Introduction
Mutual funds provide various investment structures, including open-ended, closed-ended, and interval funds, each representing distinct categories based on trading frequency. Open-ended funds, known for their unrestricted trading capabilities, are preferred by investors. However, closed-ended funds are also gaining attention. In this exploration, we focus on closed-ended mutual funds, explaining their benefits, and exploring other important aspects of these investment vehicles.
What are Closed Ended Funds?
Closed-ended funds differ from open-ended ones by offering a fixed number of shares at launch, which cannot be redeemed until maturity. Prices fluctuate on exchanges similar to stocks. Investors purchase shares during the IPO and trade them later. SIPs are not available, and exits occur through selling on exchanges or buybacks. With fixed tenures, managers are free from redemption worries, enabling them to pursue unique investment strategies for potentially higher returns.
How Do Closed Ended Funds Work?
Closed-ended funds start with a New Fund Offering (NFO) where investors can subscribe for a limited time. After the NFO closes, the fund trades on stock exchanges like a stock. The total number of units remains fixed, and the price fluctuates based on investor demand. While the Net Asset Value (NAV) reflects the fund’s underlying value, the actual market price can be higher or lower than the NAV. The NAV is typically disclosed weekly. Investors can buy or sell units on the exchange during the fund’s lifespan, which usually lasts 5-7 years. This structure offers flexibility while ensuring transparency about the fund’s value and investment horizon.
Understanding the Risks:
- Limited Trading and Market Swings: Unlike open-ended funds, closed-ended funds have fewer shares outstanding, making them less actively traded. This can expose investors to market ups and downs since selling might be trickier.
- Price Fluctuations and Redemption Limits:Â The price of closed-ended fund shares can vary from the fund’s actual value (NAV), and investors have limited options to redeem their shares directly from the fund. This means you could buy high or sell low.
- Managerial and Duration Risks:Â As with any investment, closed-ended funds are impacted by the manager’s skills. Poor investment decisions can affect returns. Additionally, for closed-ended funds that invest in bonds, there’s duration risk. This means that changes in interest rates can influence bond prices and the fund’s overall value.
Benefits of Closed Ended Funds
Closed Ended funds offers range of benefits:
- Higher Returns: Some closed-ended funds use a strategy to potentially increase returns, which can be appealing if you’re looking for higher income or capital gains.
- Access to Unique Investments: These funds can focus on specific areas of the market, like emerging markets or high-yield bonds, providing access to opportunities that might be difficult for individual investors to find on their own.
- Expert Management: Experienced fund managers actively manage these funds, which can be beneficial for investors who don’t have the time or knowledge to manage their own investments.
- Potentially Lower Costs: Some closed-ended funds may have lower fees compared to open-ended funds due to their fixed structure and less trading activity.
- Discount Opportunities: Shares may trade at a price lower than the fund’s actual value (NAV), offering a chance to buy undervalued assets. However, careful research is crucial to minimise risks.
Features of Closed Ended Funds
Here are the key features of closed ended funds, simplified for easy understanding:
- Fixed Number of Shares: Unlike open-ended funds that can create new shares, closed-ended funds issue a fixed number during their IPO and don’t create more afterward.
- Limited Selling Options: Unlike open-ended funds where you can sell your shares directly to the fund, closed-ended funds have limited ways to sell. These might include periodic buyback offers from the fund manager or selling your shares on the stock exchange.
- Trading on Exchanges: Shares trade on stock exchanges like regular stocks, allowing buying and selling during market hours. This activity influences the market price, which can differ from the fund’s actual value.
- Discounts and Premiums: Market prices may fluctuate and trade at a discount or a premium than the fund’s actual value due to various factors like supply and demand.
- Specialised Strategies: These funds may focus on specific market sectors or investment approaches, offering unique diversification and return potential that might not be readily available to individual investors.
Who all should invest?
Closed-ended funds require lump sum investments and offer limited redemption options until maturity, making them suitable for investors with aligned investment horizons and sufficient capital. Risks and returns depend on the fund’s asset allocation, as outlined in the offer document. Taxation varies based on the fund’s equity or debt allocation, affecting applicable tax rates. Despite being tradable on stock exchanges, these funds cater to investors seeking fixed tenure investments. While they lack SIP options and may not yield significant capital gains due to fixed tenures, they are suitable for investors comfortable with lump sum investments and long-term holdings.
Conclusion
closed-ended mutual funds offer unique investment opportunities with fixed tenure and limited redemption options, making them suitable for investors with aligned investment horizons and capital. Risks and returns depend on the fund’s asset allocation and taxation policies. Despite limited liquidity and potential price fluctuations, these funds provide access to specialized strategies and expert management, potentially offering higher returns and lower costs compared to open-ended funds. However, careful consideration of the fund’s structure, risks, and benefits is essential for making informed investment decisions.
Disclaimer: The views expressed here are of the author and do not reflect those of Dhanvantree. Mutual funds are subject to market risks, please read the scheme documents carefully before investing.