When exploring investment opportunities in the Indian financial market, mutual funds often come to the forefront. Among the various mutual fund categories, closed-ended funds hold a unique position. These funds can be an excellent choice for disciplined investors looking for structured investments, yet they remain underexplored compared to their open-ended counterparts.
This guide aims to demystify closed-ended funds, highlighting their features, advantages, and drawbacks, with examples specific to the Indian market.
What Are Closed-Ended Funds?
A closed-ended fund is a type of mutual fund where the fund house raises a fixed corpus during its New Fund Offer (NFO) period. Investors can subscribe to the fund only during this initial phase. Once the subscription period ends, no new units are issued, and the fund is listed on a stock exchange to facilitate trading among investors.
Unlike open-ended funds, where you can buy or redeem units at any time, closed-ended funds have a fixed tenure, usually ranging from 3 to 7 years. At the end of this tenure, the fund is either liquidated or converted into an open-ended scheme.
How Do Closed-Ended Funds Work?
Let’s break down how closed-ended funds function with a relatable example:
- Launch Phase Imagine a fund house in India, say HDFC Mutual Fund, launches a closed-ended equity scheme called “HDFC Growth Opportunities Fund.” During the NFO, the fund collects ₹1,000 crores from investors.
- Fixed Corpus After the NFO closes, the fund corpus is locked at ₹1,000 crores. No additional investments are allowed. Investors who missed the NFO must purchase units on the stock exchange, just like buying shares.
- Trading on Stock Exchanges Units of the fund are listed on the NSE or BSE, allowing investors to trade them. However, the price of these units is determined by market demand and supply, not the Net Asset Value (NAV).
- Fixed Maturity If the fund has a 5-year tenure, it will be liquidated at the end of 5 years. Investors receive their returns based on the fund’s NAV at maturity.
Key Features of Closed-Ended Funds
- Limited Subscription Period Investors can only subscribe to the fund during the NFO phase, ensuring a fixed corpus.
- Listing on Stock Exchanges These funds are listed on exchanges, offering liquidity to investors who wish to exit before maturity.
- Lock-In Period A fixed maturity period discourages impulsive exits and promotes long-term investment.
- Managed NAV Unlike open-ended funds, the NAV of closed-ended funds is not directly accessible during trading. Prices are influenced by demand and supply in the market.
Advantages/Disadvantage of Closed-Ended Funds
Advantages of Closed-Ended Funds
- Structured Investments The fixed tenure allows fund managers to take long-term investment decisions without worrying about sudden redemptions, often seen in open-ended funds.
- Discipline for Investors The lock-in period prevents frequent buying and selling, fostering a disciplined approach to investing.
- Access to Illiquid Assets Fund managers often invest in long-term or illiquid assets such as infrastructure projects, which may yield better returns over time.
- Potential for Higher Returns With a defined investment horizon, fund managers can implement focused strategies, potentially leading to higher returns.
Drawbacks of Closed-Ended Funds
- Limited Liquidity Trading units on the exchange depends on market conditions, which may lead to buying or selling at a discount or premium to the NAV.
- No Additional Investment Unlike SIPs (Systematic Investment Plans) in open-ended funds, investors cannot add to their investments post the NFO.
- Market Risks If the units trade at a discount on the exchange, investors might face losses even if the NAV has increased.
Types of Closed-Ended Funds
- Equity-Oriented Funds These funds primarily invest in equity and equity-related instruments, aiming for high returns over the long term.
- Debt-Oriented Funds These funds focus on fixed-income securities like bonds and government securities, suitable for conservative investors.
- Balanced Funds A mix of equity and debt instruments, balanced funds aim to provide moderate growth with reduced risk.
- Interval Funds A hybrid of closed-ended and open-ended funds, interval funds allow redemption or subscription only during specific periods.
How Are Returns in Closed-Ended Funds Calculated?
Returns in closed-ended funds are calculated based on the NAV at the end of the investment tenure.
For example:
- Suppose you invest ₹10,000 in the NFO at ₹10 per unit. You receive 1,000 units.
- At maturity, the NAV rises to ₹20.
- Your total investment value = 1,000 units × ₹20 NAV = ₹20,000.
- Profit = ₹20,000 – ₹10,000 = ₹10,000 (100% return over the tenure).
However, if you sell the units on the exchange before maturity, your returns depend on the trading price, which could be higher or lower than the NAV.
How Are Closed-Ended Funds Priced?
The trading price of closed-ended fund units on stock exchanges is determined by:
- NAV of the Fund: Indicates the intrinsic value of the units.
- Demand and Supply: A higher demand may lead to a premium, while low demand may cause a discount to NAV.
For instance:
If the NAV of “HDFC Growth Opportunities Fund” is ₹100 but high demand pushes the trading price to ₹110, the fund is trading at a 10% premium. Conversely, if the price falls to ₹90, it trades at a 10% discount.
Closed-Ended Funds vs. Open-Ended Funds
| Feature | Closed-Ended Funds | Open-Ended Funds |
| Subscription Period | Limited to NFO | Open throughout |
| Liquidity | Limited (Stock Exchange) | High (Buy/Sell Anytime) |
| Fund Corpus | Fixed | Variable |
| Investment Discipline | High (Due to Lock-In) | Moderate |
Closed-Ended Funds vs. ETFs
| Feature | Closed-Ended Funds | Exchange-Traded Funds (ETFs) |
| Fund Management | Actively Managed | Mostly Passive |
| Trading Price | May Trade at Premium/Discount | Tracks Underlying Index |
| Expense Ratio | Higher | Lower |
| Liquidity | Limited | High |
Are Closed-Ended Funds Right for You?
Closed-ended funds can be a great fit for investors who:
- Have a long-term financial goal.
- Prefer a disciplined investment approach.
- Are willing to explore high-risk, high-reward opportunities.
However, if you prioritize liquidity and frequent portfolio adjustments, open-ended funds or ETFs may be better suited for you.
Key Takeaways
- Closed-ended funds provide a structured and disciplined investment avenue.
- They are ideal for long-term goals but require patience and a clear understanding of market risks.
- Before investing, evaluate the fund’s strategy, track record, and expense ratio.
Closed-ended funds, though not as popular as open-ended funds in India, hold the potential to deliver substantial returns for informed investors. As always, consult with a financial advisor to ensure alignment with your financial goals.