Closed-ended MF schemes are too risky
Mutual funds say they exist so investors are forced to be disciplined, but they are much riskier than open-ended schemes. For experienced investors only.
Many poor schemes benefit from being part of the mutual fund industry. The media is prone to hyping mutual funds. They may suggest one over the other, but the key takeaway for most readers is that mutual funds are better than other investments, even if they are volatile. This is a dangerous belief, not counting the risks that stock market volatility and interest rate changes pose. Take closed-ended equity schemes as an example. These schemes have a fixed maturity, which means redemptions aren’t allowed until the end. Mutual funds and their distributors claim that these schemes solve a lot of problems. Investors, who should keep their money in equity schemes for the long-term, can’t take their money out the moment the stock market tanks. The inability to withdraw from the scheme also presents fund managers with a few advantages.
A number of closed-ended equity schemes have recently been – or are soon to be – launched. You can only buy them at the very beginning, during the new fund offer. Once this period is over, no redemptions can be made until it matures (usually five years) and no further investment can be made. When the scheme matures, your money does, too. Now, why is this risky?
Time the market: First, you can’t invest via the SIP route, which means that you have to time the market. If much of the value of your investment is wiped away in the first few months, it’s going to be difficult for it to recover. The SIP route, which allows you to invest small amounts every month, significantly lowers this risk. But it is only available with open-ended schemes.
Severely restricted: Then there’s also the problem of redeeming your investment. The mutual funds say that the closed-ended nature of the scheme is a good thing, as you can’t redeem your investment. But what if the scheme really is doing poorly? You can’t exit. If you need the money at all during those five years, you’re going to regret it.
No choice: The money is automatically redeemed on maturity. The returns will obviously be shaped by the market at that time. You won’t have a choice. Some closed-ended mutual funds do have the option of becoming open-ended schemes after a certain period. However, you don’t know if they will take this option.
Higher commissions: Distributors, by the way, also receive higher commissions when they sell you one of these. You don’t pay a higher commission; the AMC simply has a lower first-year margin (they’ve got you locked in, don’t they?). It’s good that the higher commission doesn’t get paid out of your pocket, but chew on the fact that the person recommending the scheme to you stands to earn more money than if he were to recommend another scheme.
How to judge? Just because a mutual fund is a risky proposition doesn’t mean you should stay away. If you know what you’re doing, there’s no problem with such schemes. But do you understand them? Even open-ended schemes are hard to judge. With closed-ended schemes, there’s no track record, no strategy to analyse before you invest. All you can go by is the fund manager.