A Beginner's Guide For Investing in a Close-Ended Mutual Fund
Mutual funds are broadly categorised into two types- open-ended and close-ended. Close-ended mutual funds are termed so since they have a stipulated maturity period, whereas an open-ended mutual fund has an indefinite maturity period.
While an open-ended mutual fund scheme allows investors the flexibility to enter or exit at any time after its launch, a close-ended scheme does not. This is perhaps why open-ended mutual funds are more popular amongst investors than close-ended mutual funds in India.
What is a Close-Ended Mutual Fund?
Close-ended mutual funds are termed 'closed' because of the restrictions placed on them on account of their stipulated maturity period. A fixed number of these equity or debt funds are issued during the launch period.
During the launch or New Fund Offer (NFO) period, investors can invest in units of a close-ended mutual fund. After which, the units are listed on the stock exchange and can be traded like regular stocks. Once the NFO period closes, the units of a close-ended mutual fund can no longer be purchased or redeemed.
Open-Ended Vs Close-Ended Mutual Funds
The most prominent and important point of difference between open-ended and closed-ended mutual funds is based on the entry and exit period. Unlike a close-ended mutual fund, where units cannot be purchased or redeemed after the NFO period is over, in an open-ended mutual fund, the launch officially begins after the NFO period.
Investors have the flexibility to either enter or exit an open-ended mutual fund. Some other differences between open-ended and close-ended mutual funds include- the ineligibility to invest through a SIP (Systematic Investment Plan) in a close-ended mutual fund. An open-ended mutual fund also supports SWP (Systematic Withdrawal Plans) and STPs (Systematic Transfer Plans).
Features
Let us now look into the salient features of a close-ended mutual fund.
- Professional fund managers manage a close-ended mutual fund.
- Investment can only occur during the NFO period until maturity (generally three to five years).
- Regular dividends can be earned if the fund portfolio performs well. Alternatively, these can be traded on a listed stock exchange at the prevailing market price (either at a premium or a discount).
- Close-ended mutual funds are suitable for long-term investment.
Advantages
A close-ended mutual fund offers the following advantages-
Steady Asset Base
Since close-ended mutual funds have a fixed maturity period, meaning funds cannot be withdrawn before the expiration of the maturity period. Therefore, fund managers do not have to worry about maintaining asset liquidity and can focus on devising a suitable investment strategy given a steady asset base.
Fund Liquidation at Market Prices
Close-ended mutual funds can be traded on the stock exchanges at the prevailing market rates determined by the forces of demand and supply. The units can be traded either at a premium (when the market price is higher than the Net Asset Value or NAV) or at a discount (when the market price is below the NAV).
The former happens when the market demand for the fund scheme is high, and the supply is low. The latter takes place when the reverse happens. Since trading close-ended mutual funds are similar to trading equity shares, stock trading strategies are also applicable.
Disadvantages
Having understood the benefits of a close-ended mutual fund scheme, let us now look into the drawbacks that it suffers from-
Unfavourable Performance History
Open-ended mutual funds have been seen as promising compared to close-ended mutual funds. The flexibility on the part of the fund managers does not translate into better returns for the investors.
Limited Investment Option
Unlike open-ended mutual fund schemes, where one can invest through SIP, a close-ended mutual fund scheme does not allow such investment options. Only a lump sum investment option is available, which is not affordable and generally locks in the capital for three to five years. As a result, the risks are higher.
Fairly Centralised
Data on fund performance over distinct market cycles are analysed for making informed decisions regarding investing in mutual funds. While this data is easily available in the case of open-ended mutual funds, closed-ended mutual funds suffer from the unavailability of relevant data.
Investors have no choice but to rely on fund managers. Fund performance largely depends on the discretion of the fund manager, which in turn increases the risk factor and the uncertainty associated with a close-ended fund scheme.
Tax Treatment of Close-Ended Mutual Funds in India
Tax treatment differs depending on whether the fund in question is an equity or debt fund. For taxation, a fund that invests 65% or more in equity or equity-related instruments is treated as an equity fund. If the holding period is less than a year, it is treated as a short-term capital gain (STCG) and is taxed at 15%. If the period of investment exceeds one year, it is treated as a long-term capital gain (LTCG) and is taxed at 10% (for LTCG over one lac)
A fund that invests 65% or more in debt instruments is treated as a debt fund. For holding periods up to three years, the tax rate is determined based on the tax slab the investors fall under. The income is treated as a long-term capital gain (LTCG) for investment periods exceeding three years and is taxed at 20% after indexation.
The offer document states asset allocation, based on which the tax rates can be arrived at.
Conclusion
Over the years, the participation of millennials (Generally having a low-risk appetite) in investments has increased. Also, among salaried individuals, investment through SIP is often preferred.
Considering these, investment in a close-ended mutual fund is not a favourable option for such investors. Rather, it is suitable for investors who plan on remaining invested for longer periods and those with a large corpus for investment.
FAQs
How can you invest in a close-ended mutual fund?
Investors can either invest directly in a close-ended mutual fund or with the help of distributors or agents. In the first case, the investor does not have to pay a commission because of the absence of an intermediary and can maximise profits.
Both offline and online modes of investment are available. For the offline mode, you must visit the mutual fund branch and if you wish to take the online route, visit the mutual fund website. In the second case, one must ensure that the distributor is registered under the Association of Mutual Funds in India (AMFI).
What are some high-performing close-ended mutual funds in India?
Based on the performance history of the funds over the last couple of years, the top close-ended mutual funds in India and their risk profile-
- SBI Small Cap Fund (moderately high)
- Mirae Asset Emerging Bluechip Fund (moderately high)
- Canara Robeco Emerging Equities (moderately high)
- Nippon India Small Cap Fund (moderately high)
- Kotak Emerging Equity Scheme (moderately high)
Why are the trading price and the NAV different for a close-ended mutual fund?
In a close-ended mutual fund, the NAV is calculated regularly, considering the net value of assets included in the portfolio. The trading or market price is the price at which the fund is traded on the stock exchange.
The invisible market forces of demand and supply determine this price. Therefore, a close-ended mutual fund's market price (MP) differs from its NAV. These funds can be sold either at a premium ( MP>NAV) or a discount (MP< NAV)
Can a close-ended mutual fund be redeemed before maturity?
The units of a close-ended mutual fund can only be purchased during the NFO period, and the redemption can take place after the maturity period (this typically ranges from three to five years, even seven in some cases). The very nature of the close-ended funds does not allow for the redemption of units before maturity.
However, suppose an investor wishes to redeem their units before maturity. In that case, they can do so by selling the units of the scheme to the fund house through periodic repurchases at NAV-related prices. An investor can also sell scheme units through the stock exchange after they are listed there.
How is a close-ended mutual fund different from a stock?
A close-ended mutual fund is a type of mutual fund that issues a specific number of units during the NFO period. They are then listed on the stock exchange. It is merely an investment structure, not an asset class like shares. Moreover, it neither leads to the creation of new shares nor does further money flow into the fund.
A stock gives a shareholder part-ownership in the company, whereas a mutual fund does not create such a relationship between the company and the investor of a mutual fund. A close-ended mutual fund is actively managed by one or more fund managers and is backed by a team of researchers and analysts. This expertise may not be available to an individual investor holding company shares.