What are Closed Ended Funds & How do They Work?
Mutual Funds can be classified based on their structure into three types: open ended, closed ended, and interval funds. This classification primarily hinges on how often you can buy or sell units of the scheme. While open ended funds are more commonly known and widely traded due to their flexibility, closed ended funds are also gaining popularity among investors. In this article, we will delve into closed ended mutual funds, exploring their different types, benefits, and much more.
What are Closed Ended Funds?
A closed ended mutual fund is an equity or debt fund launched with a fixed number of units issued by the fund house. Once the New Fund Offer (NFO) period ends, investors can no longer buy or redeem units. These funds are initially launched through an NFO and then traded on the stock market like shares, with a predetermined maturity period.
The Net Asset Value (NAV) determines the fund’s actual value. However, the trading price may vary above or below the NAV based on demand and supply. Essentially, a closed-ended fund ‘closes’ after the launch period and remains locked until maturity, giving the fund manager greater flexibility to focus on achieving the fund’s investment objectives.
How do Closed Ended Funds Work?
When an asset management company launches a New Fund Offer (NFO), investors purchase units of the scheme at a set price. Once the NFO period ends, no new investors can join, and existing investors cannot exit until the scheme matures. At maturity, the scheme dissolves, and the funds are returned to investors. Their return value is based on the net asset value (NAV) at that time. If an investor wants to exit before maturity, they can trade their units on the stock market.
A closed-end mutual fund typically begins with an initial public offering (IPO) to raise capital. Investors who contribute to the fund receive units in return. These units are then traded on the secondary market, where supply and demand dictate their value. As the name implies, a closed-end mutual fund issues units only once and does not issue new ones or repurchase existing ones. To join the fund later, investors must buy existing units on the open market.
Types of Closed Ended Fund Investments
Closed-ended funds typically involve two main types of investments:
- Bond Closed-End Funds: These funds primarily consist of bonds and carry both market and credit risks. Market risk arises from the potential increase in interest rates, which could lower the value of the bonds held by the fund. This risk tends to cause greater fluctuations in the fund’s net asset value (NAV) when the maturity of the bonds is longer.
- Equity Closed-End Funds: These funds are exposed to the risk of a decline in both NAV and market price. The value of the stocks in the fund’s portfolio can be influenced by several factors, including the financial and operational health of the issuing company, industry-specific market dynamics, and the overall condition of the stock market.
Features of Closed Ended Funds
Here are a few key features of closed ended funds:
Limited Share Issuance
Closed ended funds (CEFs) issue a fixed number of shares during an initial public offering (IPO). Once these shares are sold, no new shares are available unless an existing owner decides to sell theirs.
Net Asset Value (NAV)
Closed ended funds have a Net Asset Value (NAV), which represents the total value of the fund’s investments. The difference between the NAV and the market price of a CEF’s shares is referred to as a discount or premium. If the share price is below the NAV, the Closed ended funds is trading at a discount.
Leverage
Many Closed ended funds use leverage as part of their investment strategy. This involves borrowing money to increase investment exposure, which can enhance potential returns. However, leverage can also magnify losses, making it a double-edged sword.
Distributions
Closed ended funds typically pay distributions to shareholders on a monthly or quarterly basis. These distributions may include income generated by the fund, such as interest, dividends, or capital gains, as well as a return of principal.
Fixed Term
Closed ended funds have a predetermined lifespan, known as a fixed term. Once the capital is raised during the IPO, no additional equity can be introduced into the fund, and the fund operates within this fixed period.
Liquidity and Redemption
Closed ended funds lack liquidity during their lock-in period, meaning investors cannot redeem their shares until this period ends. Investment opportunities are restricted to the new fund offer (NFO) phase, and systematic investment plans (SIPs) are not available. Additionally, once the NFO period concludes, averaging facilities are no longer accessible.
Secondary Market Trading
Closed ended funds are traded on secondary markets, such as stock exchanges. Their share prices reflect both the Net Asset Value (NAV) of the underlying assets and market supply and demand, which can result in the fund trading at either a premium or a discount to its NAV per share.
How to Invest in Closed Ended Funds?
