The Hindu Business Line : Closed-end funds: Stepping out of the rat race

The success of close-end funds could usher long-term funds into the equity market. They could provide investors with a transparent, cost-effective and tax-efficient avenue to invest for the long-term. It could also favourably influence behaviour of investors in, and fund managers of, open-end funds.

AT LEAST a minority of Indians wants to stay away from the rat race. For them, comparisons are odious. Their focus is on achieving objectives they have set for themselves. Close-end funds are similar. They have no brief other than to build wealth over a longer period. Quarterly returns, liquidity and comparisons with other open-end funds matter little.

In the next few months, investors may welcome the opportunity to invest in close-end funds. Fund houses such as Prudential ICICI, Franklin Templeton, HDFC and Deutsche have planned to launch a few of them. The risks, however, are higher, and the history of close-end funds in India is not inspiring. Nevertheless, they have the potential to add value to an investor's portfolio.

Open and close: Open-end funds offer liquidity that investors value. Liquidity is akin to the remote control in your hand. You change channels if you don't like. It has, however, become a double-edged sword, though investors are still intent on utilising this facility only to trade.

The thrill of going one up on Mr Market by getting in and getting out at will appears to overpower their senses. The time-tested strategy of building wealth by staying invested in equities does not find favour.

Trading in mutual funds is so entrenched that most investors view equities as short-term investments. The average holding period in equity mutual funds is 8-15 months, a study by leading mutual fund transaction processing company has found out.

Trading has other costs too. Fund managers feel that it restricts their investment strategy. One of the top performing fund managers suggested that the open-end format forces managers to look for stocks that would out-perform in the next three months. They tend to avoid stocks that may under-perform in the short term but would out-perform over a longer period. For them, quarterly rankings are important since those decide the fund inflows. This can only detract from the scheme's long-term performance.

Close-end funds, in which money is locked for a few specified years, neatly deflect the fund manager's attention from quarterly rankings. The focus shifts away from the glamour of quarterly returns and annual rankings to the more staid yet desirable world of building sustainable wealth.

Only that would fetch the fund house more fee income in close-end funds. Such funds also allow managers to invest in stocks of smaller capitalisation companies, which they now dread to touch because of liquidity concerns. The odds of such funds doing well are rather high in theory.

The downside: If close-end funds are so angelic, why have more such funds not been launched till date? Until now, open-end funds have delivered the goods for investors. Open-end diversified equity funds have managed to out-perform benchmark indices in a spectacular fashion till date.

Besides, the experience of investors with close-end funds in the early 1990s has not been good at all. The performance of many close-end funds launched in that decade has been below par.

Alarmingly, a few close-end funds such as HDFC Capital Builder (then Zurich India Capital Builder) and Prudential ICICI Power improved significantly after they were converted to open-end funds. It appeared as if the fund houses had neglected close-end funds until they turned open-ended.

Given this backdrop, fund houses have stayed away from launching close-end funds. They now sense a greater willingness among investors to let their money work for longer periods. Fund houses, naturally, want to cash in. For them this will fill a gap in their suite of products.

It would, however, prove exciting if fund houses view close-end funds as more than a business opportunity. The success of close-end funds could usher in long-term funds into the equity market. It could also favourably influence the behaviour of investors in, and fund managers of, open-end funds.

The world over, close-end funds are a mere fraction of the total amount invested in mutual funds.

Long-term money does not flow into mutual funds; it goes into insurance and pension schemes. If Indian close-end funds do well, it would provide investors with a transparent, cost-effective and tax-efficient avenue to invest for the long term.

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