The Hindu Business Line : Close-end funds are not the answer

Close-end funds do seem appealing at a time when open-end funds are increasingly buffeted by short-term market pressures. A great deal of attention is now focused on monthly and quarterly return rankings for funds. Funds that fail to measure up are swiftly punished, with a set of investors punting actively on open-end funds. This forces fund managers to hunt for stocks that can deliver instant gains and promotes frenetic churning.

All this has spawned the idea that it would be ideal if investors locked into a fund and the fund manager is left free to pursue long-term investment goals. This is exactly what pure close-end funds do.

A picture of neglect

While this argument is sound in theory, there is little to prove that fund managers of close-end funds put this freedom to good use. The close-end funds that exist today (mainly tax saving funds launched in the 1990s) have lagged woefully behind their open- end peers in generating returns for their investors over a five-year period. Over the past five years, the average close end fund has managed an absolute return of 215 per cent. Open-end funds are leagues ahead, with a 300 per cent return!

If you ranked all equity funds by their absolute returns over the past five years, more than half the funds would have bettered Morgan Stanley Growth Fund, the sole close-end fund to remain listed on the exchanges. Even fund houses that have been adept at managing open-end equity funds have not replicated this success with their close-end tax-saving funds launched in the1990s.

Why, despite greater leeway to the fund manager, do close-end funds deliver lower returns than open-end funds? Well, too little pressure on the fund manager to deliver performance is probably as bad as too much pressure.

The impression that one gathers from the returns for some close-end funds is that of neglect. If a fund house is managing both open and close end funds, rarely does it depute its star fund manager to the close-end fund. Since portfolio disclosures from close end funds are also sporadic at best, investors rarely have the opportunity to question the stock choices made. In a pure close-end fund, investors also cannot vote with their feet when the fund fails to deliver. They must simply stay put until the fund is wound up.

Leave it to the market

A large-scale shift in investor preference from open- to close-end funds is also not desirable for a healthy marketplace. Slowly but surely, investor money, over the past few years, has been migrating towards funds and fund houses that have built a convincing long-term track record. This automatically provides fund houses and managers with the incentive to deliver better performance.

Tracking the pattern of fund flows across years, you would find clear evidence that Indian investors do have more than a clue about long-term fund performance. Fund houses such as Franklin Templeton and HDFC have managed steady inflows into their better performing diversified funds over two/three years.

Investors have also been nimble enough to notice the comeback of SBI Mutual Fund's schemes over the past two years and buy into them at the right time. Not only does money flow into fund houses with a good record, investors are also discerning about the record of individual products managed by a fund house.

A compromise formula

All this suggests that open-end funds have several merits that need to be retained, while new products are structured. Yes, there are certain segments of the mutual fund market, where a close-end structure can mean a lot of value for investors.

Fixed-tenure debt funds, where investors start out with a good idea of the kind of yields they can expect from the fund, are welcome. A fund that focuses on small-cap stocks would also benefit from a stable corpus. Because of the limited liquidity on such stocks, investors in a small-cap fund could pay a disproportionate price, if a section of assets move in and out at frequent intervals.

But a hybrid structure could effectively marry the benefits of both open- and close-end funds. An interval fund, which does not accept fresh money, but opens a periodic repurchase window to allow investors to sell units, would work well. This is the structure adopted by the Franklin India Smaller Companies Fund.

If speculative punting on the fund is the worry, investors could be deterred from frequent entry and exits through a stiff load structure. Given that Indian investors tend to be very cost-conscious, a stiff exit load will surely be effective.

If corporate and large investors are the problem, separate products could be floated for retail investors, with a cap on investment size.

If the idea is to detract investors from a "short-term mindset," then forcing them to stay with a fund irrespective of how it performs, is certainly not the solution. Liquidity is now one of the key selling points for mutual fund investments.

Fund houses should continue to offer this. If equity funds do continue to outperform other investment avenues the way they have over the past few years, investors will make a decision to stay for the long term, on their own.

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