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ALL ABOUT CLOSE-ENDED MUTUAL FUNDS

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Mutual funds are categorised into two broad types – open-ended funds and close-ended funds. A mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending on its maturity period. While open-ended schemes are more popular with investors, close-ended funds in India are gaining traction too.

This article will cover everything you need to know about close-ended mutual funds before you consider investing in them.

What is a close-ended fund?

The Securities and Exchange Board of India (SEBI) defines close-ended funds as mutual funds that have a stipulated maturity period. These mutual funds are available for subscription during a specified period at the time of the scheme’s launch. Investors can invest in these mutual funds during this New Fund Offer (NFO) period, post which, they can list the units on the stock exchanges.

How do close-ended funds work?

After an asset management company (AMC) sets up a new fund offer (NFO), investors purchase units of the scheme at a specific price. Once the NFO period ends, no new investor can enter the scheme. Additionally, investors are not allowed to exit the fund before the scheme matures. At maturity, the scheme is dissolved, and the money is returned to the investors at the prevailing NAV (net asset value) on that date.

Investors who wish to exit the scheme before the maturity period ends can trade their units on the stock exchanges.

Benefits of close-ended funds

Following are some of the benefits of investing in close-ended mutual fund schemes:

  1. Stability: As investors cannot redeem their units before maturity, as with open-ended schemes, close-ended funds are stable in terms of their asset valuation. This stability helps the fund managers to create a steady asset base and devise the right investment strategy. They are also not worried about maintaining liquidity as there are no redemptions.
  2. Freedom from significant flows: Unlike open-ended mutual funds, close-ended schemes are immune to large inflows or outflows. A sudden outflow of cash from a mutual fund scheme can force a fund manager to make impulsive investment decisions and sell the securities at unfavourable prices. With close-ended schemes, the investor’s money is locked-in until maturity, which allows the fund manager to make rational decisions.
  3. Trading on the stock exchanges: Investors can trade their units in a close-ended scheme on stock markets like equity shares. This opportunity to buy or sell fund units is based on real-time prices. The trading price can be above (premium) or below (discount) the fund’s NAV. Investors can also make use of stock trading strategies such as limit/market orders and margin trading.
  4. Unique portfolio: Close-ended funds allow the fund manager to create a unique portfolio that has the potential to fetch returns. Owing to the lock-in period of close-ended schemes, fund managers can explore undervalued debt and equity securities that would otherwise not feature in the portfolio.

Tax benefits of Close-ended funds

The tax treatment of open-ended funds depends on whether it is an equity fund or a debt fund.

Type of fund

Particulars

Short term capital gains tax (STCG)

Long term capital gains tax (LTCG)

Equity-oriented scheme

Holding period

Up to 1 year

More than 1 year

Tax rate

15%

10%*

Debt-oriented scheme

Holding period

Up to 3 years

More than 3 years

Tax rate

According to the tax slab of the investor

20% after indexation

*LTCG over Rs 1 lac are taxed at 10%

Relation between NAV and closed funds

One of the unique features of close-ended schemes is how they are priced. The price at which it is traded on the stock exchanges depends entirely on the demand and supply. Investors’ demand could result in close-ended mutual funds being traded either at a discount or a premium to their NAV. A discount price means that the price of the share is below the NAV, while a premium price means it’s above the NAV.

Close-ended schemes could be traded at premium or discount for several reasons as they could be focused on a popular sector and reflect the sentiments of that sector. They might also trade at a premium if a historically successful fund manager manages the scheme. Conversely, a poor risk versus return profile or lack of investor demand for the fund can also lead to the fund trading at a discount to its NAV.

Who should invest in Close-ended funds?

Given the mandatory lock-in period, close-ended funds are ideal for investors with a long-term investment horizon. Also, close-ended mutual funds require lumpsum investment and do not provide redemption facility until maturity. Hence, investors with an investment horizon and investible corpus in sync with the maturity date can consider investing in these mutual funds.

Risk factor in close-ended funds

As you can buy the units of a close-ended fund only during the initial launch period, an investor is mandated to make a lumpsum investment. This can be a risky approach to deal w.r.t mutual fund investments. Additionally, a large number of salaried individuals are unable to afford lumpsum investments and prefer SIP (systematic investment plan) as it is affordable and spreads the risk.

How to invest in close-ended funds?

If you are wondering how to buy close-ended funds, follow these simple steps:

  1. Create a mutual fund account with an AMC (Asset Management Company)
  2. Complete your KYC (know your customer) formalities if you have not done it already
  3. Input the necessary details, as required
  4. Identify the fund(s) you wish to invest in based on your personal and financial goals, risk tolerance, and investment horizon
  5. Select the apt close-ended fund that best suits your portfolio and transfer the required amount

(N.B.: Unlike open-ended schemes, close-ended funds do not allow investments via SIP (systematic investment plan), STP (systematic transfer plan), or SWP (systematic withdrawal plans), but just through lumpsum investments.) 

The performance of a scheme, whether close-ended or open-ended, depends on the fund management, the fund category, and the investment style. Several investors investing in open-ended schemes are often quick to redeem their units and book their profits after the NAV appreciates by 5-10%. This affects investors who are invested in the scheme. Thus, close-ended mutual funds are a better option in such situations as the lock-in period prevents early redemption and protects the interests of all investors. Happy investing!