Investing in closed ended mutual funds can be a straightforward process. Here’s a guide to get you started:
- Open a demat/trading/brokerage account. Investors can open a demat account with smallcase!
- Register online at any AMC website.
- Explore different closed ended funds, including the different types of closed ended funds, to figure out which one suits your investment objectives.
- Investors can use tools like the Tickertape Mutual Fund Screener to sort through these closed ended funds and explore their fundamentals and performance in the past. They can sort through the 200+ filters available to track fund performance.
- Proceed to invest by clicking on the appropriate option and specifying the amount and investment mode (SIP or Lumpsum).
- Submit your KYC details, including your PAN number and bank details, to finalise your investment.
Note: It is important to conduct thorough research and consult a financial advisor before investing in anything.
Who Should Invest in Closed Ended Funds?
Closed ended funds require a lumpsum investment and do not allow redemption until maturity. Therefore, they may suit investors with a substantial investable corpus and a time horizon aligned with the fund’s maturity. It’s important to assess the risks and returns based on the scheme’s asset allocation as detailed in the offer document. Here are a few types of investors who may find closed ended funds attractive:
- Long-Term Commitment: Closed ended funds are designed for investors who can commit their funds for the entire duration without needing access to their money.
- Goal Alignment: These funds are ideal for those with specific financial goals, such as saving for a child’s education or building a retirement corpus, where the fund’s maturity matches the target date.
- Risk Awareness: Closed ended funds may invest in various assets, including equities, which can introduce risk. Investors need to have the appropriate risk tolerance and be aware of market volatility.
- Patience Required: Given the lack of redemption options before maturity, investors must be patient and willing to remain invested for the full tenure.
- Consistency: Investors should be comfortable with the fund manager’s strategy and not require frequent changes to their investment portfolio.
Benefits of Investing in Closed Ended Funds
Here are a few potential benefits of closed ended mutual funds:
- Stability for Fund Managers: Closed-ended funds do not allow investors to redeem units before maturity. This can provide fund managers with a stable asset base. This stability allows managers to focus on long-term strategies without worrying about liquidity.
- Market Price Based on Demand and Supply: Investors trade units of closed-ended funds on stock exchanges. Thus, supply and demand influence their prices. Increased demand and limited supply can drive the market price above the fund’s NAV (Net Asset Value).
- Liquidity Through the Stock Exchange: Despite restrictions on unit redemption by the fund house, closed-ended fund units can be bought or sold on the stock exchange. This can offer investors significant liquidity at current market prices.
- Capital Appreciation Potential: The share price of closed-ended funds can appreciate over time. This is similar to stocks and can potentially lead to capital gains.
- Stable Asset Management: With no pressure from capital flows, fund managers have better control and can make long-term decisions, contributing to more stable management.
- Lower Operating Costs: Closed-ended funds often have lower turnover rates, which leads to reduced operating and management costs.
Challenges of Investing in Closed Ended Funds
Here are some key disadvantages of closed ended mutual funds:
- Past Performance: Closed ended funds have historically not delivered better returns than open ended funds, despite the strategic flexibility of fund managers.
- Lump Sum Investment: Investors can only purchase units of closed ended funds during the initial launch period. This necessitates a lump sum investment. This approach can increase risk, whereas many investors prefer the systematic investment plan (SIP) for its affordability and risk distribution.
- Dependence on Fund Manager: The performance of closed ended funds largely hinges on the decisions of the fund manager. Unlike open ended funds, which provide performance data over various market cycles, closed ended funds lack such transparency, making their success highly dependent on managerial choices.
