units from the market, if there are any sellers.

Expense ratio: The size of the fund’s corpus of a close-ended scheme is limited as the fund house does not buy or sell units after it closes the NFO. Hence, its expense ratio could be higher if the corpus size is low. On the other hand, since the fund corpus is limited, the fund house may invest in select 20-30 stocks for the long term and may not churn the portfolio much during the tenure of the scheme. This could reduce the expense ratio and generate higher returns for the investors. Considering these factors, an open-ended scheme may appear to be better than a close-ended scheme.