What is Closed End Mutual Fund?

What are Close Ended Funds?

The closed-end mutual fund refers to a debt fund or equity where a fund house must issue a specified units during its launch. When the time period of the NFO ends, the investors can no longer redeem or purchase units of the close-ended mutual fund. Such funds are usually launched through the NFO, later traded in a stock market, and come with a specified maturity time. The NAV aids in determining the actual price, and hence, the traded unit or price is likely to be below or above the NAV. It is dependent on the unit's supply and demand. To put it simply, close-ended mutual funds close when its launch period is over until its maturity. It enables the funding manager to follow the fund's investment objectives.

How Do Close Ended Funds Work?

After the asset management company sets up a New Fund Offer, the investors purchase a unit of this scheme at a certain price. During the end of the NFO period, it did not allow any new investor to enter the scheme. Moreover, the investors cannot exit the funds before the maturity of the scheme. At maturity, this scheme dissolves, and the money gets transferred to the investor at the prevailing net asset value on that particular date. So, if any investor wishes to exit this scheme before the end of its maturity period can trade the units on the stock markets.
An initial public offering is started in a closed-end mutual fund to raise money for the fund. Those who make financial contributions to the mutual fund receive shares in return. The shares are then published on the secondary market, where investors can trade them according to supply and demand. As the name suggests, a closed-end mutual fund doesn't issue new shares or repurchase existing ones. Shares of a closed-end fund are only issued once. Purchasing some of those current shares on the open market is the only method to get into this fund later.
 

Advantages And Disadvantages of Close Ended Funds

Take a quick glance at the advantages of close-ended funds:

●    High Stability For Fund Managers

In a close-ended mutual fund, the investors are unable to redeem the units before their maturity. So, fund managers work with a pre-determined asset base. They don't have to maintain liquidity as there aren't any redemptions. This helps a fund manager to utilise a good strategy and fulfill the investment goals of this scheme.

●    The Market Price is based on Supply and Demand

Similar to equity shares, a close ended fund's units are only at the stock market whose prices are decided by the unit's supply and demand of this scheme. Thus, with the increase in demand for any specific closed end mutual fund scheme, its supply will be low. So, its units will get sold at the price above the scheme's NAV.

●    They aren’t Illiquid

Although a closed end mutual fund may first appear to have little liquidity as the funding house forbids unit redemption, there are countless chances to acquire and sell all the units on the stock exchange. Close ended funds provide investors with a high level of liquidity. A closed ended fund's units can be purchased or sold on the stock market at the market rate.

Here are some of the disadvantages of close ended mutual fund policies:

●    Past Performance is not Great

The closed ended fund's manager is likely to be in a great position to build investment techniques to enable him to achieve various investment goals of this scheme. Nevertheless, if you consider the past performance of the closed ended mutual funds, it won't reflect good returns in comparison to the open ended funds.

●    Huge Amount Investment Option is Only Available

It is essential for you to invest a lump sum amount as you may buy the scheme’s units during its initial launch. It tends to increase the risk, and most investors choose the SIP approach for investment since it's more affordable and less risky.

●    Highly Impact of the Fund Manager’s Decisions

Investors often evaluate the mutual fund scheme's performance over several market cycles for overviewing whether making an investment in it is wise. While this data is easily accessible for the open-ended schemes, it is not accessible for closed ended funds. As a result, the fund manager's actions significantly impact the fund's success.

Key Differences Between Close Ended Funds and Open Ended Funds

Want to know the key difference between open ended and closed ended mutual funds? Here's what differentiates closed ended funds from open ended mutual funds:

●    In the case of closed ended funds, there is no liquidity during its lock-in period, whereas there's high liquidity in the open ended funds.
●    Unlike open-ended mutual funds, where you may invest in a lump sum or through SIPs, close ended funds enable you to invest only during the NFO and not through SIPs.
●    Since no track record is present in a close ended mutual fund, you may purchase it only during the new fund offer, which is not the case in open ended funds.
●    The minimum amount for investment in a closed end mutual fund is Rs 5000, whereas open ended funds allow you to invest with a minimum amount of Rs 500 or Rs 1000.
●    There is no averaging facility applicable in the close ended funds since they don't accept investments after the end of the NFO period. However, open ended funds allow you to benefit from the rupee cost of averaging the unit price through the SIPs.
 

