Do closed ended funds offer superior returns to open ended funds?

Equity mutual funds (MF) classified broadly as closed-ended and open-ended. This is different from the categorization based on theme, sector and capitalization, etc. The just mentioned classification in the way the fund is invested i.e. among the types of stocks, but the closed or open-ended schemes indicate a completely different classification based on their accessibility of fund to transact.

In a closed-ended scheme, the fund is either open only at the time of the fund offer i.e. NFO, a period of time stipulated by the regulator, Securities Exchange Board of India (SEBI) during which a subscriber (investor) could invest in. Whereas in an open-ended scheme of a MF, the subscriber or investor could transact at any point of time until and unless the fund house decides stopping to accept any further or fresh infusions into the fund.

In a closed-ended fund, the subscriber, once invested, is restricted to make any transactions, i.e. to switch, redeem or make fresh purchases into the fund. As the name suggests, it's closed for any such transactions for the subscribers. The investor would get the redemption proceeds once the defined investment period is matured. While in an open-ended fund, any investor could make fresh purchases of units at any point of time, switch from any other fund to this fund or vice versa and/or redeem at any required time.

From the point of the fund house or manager, in a closed-ended scheme, the fund manager is given a mandate on the entire collected fund at the time of the initial offer and there is no pressure for redemption till the maturity. This allows the fund manager to have a fixed horizon for investment along with an almost fixed amount to invest.

The investment decisions hence would be tied to the maturity period and would get a clear mandate on how the funds could be utilized till then. The fixed time of the fund could also handicap the fund manager as he wouldn't get any additional time to course correct due to changes in the external market conditions.

However, in an open-ended fund, the fund manager would have access to fresh investments time-to-time, though dependent on the fund performance or the broader market scenario.Simultaneously, he's also burdened by redemption pressure by the investors particularly in times of distress in the equity markets. This is the exact point of time, when rationale is lost to panic leading to heavy reaction that could result to loss of assets of the fund and possibly leading to further underperformance.

Though, at certain times, even an open-ended fund could be closed for fresh subscriptions or restricted access to transactions due to the increased size of the fund (turning to unmanageable levels with regards to the philosophy or objective of the fund) or unfavorable extraneous market conditions that impair fund performance or restrict the fund manager to stick to the objective (due to the changes in the market environment).

Barring such situations, an open-ended fund continues to operate in the market accepting all the possible transactions to be performed by the subscribers. So, which would of the funds benefit the investor? There's no such conclusive evidence that closed-ended funds perform better than an open-ended funds or otherwise. This is because the performance of the fund is primarily defined by the overall objective of the fund and the fund philosophy.

This when aligned with the external factors i.e. say a specific sector or theme works better and the fund performance depends upon the extent of the exposure in these sectors. Though, the higher control of the capital for the fund manager doesn't always translate to better performance for the very reasons mentioned earlier.

In some specific cases like that of a fixed maturity plans of debt category of funds, the closed-ended nature helps the investor to generate better returns. It could also benefit in an opportunist cases of equity MF where the timing i.e. the circumstances of the overall equity market along with the select focus aligned with an exposure into this segment could enhance the investor returns.

A judicious approach of mix of both closed and open-ended funds would help as long as the fund objective is in-line with the risk appetite of the investor.The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)