Overview

Mutual funds are a popular way to invest money for the long term with a hands-off approach. Despite its prevalence, not many may be aware that there are three categories of mutual funds including open-ended, interval and closed-end funds. Closed-end funds may share the characteristics of mutual funds, exchange-traded funds (ETFs) and stocks, but they are a unique type of investment. In fact, fundamentally, closed-end funds are not an asset class but an investment structure.

Open-end funds are more widely prevalent than closed-end funds since there are lesser restrictions on their trading. Closed-end funds differ from open-end funds in that they are issued only once and the issuer never buys back the units.

What are closed-ended funds?

A closed-end mutual fund, “closed-end fund” or “closed-end investment” is a debt or equity fund comprising of a pool of assets that are issued in a predetermined number of units during its launch. This offer is called a new fund offer (NFO) and investors cannot buy or sell units once it is closed.

The funds are traded like stocks. They have a fixed period of maturity, and can be redeemed only after this is achieved. The fund’s Net Asset Value (NAV) dictates its price, but it can be bought and sold as per the demand and supply of the fund units.

A closed-end fund sports the features of mutual funds, exchange-traded funds (ETFs) as well as stocks, but is, in essence, unique. Its portfolio is managed by a professional who decides where to buy or sell holding assets, much like a mutual fund. Like ETFs, it trades as equity does – with the price fluctuations throughout the day. Finally, much like stocks, such funds can only be traded on secondary markets by investors after FPO. It differs in that the parent company does not issue any additional units after the initial issue and never buys back those units.

Ideally, closed-end funds should offer better returns than open-end mutual funds since the cash reserve raised after the initial issue remains the same. The company does not buy back units from the investors either, and investors can trade the units among themselves. Managers can liberally use leverage against the fund accumulated to increase the returns as well.

How closed-end funds are priced

While the NAV of the closed-end fund is calculated regularly, in effect, its price depends on the demand and supply of its units. This means that closed-end funds can trade at premiums as well as at discounts. Suppose the fund is managed by a manager with a history of successfully picking stocks, chances are that it will trade at a higher price than NAV, that is, at a premium. On the other hand, a risk and return profile that does not appeal to the investor can lead to a discounted price.

Benefits

Closed-end funds are not illiquid

While on the surface closed-end funds may seem to be highly illiquid, they are, in effect, not. It may seem that once you purchase a unit of a closed-end fund, you will be stuck with it, but stock exchanges actually offer many opportunities to buy or sell the units at existing market prices. Investment in illiquid securities like emerging-market stocks is high-risk. However, with a closed-end fund, this risk can be taken more freely. In fact, the higher risk that accompanies investment in illiquid securities can also result in potentially higher returns for shareholders.

More freedom and stability for fund managers

Since closed-end mutual funds cannot be redeemed before the date of maturity, fund managers have ample freedom to make decisions about the asset base. Managers can strategically achieve their investment goals. Managers of closed-end funds are free from the risk of reinvestment from the daily share issuance. They are not required to hold excess cash in order to meet calls for redemption of fund units. The absence of the need for raising quick capital to service unexpected redemption requests makes the capital base more stable.

Market price is based on demand and supply

Closed-end funds trade on stock exchanges based on the demand and supply of their units, just like equity shares. If demand rises and supply is low, the closed-end funds can be sold at a price that was higher than the NAV.

Drawbacks

You can invest only in a lump sum

The risk quotient increases for those looking to buy a closed-end fund because their units can be paid for only in a lump sum. This is because the opportunity to make the payment only presents itself once – during the initial launch. This can be a deterrent to investors who prefer the systematic investment plan (SIP) approach instead.

Fund managers wield full control

While with open-end schemes and mutual funds there is an option to assess the investment over different market cycles, such data is not available for closed-end funds. The decisions made for the fund and its performance are largely dependent on the fund manager.

Poor track record

An analysis of the performance of closed-traded funds in the past reveals that it does not offer better returns compared to open-end schemes.

Conclusion

Investors should analyse the risk of every individual closed-end scheme instead of making sweeping judgments about the investment tool as a whole. Those who possess the large amount of funds required for the one-time investment in closed-end funds should go for such an investment. Finally, investors should calculate if the maturity period of these funds is in line with their expectations and long-term plans.