5 reasons why avoid investing in close ended mutual funds

close ended mutual funds

In the last year and a half, there were almost 40-45 close ended mutual funds that had been launched, which collected more than Rs 5000 crore from investors.

Starting with the value theme which said stocks are available at discounts, to ‘Make in India’ theme after the changes in political scenario, mutual fund houses had launched many close-ended mutual funds. Some fund houses had come up with multiple series of the same fund, and collected good investments.

Announcing close ended mutual funds makes good business sense for asset management companies (AMCs), as it gathers stable asset base for them and thus a regular and clear income stream, but it has many drawbacks for the retail investors. Few are pointed as under.

Why not invest in Close ended mutual funds?

  1. No past track Record in New Fund Offer (NFO)

To make you invest in a particular scheme, fund houses have to come up with an exciting theme and catchy name. But the launch would be an NFO. An NFO doesn’t have a performance track record.

You won’t have any data to make your decision on. Performance as compared to peers, alpha generation as compared to funds own benchmark and scheme sector average etc. are some of other numbers which we consider while selecting a fund to invest in and all these would not be available in an NFO.

Also, you can’t be sure if the theme on which the fund portfolio would be based on, will actually work in future or not.

  1. Low Liquidity –

Once invested you have to stay put for specific years. Even if in between you feel that fund’s performance is coming down or is not doing as per your expectation, you won’t have an option to come out. If your investment is based on the trust you put on a particular fund manager, what if he leaves the AMC or starts managing another fund?

However, you may sell out your holding on the stock exchange, if you can find a buyer there as all the close ended funds have to be compulsorily listed. But then again it has been experienced that stock exchange transactions in close ended mutual funds always happens at a discount, and there is quite a less demand.

  1. It doesn’t allow systematic purchases –

Most of the close ended funds come up when markets are doing well when it is easy to convince investors to put in money. But in rising market scenario when valuations are also rising, investing lump sum could be risky. Moreover, you never know which side market will move next day, so it is always better to take exposure into equity market through mutual funds using staggered or systematic routes like STP or SIP.

Close ended schemes require lump sum investments which may make an investor uncomfortable especially in falling markets when he could not even average out the investments by buying more.

  1. Asset allocation/rebalancing is not possible-

All those who make investments with a clear structure and through goal-based planning must know the importance of asset allocation in an investment portfolio. 

Investing in close ended mutual funds doesn’t provide the option of partial redemption or additional purchase, and both these restrictions don’t go well in an asset allocated structure.

In the rising equity market you may need to partially withdraw from equity funds and put into debt funds and same manner in falling equity market you may have to invest more into equity, which is not possible in close-ended structure.

  1. No extra returns due to structure-

Though product sellers claim many benefits of this close ended structure like it ensures commitment from investors for a specific time frame which helps fund manager to take risky calls. It also helps in managing portfolio better as investors have to stay put during both sides of the market and thus the greed and fear

Another claim they make is that it also helps in managing portfolio better as investors have to stay put during both sides of the market and thus the greed and fear do not guide the choice of investors. But even after these “so-called benefits” no significant performance has been witnessed in any close ended funds as compared to their open-ended peers.

Investors suffer from recency effect, which is a behavioral bias and leads people to believe that the recent happenings will continue for long. In financial markets, this can be gauged from the way the investments start pouring in due to recent stock market performance, and also when investors exit looking at the recent fall.

In both the situations, there’s no rational basis of entering or exiting investments, thus impacting the overall investments portfolio very badly. Product manufacturers are very smart. They know how investors behave and that’s why they come up with as many new funds as they can to take advantage of investors upbeat sentiments. But investors should be wary of these tactics and should make investments only on the basis of goals.

Close ended mutual funds do not fit into a properly designed goal based financially planned portfolio.

This article was originally written by me for moneycontrol.com . Published on 27 July’2015

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