Here is why you should not invest in closed-ended mutual funds

Published: September 25, 2014 at 9:41 am

Last Updated on

It is raining closed-ended mutual fund NFOs. Here is why one should avoid this category of mutual funds.

There are many articles that describe the features of closed-ended mutual funds. Therefore, I will not mention them here. Let us focus on the titular suggestion alone.

1) The first and foremost rule of purchasing – be it a financial product or a bottle of shampoo. Never buy anything based on unsolicited recommendations.

There is usually a pretty good reason why a product is recommend to you without your asking for it and it has nothing to do with you!

Bank branch mangers/relationship managers or mutual fund distributor are eager to push closed-ended mutual funds because of high commissions! In a closed-ended mutual fund, the intermediary is paid the entire commission of the tenure upfront, unlike a SIP or lump sum investment in an open-ended mutual fund.

This is the reason for the aggressive selling.

Yes, yes, yes, not all distributors are like that and all that sort of thing.

Let us choose to believe that investors read the SID cover to cover and chose, of their own free will, to invest an insignificant AUM of 4,500 Crore in such funds. Naturally no one made any promises of high returns to these investors.

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2) What are you doing with a lump sum in the first place?
If you are considering a closed-ended fund, you have a lump sum free to be invested (who on Earth would invest a small amount in such funds?!).

Ask yourself where does this lump sum figure in your scheme of things? Has it been tagged to a financial goal?

A person who has budgeted efficiently, accounted for all present and future expenses (foreseen and unforeseen) will not have any lump sum lying around to invest each time an NFO pops up.

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3) Do you know how to expect when you are expecting?

Let us face it. Be it a sector fund or a fixed deposit, every investor has expectations. What are the expectations of a closed-ended mutual fund investor? Especially the ones who choose predominantly equity-based closed ended funds for 3 or 5 years.

Surely it is not a single digit return!

Just because redemptions are not allowed does not make a fund better. What matter is intelligent stock selection and the necessary time for the stocks to perform. There is no evidence that closed-ended funds have performed better than open-ended funds (you can check at VR online).

A skilled, experienced fund manager is certainly a plus for any active fund – closed or open. Unfortunately, that cannot guarantee returns. Equity as an asset class is too volatile for such short periods of time to  have any kind of return expectations.

It is time existing and prospective closed-ended fund investors learn about standard deviation and how compounding occurs in a volatile instrument. You could start here: Understanding the nature of the stock market returns.

A ‘veteran’ fee-based financial planner revered by his colleagues stated to a reporter that closed-ended funds are good because the money is locked-in therefore enabling many investors to spend time in the market. What utter bollocks!

If anyone says three years is long-term for equity investing, they are either trying to sell a product or are clueless about risk.

They call it advisory ‘business’ for a pretty good reason!

Launching equity-based closed-ended mutual funds is an opportunistic exercise by AMCs to lure investors clueless about equity investing. All things that look good on paper (acche din) do not turn out that way. At least not within a definite time frame.

Bottom Line: Closed-ended mutual funds are utterly unsuitable for goal-based financial planning. Stay away  …. unless you like clutter.

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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com

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10 Comments

  1. Respected Pattu Sir, as an IFA (You call it Distributor); here is my contrarian view on the topic..
    1) High commission which you are referring to is JUST 4% for the duration of 3 to 5 years in these close-ended NFOs which mathematically means Rs 20,000 on Rs 5 lakh mobilized in these NFO funds..Rs 20,000 for 3-5 years funds is like Rs 7,000 yearly for 3 year term or Rs 550 per month approximately..I fail to see the HIGH side of it 🙁
    2) More than 95% of my client + prospective clients are from RETAIL segment (Aam aadmi) and for them investing lumpsum means setting aside Rs 20,000 to Rs 25,000…With this being the case majorly in our country and because I am mathematically not as good as you – i cannot comprehend how many retail investors will be needed; which how much amount to garner AUM of Rs 4,500 crore as you have mentioned.
    3) I have many clients/investors who have got bonuses or salary hike; or profit from their business and so they have some lumpsum with them..And lumpsum should be there with everybody; otherwise ho will they meet some day to day requirement..
    4) Nobdoy is expecting miracles from NFOs..but neither did the intial investors expected anything from HDFC Top 200 fund or Reliance Growth Fund or ICICI Prudential Focussed Bluechip Equity fund..and they turn out to be Five-Star rated wealth accumulators..Who knows, these NFOs can do the same for the investors if he remain invested for longer duration ??

    There is a lot of scope of debate and argument on this topic and since I have no client meeting today, so thought of writing such long reply 😉

    1. Dhawal, it is cafemutual which points to high commissions in this regard. I cannot comment on the advice you give on case to case basis. on other aspects let us agree to disagree!

  2. Respected Pattu Sir, as an IFA (You call it Distributor); here is my contrarian view on the topic..
    1) High commission which you are referring to is JUST 4% for the duration of 3 to 5 years in these close-ended NFOs which mathematically means Rs 20,000 on Rs 5 lakh mobilized in these NFO funds..Rs 20,000 for 3-5 years funds is like Rs 7,000 yearly for 3 year term or Rs 550 per month approximately..I fail to see the HIGH side of it 🙁
    2) More than 95% of my client + prospective clients are from RETAIL segment (Aam aadmi) and for them investing lumpsum means setting aside Rs 20,000 to Rs 25,000…With this being the case majorly in our country and because I am mathematically not as good as you – i cannot comprehend how many retail investors will be needed; which how much amount to garner AUM of Rs 4,500 crore as you have mentioned.
    3) I have many clients/investors who have got bonuses or salary hike; or profit from their business and so they have some lumpsum with them..And lumpsum should be there with everybody; otherwise ho will they meet some day to day requirement..
    4) Nobdoy is expecting miracles from NFOs..but neither did the intial investors expected anything from HDFC Top 200 fund or Reliance Growth Fund or ICICI Prudential Focussed Bluechip Equity fund..and they turn out to be Five-Star rated wealth accumulators..Who knows, these NFOs can do the same for the investors if he remain invested for longer duration ??

    There is a lot of scope of debate and argument on this topic and since I have no client meeting today, so thought of writing such long reply 😉

    1. Dhawal, it is cafemutual which points to high commissions in this regard. I cannot comment on the advice you give on case to case basis. on other aspects let us agree to disagree!

Comments are closed.