Money Saver India
Case Closed: Closed-ended funds are costly and risky

Case Closed: Closed-ended funds are costly and risky

Agents claim closed-ended mutual funds save investors from themselves, but the upfront commissions they earn on them are three times the usual amount.

Closed-ended mutual funds are the flavour of the season, with several fund houses launching multiple such schemes over the past six months. Sundaram Mutual Fund, for example, has alone launched a whopping 15 of them. The reason, mutual funds and their agents claim, is that it compels investors to stay invested for at least the medium term regardless of market turns, because of the fixed three-year investment period. While it is true that markets are less volatile over longer periods, such concern for your financial well-being from large fund houses should be viewed with suspicion.

Bad Timing
Not too long ago, mutual funds claimed that it was not worth attempting to time the market. Therefore, they encouraged Systematic Investment Plans (SIPs), wherein you invest fixed amounts every month. This is sound advice. So why is it that the same mutual funds are now encouraging investment in closed-ended mutual funds, which require you to do exactly the opposite of what SIPs enable?

Closed-ended mutual funds have a defined life, usually of three years. Therefore, money is invested on a certain date and sold off completely at another date. Therefore, in the entirely possible case of a dip in the stock market toward the end of the three years, you could end up losing significantly. Moreover, the fund is ‘closed’ right after its launch, so you can only buy-in at the very beginning (that is, lump sum investment only).

What you’re effectively doing is making a lump sum investment on the stock market, just as you would make a term deposit with the bank. To give you an idea of why this is very risky, have a look at how volatile the SENSEX has been over the past three years.

Difficult to evaluate
There’s no way to evaluate a closed-ended mutual fund. Reading its prospectus would give you an idea of its investment plan and you’d know the fund manager in charge. But all other parameters relating to open-ended schemes with a sizeable history are unavailable. This alone is reason enough not to make the investment, particularly a lump sum investment.

Why the push?
Fund houses are pushing these schemes because distributors are willing to push them aggressively. Of course, it’s because they stand to earn higher commissions. This is so because mutual funds charge around 2.5% a year as asset management fees. A certain percentage of this is given to the distributor each year. With open-ended funds, it is usually up to 1% on investment and up to 0.5% in subsequent years (if the investor keeps his money in the fund).

Closed-ended funds follow a different incentive structure. As the money is certain to stay with the fund house for three years, it is assured of earning up to 7.5%. So mutual funds end up paying 4.5% to 6% as upfront commission to distributors. This is what is driving so many distributors to push the angle that the scheme saves investors from themselves. It’s what agents selling unit-linked insurance plans have been claiming for years.

This incentive structure has brought about the strong return of closed-ended funds, which only a few years ago seemed to be on their way out.
Of course, there are direct plans, which would be cheaper. But the fact that you need to time the market with these schemes should be enough to turn you away from them.

ELSS – a better option
If you’ve fallen for the logic that a closed-ended scheme saves you from yourself, it may be a good idea to read up on equity-linked saving schemes. These tax-saving schemes (only up to Rs1.5 lakh a year) also come with a three-year lock-in, thereby protecting you from yourself. You can also pick a scheme based on its track record. Several of them have been running for well over a decade. Finally, as commissions are paid out annually, the scheme isn’t as front-loaded as would be the case with a closed-ended mutual fund whose commission is a one-time upfront payment.

Here’s a list of long-running equity-linked saving schemes and their three-year returns:

Scheme Launch Expense Ratio 3-year CAGR
Axis Long-term Equity Fund December 2009 2.55 37.45
Birla Sun Life Tax Plan February 1999 3.08 31.26
BNP Paribas Long-term Equity Fund January 2006 2.89 30.74
Reliance Tax Saver Fund September 2005 2.34 37.13
Tata Tax Saving Fund March 1996 2.82 26.32

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