Why not to invest in close ended products?

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Of late there have been queries from some of our clients regarding investment in some newly launched close ended mutual funds products. We squarely advised them not to invest money in these products. We thought of educating investors regarding close ended products, why they are launched and why they are recommended by many salespersons and mutual fund distributors.

Close Ended Equity Schemes are those which are open for investments only for a limited period. Post that period, the scheme doesn’t allow any new purchase or redemption for a pre-defined period of time. The lock-in period can range from 3 years to 7 years. We have never recommended close ended funds in the past and would never recommend going forward for the following reasons:

  1. No Track Record: Close ended schemes come as an NFO (New Fund Offer) and hence there is no past track record of performance which is one of the many key criteria for making investment decision. We would prefer to invest in a scheme where there is a performance track record to understand fund management style.
  1. Complex Structure: Some close ended schemes with complex structure of equity and derivatives play. This becomes difficult to understand and many a times their returns post tax do not exceed index returns. Plain vanilla diversified equity mutual funds with right asset allocation would always be better than options for investments.
  1. Can’t Redeem at Expensive Valuations:Due to lock-in structure, even if markets are over-heated and are poised to slump significantly, we lose our liberty to switch or withdraw from close ended products. This is most difficult situation to be in where despite seeing market melting; we can’t do anything about our investments. An open-ended fund will not have this constraint.

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  1. Can’t Switch to another fund:Even if the fund performance is below average than its peers, we cannot shift to a better fund due to close ended structure. Again, in case of open ended funds, we can always shift our investments from under-performing schemes.

 

The only rationale many sales people paddle for close ended products is that a fund manager can take a long term view. However, there are no verifiable records of such claims fetching higher returns. Many good open-ended mutual funds also take a long term view for stock selection which can be easily seen from their portfolio turnover ratio of only 20%.

Now, why these close-ended funds are pushed despite these flaws and constraints which are against investor’s interest? Simply because the close ended products earns the distributor higher and continued commissions for the locked-in period. And for a fund house, it helps them in gathering assets and they have got money committed for locked-in period to earn fees.

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We hope, through this article we were able to explain why investing in close ended products is not a good idea. We would be happy to receive your feedback in the comment section below.

Please Note: This is a financial education initiative by Truemind Capital Services to promote investment literacy among the masses. Truemind Capital Services is a SEBI registered investment adviser and operates www.truemindcapital.com for investments in mutual funds. You agree to accept and abide by terms & conditions if you take any decision based on the content in the above article.

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