Capitalmind
Capitalmind
Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial
Stocks

Closed Ended Mutual Funds: Why You Shouldn't Bother

Many fund houses have come up with “closed ended funds” which have been the rage with distributors lately, largely (almost entirely) because of the much higher commission structure. Should you buy into the madness?

If it’s the rage with distributors because of commissions, the answer should be a BIG NO.

Let’s see why. Firstly, what the heck are closed ended funds?

Here’s a video we did a long time back:

(Ignore the points about capital gains after one year, now it’s three years for debt funds. )

The concept is:

  • You buy now
  • You can’t sell until the “term” of the fund is over
  • You can’t buy any more either, because closed ended actually means closed right after the beginning.
  • At the end of the term you’ll get your money (if it’s grown, with a profit, else with a loss)

Why do distributors like it?

Because they get more commissions. Remember that mutual funds pay commissions to distributors and adjust it as part of their management fee, which can be a max of 2.5% of total assets.

Typically this meant about 1% “entry time” commissions, and then 0.5% a year of trailing commissions.

If you know a customer can’t exit for three years, then you can pay the distributor 6% upfront and no trailing fees, and recover that amount over the next three years. You’ll net make just 1.5% but that’s better than not making anything at all.

So the distributor, who loves the concept of a 6% commission, will go at you hammer and tongs to buy this fund.

Why Should You Not Like It?

The incentives are all screwed up. (for you as an investor)

The distributor gets 6% upfront – he has no reason to get you into a good fund and nothing to answer for if the fund does badly. You can’t get out, and he’ll just tell you to wait till exit at which point he’ll say how could I have known, etc.

A mutual fund has no incentive to perform if you are locked in, because you can’t get out easily. In fact they can’t even attract more people (since you can’t buy into the fund after the NFO) so there’s no point really.

Having said that, fund managers do want to attract people to subsequently issued funds, so you might see one positive incentive there. Even if you are locked in, you might find they want to perform well. (More on this later)

Plus, they have already paid 6% from their pocket (remember, they are yet to charge you). They just have you as a customer, and probably aren’t earning too much (if they pay out 6% out of a 7.5% three year potential payout, they are earning very little). No earning = no incentive; remember, in this example, your distributor has earned 4x what the fund manager has, and the fund manager has to do all the work!

Finally, remember that the distribution costs will ensure that the fund always charges the maximum possible fees. Yes the fees are capped at 2.5% today but managers could charge lower fees, if they wanted. A high distribution cost, though, ensures that will not happen.

Is There A Reason To Like These Funds?

I honestly don’t think so. Such funds are designed to protect you from yourself. So that you don’t redeem early. And largely to give more commissions.

But there could be a reason to like another kind of fund that’s locked in: Tax Saving Funds.

Tax saving funds are also locked in for three years, and many offer ludicrously high commissions as well.

However, these funds are open ended – you can get in any time you like.

The performance, in recent years, has been interesting. For instance, Reliance’s Tax Saver Fund has given a 39% annualized return over three years, while the best Reliance mid/large cap fund is the Reliance Top 200, which is a 30% return. Many of the others have matched or beaten their large cap equity peers (from the same fund house)

See Value Research for

If you can’t trust yourself to not yank off your money, the tax saving funds may be a better bet?

And you should avoid commissions by investing in the “DIRECT” Option. But this means not trading through your bank or a distributor (even from online sites).

(However, if you were the kind who would invest direct, you probably will never invest in such funds in the first place. )

What If I have already invested?

You can do nothing. Sit tight and wait till the fund runs its course.