Types of Investments in Close Ended Funds

Mainly there are two major types of investments in a close ended funds, namely;

Bond Closed End Funds- The majority of assets in closed-end funds have been made up of bond funds. Market risk and credit risk exist in some form in all closed-end bond funds. Market risk is the possibility that interest rates would increase, which would decrease the value of the bonds owned by the fund. Generally speaking, market risk causes a fund's net asset value (NAV) to fluctuate more when a portfolio security's remaining maturity is longer.

Equity Closed-End Funds- All equities closed-end funds run the danger of seeing their NAV and market price fall as a result of the portfolio assets they hold losing value. The business operations and financial standing of the stock's issuer, market and economic factors that impact the issuer's industry, or the state of the stock market in general, can all affect the value of a specific stock in a fund's portfolio.
 

How to Evaluate Close Ended Funds Before Investing

The Closed end mutual fund meaning implies that it cannot be redeemed until they reach maturity. This has certain tax benefits, but it is also easily traded on exchanges, which has some liquidity advantages as well. Withdrawal limits are minimal for open ended funds. Like with any investment, making the best decision requires careful consideration of one's requirements and goals. For investors with a longer time horizon, a closed end mutual fund could provide more stability as fund managers can make investments with greater freedom without worrying about redemptions.

Evaluate the following factors when investing in a close ended funds before investing:
●    Risk-adjusted returns
●    Benchmark
●    Relative performance with peers
●    Quality of stocks in the portfolio
●    Track record and competence of the fund manager
 

Understanding the Role of Premiums and Discounts in Close Ended Funds

A CEF is considered to be trading at a premium if its market price is higher than its net asset value (NAV). The CEF is selling at a discount when a fund's market price is lower than NAV, on the other hand. According to these concepts, it is generally believed that premiums are preferable to discounts and vice versa. However, this assumption is somewhat oversimplified as premium or discount prices don't provide a whole picture of the situation.

Distributions can be sensitive to the state of the stock market; discounts and premiums can change considerably with investor sentiment. Financial leverage increases volatility, and management costs can reduce profits. Investing in closed-end funds is a great example of how putting all your income-producing eggs in one basket is never a good idea. No more than 20% of a balanced retirement portfolio should be invested in closed-end funds.

Advantages And Disadvantages of Closed-End Funds

Who Should Consider Investing in Closed-Ended Mutual Funds?

Closed-ended mutual funds are ideal for investors who can commit a lump sum of money for a fixed investment horizon aligned with the scheme’s maturity. Since these funds do not offer redemption before maturity, they suit those with a long-term view and a disciplined investment mindset. However, it’s essential to review the scheme’s asset allocation detailed in the offer document to understand the risk-return profile.

Taxation Angle
The tax treatment of gains depends on the fund’s investment composition. If it invests 65% or more in equities, it is taxed like an equity fund; if the allocation is 65% or more in debt, it is treated as a debt fund. Always check the fund’s asset mix to know your potential tax liability upfront.
 

When do closed-end mutual funds mature?

Closed-end mutual funds in India come with a fixed maturity period, which is mentioned in the scheme’s offer document at the time of launch. These funds typically have a tenure ranging from 3 to 5 years, though some may go up to 7 years, depending on the fund’s objective and strategy. Once an investor buys units during the New Fund Offer (NFO) period, they must stay invested until the scheme matures, as redemption before maturity is not allowed.

However, investors can still exit early by selling units on the stock exchange, where these funds are mandatorily listed, although liquidity and pricing may vary due to market demand and supply.

Upon maturity, the fund house automatically redeems the units at the prevailing Net Asset Value (NAV) and credits the amount to the investor’s bank account. Hence, investors must match their investment horizon with the fund’s maturity timeline before committing capital.

Conclusion

Closed-end funds can be an excellent way to generate income. However, if you have made it this far, you are fully aware of the complexities and risks involved with investing in closed-end funds. In general, a closed-end mutual fund seems most appropriate for relatively sophisticated investors with well-diversified income portfolios (i.e., their lifestyles could tolerate a 50% drop in income from their closed-end funds), a stomach for price volatility and a long-term investment time horizon.