The Hindu Business Line : Harvesting alphas: Why closed-end funds are a better route

The mutual fund industry is biased towards open-end fund structure. Is this because investors want an exit route or because it is easier for fund-houses to increase their AUMs? The article argues that such a structure leads to sub-optimal harvesting of alphas, and suggests an alternative structure that may be beneficial for fund-houses and investors.

B. Venkatesh

A mutual fund manager recently complained about the open-end fund structure as it encourages redemptions when the market declines. Open-end equity funds saw redemptions of Rs 6,752 crore in January 2008, the month the market crashed.

While inflows were double at Rs 12,566 crore, the fact remains that investors typically redeem units when a fund underperforms or when asset prices decline.

But rather than solely blame the investors for their myopia, the mutual fund industry should accept its share of responsibility. This article shows that fund-houses prefer open-end structure as it enables them to increase their assets under management (AUM).

It also argues that such a structure acts as an impediment to generating alpha returns, as it forces fund managers to focus on near-term performance.

The article urges the industry to have a quality defector — one who will dare to float closed-end equity funds and generate significant alphas.

Then, other fund-houses will either follow suit or fade away. This process will have a positive side-effect — fund-houses will stop NFOs just to increase their AUMs.

As of February 2008, less than 20 per cent of the total assets under management were in closed-end fund structure.

Chasing assets

There could be two reasons for this bias. One, the open-end structure provides an optimal exit route for investors. And, two, it helps fund-houses to enhance revenues.

Consider the first argument. Investors do not know ex-ante if their fund manager will outperform the market. An open-end structure provides investors an exit route in the event their fund manager underperforms.

This argument is, however, not compelling. As of February 2008, closed-end bond funds had AUM of Rs 76,649 crore, nearly double that of closed-end equity funds.

The above argument would mean that the fixed-income investors are more tolerant about their fund mangers underperforming the benchmark indices than their equity counterparts. But there is no reason to believe so.

Now, consider the second argument. Fund-houses charge fees as a percentage of AUM. And it is easy for fund-houses to increase their AUM through the open-end fund structure.

But suppose there were only closed-end equity funds. There will be a strong incentive for the alpha-generating manager to defect from the industry norm and gather more assets by switching to open-end fund structure.

But if one fund defects, others have a stronger incentive to do so too! And that could be a reason why fund-houses typically float open-end funds.

Alpha problem

Investors are typically myopic. Such investor behaviour forces fund managers’ to concentrate on near-term performance.

Otherwise, funds would face redemption pressures due to the open-end structure. This pressure on near-term performance forces managers away from high alpha-generating assets.

Alpha returns reside in contrarian strategies and in illiquid assets. Of course, fund managers can generate short-term alpha returns from market timing. But that is not a skill all managers possess. Most managers are good at contrarian picks that generate alpha returns over a longer horizon.

Take the technology sector. Suppose an alpha-generating value-style manager thought that the tech sector was overvalued in 1999. The fund manager would have taken profits from the tech sector and moved into another value sector.

The fund would have underperformed the peer universe through the year till the technology bubble burst. And investors would have penalised the manager by pulling their money from the fund.

Since fund managers are concerned about AUM, near-term performance overwhelms the need to generate longer-horizon alphas.

Follow-on offers?

An optimal structure should be such that the fund is closed-end so that managers can harvest high alphas and yet increase the assets size through sale of mutual fund units.

What if alpha-managers increase their asset size through follow-on offers just as companies do? The follow-on offer will be at the current net asset value. But the process would be somewhat complicated.

Suppose a fund has 20 stocks in its portfolio and its NAV is Rs 25. A follow-on offer at Rs 25 will change the portfolio composition because of the proceeds from the sale of new units. These proceeds will lead to a cash-drag till they are fully invested. And that is a cost to the existing unit-holders.

The fund-house, hence, has to take the proceeds into a separate account, buy the same 20 stocks in the same proportion and then transfer those shares to the existing portfolio.

That way, the fund can avoid cash-drag on the portfolio due to the follow-on offer and also maintain the portfolio composition.

The choice between open-end and closed-end structure should depend on the investment style. It would be optimal if fund-houses have closed-end structure for value-style investing and open-end structure for momentum funds. That way, value-style managers will have more time to generate alphas while underperforming market-timers will fade away in the open-end structure.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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