Difference Between Closed Ended and Open Ended Funds
Here is a table of comparison between closed ended and open ended funds:
| Comparison Basis | Open ended Funds | Closed ended Funds |
| Definition | Schemes that continuously offer units to investors. | Schemes that offer units only for a limited time. |
| Subscription | Available for subscription throughout the year. | Available for subscription only during the NFO. |
| Investment | Can be made through lump sum or SIPs. | Can only be made through a lump sum during the NFO. SIPs are not available. |
| Transactions | Executed at day end. | Executed in real-time on the stock market. |
| Maturity | No fixed maturity. | Fixed maturity period, usually 3 to 5 years. |
| Liquidity Provider | The fund itself provides liquidity. | Liquidity is provided by the stock market. |
| Corpus | Variable; changes with subscriptions and redemptions. | Fixed; set at the time of the initial offering. |
| Price Determination | Price is close to the NAV, as transactions occur directly with the fund. | Price is determined by supply and demand on the stock market. |
| Listing | Not listed on stock exchanges; transactions are handled directly through the fund. | Listed and traded on a regulated stock market. |
| Issue Size | Unlimited. | Fixed at the time of the initial offering. |
Premiums and Discounts in Closed Ended Funds
A closed ended fund (CEF) trades at a premium when its market price exceeds its net asset value (NAV). Conversely, it trades at a discount when its market price falls below the NAV. While many believe premiums are preferable to discounts, this view oversimplifies the situation. Premiums and discounts don’t fully reflect the fund’s overall performance.
Factors such as market conditions, investor sentiment, financial leverage, and management costs can all impact a CEF’s value and distributions. Investing solely in closed end funds is not advisable. It’s recommended that no more than 20% of a balanced retirement portfolio be allocated to these funds.
Taxation on Closed Ended Funds as per the Union Budget 2024-25
The taxation on capital gains from your mutual fund investments is based on their holding periods and asset allocation. A few revisions were made to the tax rates, depending on their types, in the Union Budget 2024-25. It may be important to learn about these revisions when considering Closed ended funds. These changes include:
Equity Mutual Funds
- Short-Term Capital Gains (STCG): The gains from equity mutual funds held for less than 12 months are now taxed at 20%. This is an increase from the previous tax rate of 15%.
- Long-Term Capital Gains (LTCG): For equity mutual funds held for over a period of over 12 months, gains are classified as long-term capital gains. The new budget introduces these key changes to the LTCG:
- Tax-Free Limit: The capital gains up to Rs. 1.25 lakh per year are tax-free. This is an increase from the previous limit of Rs. 1 lakh.
- Tax Rate: The gains exceeding Rs. 1.25 lakh are now taxed at a flat rate of 12.5%. This is an increase from the previous rate of 10%.
- Indexation: The benefit of indexation, which allowed investors to adjust the purchase price for inflation, has been removed for all asset classes, including equity mutual funds.
Indexation was a method that allowed investors to adjust the purchase price of assets for inflation. This adjustment reduced taxable profits when selling assets like property or gold. Previously, these long-term capital gains were taxed at 20%. The new rule imposes a flat 12.5% tax on all long-term capital gains but eliminates any indexation benefits.
| Capital Gains Tax | Holding Period | Old Rate | New Rate |
| Short-Term Capital Gains (STCG) | Less than 12 months | 15% | 20% |
| Long-Term Capital Gains (LTCG) | More than 12 months | 10% | 12.50% |
Debt Mutual Funds
- Short-Term Capital Gains (STCG): If you sell your debt fund units within a period of 36 months, the gains are classified as short-term capital gains. The STCG will be taxed according to your income tax slab rate.
- Long-Term Capital Gains (LTCG): For debt funds held for a period over 36 months, the gains are classified as long-term capital gains. The new budget outlines a few changes on the LTCG for debt funds, including:
- Tax Rate: A flat 12.5% tax rate applies to these gains.
- No Indexation Benefit: The previous benefit of adjusting the purchase price for inflation is removed. Now, the entire gain after three years is taxable at 12.5%.
- Change in Holding Period for Specified Mutual Funds: Previously, debt mutual funds with a holding period of over 36 months were taxed based on the investor’s tax slab, classified as Long-Term Capital Gains (LTCG). Now, for specified mutual funds where over 65% of the investment is in debt, the holding period for taxation has been reduced to over 24 months. These funds will still be taxed according to the investor’s tax slab as either LTCG or STCG.
| Capital Gains Tax | Holding Period | Old Rate | New Rate |
| Short-Term Capital Gains (STCG) | Less than 36 months | Taxed according to your income tax slab | Taxed according to your income tax slab |
| Long-Term Capital Gains (LTCG) | More than 36 months | 10% | 12.50% |
Hybrid Mutual Funds
Short-Term Capital Gains (STCG)
The tax on short-term capital gains depends on the fund’s asset allocation when it comes to hybrid mutual funds. Here is a breakdown of STCG tax rates according to their asset allocation in hybrid funds:
- Equity-Oriented Hybrid Funds (more than 65% in equity): The gains from units sold within 12 months are taxed at 20%.
