Investing in mutual funds is a popular way for individuals to grow their wealth over time, but not all mutual funds are created equal. Among the different types of mutual funds, closed-ended funds often confuse new investors due to their unique structure.
In this detailed guide, we will break down what closed-ended funds are, how they work, their features, and how they differ from other types of funds like open-ended funds.
By the end, you will have a thorough understanding of closed-ended funds and whether they are a good fit for your investment strategy.
What Are Closed-Ended Funds?
A closed-ended fund is a type of investment fund that raises capital through an initial public offering (IPO) of a fixed number of shares, which are then traded on a stock exchange. Unlike open-ended funds, which issue and redeem shares on demand, closed-ended funds do not issue new shares after the IPO and do not redeem shares.
Instead, shares are bought and sold between investors on the stock exchange at market prices.
The capital collected by the fund is used to invest in a portfolio of assets such as stocks, bonds, real estate, or other securities, depending on the fund’s investment objective. Once the fund is launched, it can continue to operate with a fixed pool of shares until the fund is wound up at its maturity date (if applicable).
How Do Closed-Ended Funds Work?
Understanding the mechanics of closed-ended funds is key to deciding if they’re a good investment for you.
Here’s a step-by-step breakdown of how they work:
1. Fund Launch – The Initial Offering (NFO)
When a closed-ended fund is created, it holds an initial public offering (IPO), also known as a New Fund Offer (NFO).
During the NFO, investors can buy units (shares) of the fund at a set price. This is the only time the fund issues new units, and it raises a fixed amount of capital. After the New Fund Offer (NFO) ends, no new shares are issued.
For example, if a closed-ended fund is looking to raise ₹100 crore and offers 10 crore units, then each unit would be priced at ₹10 during the NFO. Once the NFO closes, investors can no longer buy units from the fund itself.
2. Trading on the Stock Market
After the New Fund Offer (NFO) period, the units of the fund are listed on a stock exchange (such as the NSE or BSE in India), and investors can buy or sell units from other investors through the exchange. This is similar to how stocks are bought and sold.
Unlike open-ended funds, the price at which a closed-ended fund unit trades on the stock market can differ from its Net Asset Value (NAV), which is the actual value of the assets held by the fund divided by the number of shares outstanding.
The market price of a closed-ended fund is determined by the supply and demand in the market, and it may trade at a premium (above the NAV) or a discount (below the NAV).
3. Fixed Number of Units
Once the closed-ended fund is launched, the number of units remains fixed.
Investors can only buy or sell units through the market and cannot create new units or redeem existing ones directly from the fund.
This fixed nature of closed-ended funds can lead to greater volatility, especially if the demand for units is high or low.
4. Fund Management and Investment Strategy
The fund manager uses the capital raised from the IPO to create a diversified portfolio of investments. This can include a variety of asset classes, such as stocks (equity funds), bonds (debt funds), or a combination of these (hybrid funds).
The goal of the fund manager is to generate returns for the investors by selecting investments that align with the fund’s strategy.
Importantly, because the fund is closed, the fund manager does not have to worry about the constant inflow and outflow of capital that open-ended funds face. This gives the manager more flexibility to invest with a long-term perspective, without the pressure of daily redemptions or subscriptions.
5. Fund Maturity and Liquidation
Most closed-ended funds have a fixed maturity period, which can range from 3 to 10 years. Once the fund reaches its maturity, the assets are liquidated (sold), and the proceeds are distributed to the investors. The amount you receive will depend on the performance of the fund’s investments and the final NAV at the time of liquidation.
Some closed-ended funds may also offer a rolling closure or have an option for partial liquidation over time, depending on the fund’s terms.
Types of Closed-Ended Funds
Closed-ended funds can be classified based on their investment strategy and the type of assets they invest in. The two primary types of closed-ended funds are:
1. Equity Closed-Ended Funds
These funds primarily invest in stocks. The goal is to provide capital appreciation (growth) by investing in a diversified portfolio of equities. They are suited for investors who are looking for higher potential returns but are willing to accept the volatility and risk associated with the stock market.
2. Debt Closed-Ended Funds
Debt closed-ended funds invest in fixed-income securities such as bonds, government securities, or corporate debt. These funds typically aim to provide regular income and capital preservation. They are less volatile than equity funds but may offer lower returns, especially in a low-interest-rate environment.
3. Hybrid Closed-Ended Funds
Hybrid funds invest in a mix of equities, bonds, and other asset classes. The goal is to provide a balance between capital appreciation and income generation, making them suitable for investors who want a diversified portfolio with a moderate risk profile.
4. Sector-Specific or Thematic Closed-Ended Funds
These funds focus on specific sectors or themes, such as technology, healthcare, real estate, or energy. They are typically more concentrated in their investments and may carry higher risk but can offer strong growth potential if the sector performs well.