If you feel you have been mis-sold the fund, contact the fund house and request a refund. But please understand that the fund house is within its rights to refuse.

divider

Subscribe to Capital Mind:

To subscribe to new posts by email, once a day, delivered to your Inbox:

[wysija_form id=”1″]

 

Also, do check out Capital Mind Premium, where we provide high
quality analysis on macro, fixed income and stocks. Also see our
portfolio which has given stellar returns in our year, trade by trade
as we progress. Take a 30-day trial:

[wysija_form id=”2″]

  • rahul says:

    Disclaimer: I am from the distributor fraternity but my school of thought is Better advice, low commission but life long clientele.
    Sir, I am one of your followers. I believe that Mutual funds are a relatively good product for retail equity investors offering expert management, ease of transaction and a low cost model. However, the low commission model has been hindering the growth of this product unlike Insurance policies/ Fixed deposits etc.
    In closed ended funds, the industry has found its fortune to gain “Attention of Distributors and Trust of Investors”. This will allow investors to see the real benefits of LONG TERM investing and bound to ignore VOLATILITY.
    If mutual funds are to grow in India over long term – this is the time the Industry should be allowed to prosper. After all, there is more than enough the regulators and bankers are doing to keep a check on the MF industry.

    • Rahul, I think it’s not a good thing. Time will of course have to be the decider of who is better, closed or open ended. But the concept of paying big commissions upfront is going to hurt in the longer term. It is far better for an investor to choose a mutual fund that allows you to exit, IMHO, and also the DIRECT option.
      Like I said, if you want a lock in, at least choose a performance based fund like an ELSS fund…

  • Billu says:

    As a guy who have seen far too many people wasting their money because they were too fickle and impatient (and blaming the stock market for it) …………. I’d say something is better than nothing.
    At the end of it they’ll have some money invested (and possibly generating returns) rather than pulling it all out at the wrong time.

  • Rajiv Ahuja says:

    Like always I have found your article to be quite informative & useful. It is bang on the dot.

  • Obu says:

    Deepak,
    I have two questions
    1. There are capital protection plans which are closed ended with lock in of 3yrs or higher. What is your view on this. They invest part in debt to protect capital and invest remaining in equity. In my experience, the old guys are hell bent on “capital protection” which is rightly so. But when I offer this formula of investing in one debt funds to make up principal and invest remaining in equity fund, there are not any takers and seem to prefer Capital protection plans.
    2.The obcession with Direct funds and a “hitting in the stomach” attitude towards distributors. Many people believe Banks and websites like fundsindia.com provide free advise and there are not charged. While they earn free commission with very less work because of the scale. The system is rigged towards insitutional guys, while the retail distributors spend a lot of time educating people about mutual funds and bringing them into Industry. Already many people are out of business. In terms of value addition, retail distributors do a lot of work and help the mutual fund industry. The upfront commission model is not being practised for retail distributors as much as posts here and elsewhere suggests. Often they are given to Insitutional distributors or powerful ones who can bring money. Its easier to sell soaps and make a living than selling mutual funds on a retail level. The attitude is not the same towards other products, FMCG, electronics etc. No one blames retailers that they are not selling at their cost price/ at producer price. And I’ve seen people who get free advice from retail disributors and finally go and do direct investment. In my opinion, if someone offers me good advice which is personalised for me, educates me, do all the admin work, its better to give him that 0.5% commission than try to save it. Infact Direct funds must be scrapped so that good retail distributors remain the industry.
    Understand I sound like a victim lampooning the system, but everyone lobbies so that things are in their favour. I am pitching for better incentives to people who are adding more value to the industry and to investor

    • 1. It’s the same thing whether you try to protect or they do. But they have brand value, so they get a better deal in that respect. But you can sell such plans on a do it yourself basis.
      2. Direct funds have their place. If people will take your advice and go direct, don’t give them advice for free. I have been a retail distributor and I know that even now upfront commissions are being offered to retail distributors, and not only institutions. Direct plans are meant for investors who do their own research, or for corporates buying things like liquid funds or debt funds without the need to pay commissions. I prefer direct plans – in fact I get a 0.2% to 0.5% greater return even in my short term debt funds because I choose the direct plan! And I don’t need any advice from distributors.
      People are making serious money in commissions as you can see with the commission disclosure statements each year. So it’s not like this business is dying, it’s just not as easy as it used to be that’s all. If you offer good advice charge for it.