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Personal Finance

Closed ended funds: Why they are popular suddenly, and why they are not really closed ended.

A lot of new fund offers are appearing as “Closed Ended” because of a notification that SEBI has introduced, saying that open ended equity funds must not charge “initial expenses” over the first five years, but offset them with entry loads. (Read “Mutual Funds NFOs have hidden costs“)

NFO expenses
What does this initial charge mean? You see all these ads on TV and on billboards asking you to buy NFOs – these are all paid for by what is called “initial marketing expenses”. Earlier upto 6% of the funds collected could be allocated to such expenses, but then fund asset management companies (AMCs) started appearing with hundreds of new issues, just to get distributors more commissions. (which are much higher than the 2.25% they get on their existing funds)

SEBI has therefore acted like a good regulator and disallowed open ended funds from charging NFO marketing charges beyond the entry load. But if AMCs do this, and charge 6% entry load, no one will buy! If they decide to take it up as their own expense, they lose money. So what to do?

The best way out, for AMCs, was to use closed ended funds instead. Closed ended funds, going by the name, are funds that, once subscribed, are closed for fresh investments and for exits. (These kind of funds are special to India perhaps – all U.S. funds are open ended) So it’s a “closed” fund. SEBI decreed that such funds could charge initial charges and amortise them over the period of the fund, meaning that you as the investor pay for those ads over the three-year period of a three year closed ended fund.

The cost of an early exit
The phrase Closed Ended is misleading. What if you invest a huge amount of money and want it back desperately? Most closed ended funds allow you to exit prematurely, somtimes at fixed days of the year like first five days of a calendar quarter etc., but that exit usually comes with an exit load.

Also, SEBI has said that apart from the exit load, if you exit early, you should pay the remaining amortised charges on the fund. Let me demonstrate with an example.

Let’s say you put in Rs. 100,000 in a 3 year closed ended NFO, which collects Rs. 100 crores. They charge 6% = 6 crores as marketing expenses. You have therefore got 0.01% of the fund and therefore your share of the marketing expense is Rs. 6,000. This is amortized for three years, meaning 2,000 per year. This is adjusted, daily, in the NAV so you don’t have to physically pay anyone, it is automatically reflected in the “repurchase price”.

After one year, you decide to sell. Now let’s say they are very nice and charge you zero load on exit. Because you were in there for a year, you have paid Rs. 2,000 of the amortised charges. But Rs. 4,000 is remaining! So when you sell, they will remove Rs. 4,000 and give you the rest back. That 4,000 is 4% of your investment! So if the fund had gone up 10%, it has now resulted in only 6% gain for you. (Note that you can get that if you put the money in a bank deposit)

Not really closed ended
So you can exit early if you want, just that you pay a charge. Which means these funds are not really closed ended. What they are really, are Closed Entry. After the NFO, for the closed period, no fresh investments are allowed in the fund.

Is “closed entry” bad for me?
What does this mean for you? Every time the market tanks or drops a lot, investors will try to take out their money, no matter what the exit load. In open ended funds that is usually balanced by some people trying to BUY the fund, because they feel it will go back up. This means that some redemptions can be met with the money coming in, so the fund manager need not sell the investments.

But in closed ended funds there is no fresh entry, so the fund manager has to sell. And therefore, when the markets recover, these funds underperform because they were not able to buy or hold when the market was low!

You will see this happening with all these funds, unfortunately, and I will show you the results after a year from today. I know there will be at least one correction before then (it has to happen) and that will put pressure on these funds.

Wait and Watch
I do not recommend these NFOs at all. But I think you may be able to get a good deal when they finish their closed ended period and become open ended instead. Let’s see.

  • Anonymous says:

    >Hi, I like not only the article but also this blog. Excellent work Keep it up. Will mail you when I get time. Thanks a lot for these brilliant inputs.

  • Anonymous says:

    >Hi Deepak,

    I found this stmt in SBI Infrastruture – 3 year closed end fund scheme details.

    “NFO open from 11th May 2007 to 8th June 2007.Scheme reopens for continuous repurchase from 6th July 2007”

    What does the 2nd stmt mean when you say that fresh investments are not allowed beyond NFO in closed end funds ???

  • Deepak Shenoy says:

    >Anonymous: this means the fund will repurchase its units on a continuous basis. That means you can sell back to the fund.

    But you still can’t buy any more units post NFO.