Key Features of Closed-Ended Funds
1. Limited Number of Units
Once the closed-ended fund is launched, the number of shares remains fixed, and no new units are issued.
This provides stability to the fund’s capital base but limits the ability of investors to add more funds unless they buy units from the secondary market.
2. Market Price vs. NAV
The market price of a closed-ended fund can be higher (premium) or lower (discount) than the fund’s Net Asset Value (NAV).
The NAV is the actual value of the fund’s portfolio, calculated by dividing the total assets by the number of outstanding units. The market price fluctuates based on investor demand, market conditions, and investor sentiment.
3. Leverage
Many closed-ended funds use leverage to increase their investment exposure. This means they borrow money to invest more than the fund’s assets. Leverage can amplify returns, but it also increases risk, especially in volatile markets.
4. Regular Distributions
Closed-ended funds often distribute income to investors in the form of dividends or interest, especially if they invest in income-generating assets like bonds or dividend-paying stocks. These distributions can be monthly, quarterly, or annual, depending on the fund.
5. Liquidity via the Stock Exchange
Though you can’t redeem units directly from the fund, you can sell them on the stock exchange, providing some liquidity. However, the ease of selling depends on the demand for the fund’s units in the market. If demand is low, you may face difficulty selling your units at a fair price.
6. Fixed Term
Most closed-ended funds have a set term (usually 3 to 10 years). At the end of the term, the fund is liquidated, and investors receive their share based on the final NAV. Some funds may offer an option for extension or rollover if they perform well.
Advantages of Investing in Closed-Ended Funds
1. Less Pressure from Investor Flows
Closed-ended funds are not affected by daily inflows or outflows of capital, unlike open-ended funds.
This allows fund managers to focus on long-term investment strategies without needing to keep a large amount of cash on hand to handle redemptions.
2. Potential for Market Appreciation
If the market price of the fund’s units rises above the NAV, investors can benefit from capital appreciation. However, this also exposes them to the risk that the market price may fall below the NAV.
3. Steady Income Streams
Closed-ended funds that invest in bonds or dividend-paying stocks can provide a steady stream of income through regular distributions. This is attractive to income-focused investors, such as retirees.
4. Diversification
Closed-ended funds offer diversification across asset classes, sectors, and geographies, reducing individual investment risk. This is especially true for equity funds that invest in a wide range of stocks or hybrid funds that invest across both stocks and bonds.
Disadvantages of Closed-Ended Funds
1. Liquidity Risk
The biggest downside of closed-ended funds is the liquidity risk. Since you can only buy or sell units on the stock exchange, the market price may not reflect the true value of the assets. Additionally, if the fund becomes unpopular, it could be hard to sell your units at a reasonable price.
2. Potential for Discount to NAV
The market price of closed-ended fund units can trade at a discount to their NAV. This is particularly true for funds that are not actively managed or do not have strong investor interest. If the units are trading at a significant discount, you could face a loss when you sell them.
3. Management Fees
Like other mutual funds, closed-ended funds charge management fees, which can reduce your returns. In some cases, these fees can be higher than the fees for open-ended funds, especially for funds with active management or specialized strategies.
4. Limited Investment Options After IPO
Once the NFO ends, investors cannot add more capital to the closed-ended fund unless they purchase units in the secondary market. This could be a disadvantage if you want to increase your investment in the fund.
Conclusion: Are Closed-Ended Funds Right for You?
Closed-ended funds can be an attractive option for investors looking for diversification, a fixed-term investment, and the potential for capital appreciation. They can be particularly appealing for income-focused investors who are looking for regular payouts. However, investors need to be aware of the liquidity risk and the potential for the units to trade at a discount to NAV.
Before investing, it’s essential to assess your investment goals, risk tolerance, and time horizon. If you prefer flexibility in your investment and want to make ongoing contributions, open-ended funds or Exchange-Traded Funds (ETFs) might be better options. But if you are willing to invest with a long-term perspective and can manage the risks, a closed-ended fund might be a valuable addition to your portfolio.
Frequently Asked Questions (FAQs)
What is a closed-ended fund in simple terms?
A closed-ended fund is a type of mutual fund where a fixed number of units are offered to investors initially. After the fund is listed, you can only buy or sell units on the stock market.
Can I redeem my units in a closed-ended fund anytime?
No, you can’t redeem your units directly with the fund. You can only sell them on the stock market, where the price may be higher or lower than the NAV.
Are closed-ended funds safe?
Like any investment, they come with risks, especially since their market prices can fluctuate. They may be a good choice for long-term investors who are comfortable with market volatility.
Can I invest in closed-ended funds through SIP?
No, closed-ended funds usually require a lump sum investment during the NFO period. SIPs are more common with open-ended funds.
What happens at the end of a closed-ended fund’s term?
At maturity, the fund will liquidate its assets, and investors will receive their share based on the final NAV.