- Debt-Oriented Hybrid Funds (less than 65% in equity): The gains from units sold within three years are taxed according to your income tax slab.
Long-Term Capital Gains (LTCG)
The capital gains tax on hybrid mutual funds that extend the specified period (12 or 36 months) is known as the long-term capital gain tax. The tax treatment under this condition is as follows:
- Equity-Oriented Hybrid Funds: The gains from units held for over a period of 12 months are taxed at 12.5%. The gains up to Rs. 1.25 lakh are tax-free.
- Debt-Oriented Hybrid Funds: The gains from units held for over a period of 36 months are taxed at 12.5% without indexation benefits. This means the entire gain is taxed at this rate, without adjustment for inflation.
| Type of Hybrid Fund | Short-Term Capital Gains (STCG) | Long-Term Capital Gains (LTCG) | Indexation Benefit |
| Equity-Oriented Hybrid Funds | 20% for holdings less than 1 year | 12.5% for holdings over 1 year, with gains up to Rs. 1.25 lakh tax-free | Not available |
| Debt-Oriented Hybrid Funds | Taxed as per income tax slab for holdings less than 3 years | 12.5% for holdings over 3 years | Not available |
Note: Mutual fund schemes where neither the equity nor debt orientation exceeds 65% will now be classified as long-term investments after 24 months. The previous holding period for these funds was 36 months. These will be taxed at the revised LTCG tax rate of 12.5%.
Factors to Consider Before Investing in Closed Ended Funds
Here are a few factors investors can consider before investing in closed ended funds:
- Investment Horizon: Closed ended funds often have a set maturity period. It’s important to select funds whose investment horizon matches your financial objectives. If you plan to invest for a long term, choose funds with a longer maturity period. Conversely, if your goals are short-term, ensure the fund’s duration aligns with this timeframe.
- Market Research: Before committing to a closed ended fund, investors can thoroughly research its historical performance. They can review the fund’s investment strategy and assess the track record of its fund manager. Understanding how the fund has performed over time and how the fund manager manages it can give you insights into its potential future performance.
- Exit Strategy: Closed ended funds can have limited liquidity compared to other investment options. It can be helpful to be aware of this limitation and prepare yourself to hold your investment until the fund reaches maturity. Understanding the implications of limited liquidity will help you manage your expectations and plan accordingly.
To Wrap It Up…
In conclusion, closed-ended mutual funds offer a distinct investment option with the potential for income generation and market outperformance. Professionals manage these funds and can provide access to various investment opportunities. However, they come with specific characteristics that investors should be aware of, such as limited liquidity and price volatility.
For beginners, it’s essential to understand that closed-ended mutual funds may be better suited for investors with a robust, diversified investment portfolio. Investors should consider their financial goals and risk tolerance when evaluating closed-ended funds. By clearly understanding these funds’ features and risks, investors can make informed choices that fit within their overall investment strategy.
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Frequently Asked Questions About Closed Ended Funds
A closed ended mutual fund locks your investment for a set period. You can invest in these funds only during the New Fund Offer (NFO) period and can redeem your units only after the specified lock-in period or the scheme’s tenure ends.
Open ended funds continuously offer new units to investors, allowing them to buy or sell units at any time. In contrast, closed ended funds issue a fixed number of units and offer them to investors only for a limited period.
Closed end funds can offer higher income potential but come with some risks. They may experience greater price volatility and less predictable total returns and dividend growth. Additionally, investors could face unexpected shocks.
A closed end fund (CEF) is called “closed-end” because it does not continually accept new investments from investors. Unlike mutual funds and ETFs, which regularly issue and redeem shares based on investor demand, a CEF only offers a fixed number of shares when launched. After this initial offering, the fund does not create or redeem shares regularly.
Yes, you can sell your closed ended fund on the secondary market through exchanges. The price at which it sells may differ from the Net Asset Value (NAV) due to market demand, potentially leading to discounts or premiums.
