What happened to close-ended funds?

Circa 2006-07, close-ended funds were the season's flavour. Fund houses were busy convincing investors to get invested on the premise that close-ended funds furthered the cause of 'long-term' investing. Investors had a plethora of options to chose from since close-ended NFOs (new fund offers) of every conceivable kind were launched i.e. mid-cap, flexi-cap, thematic, fund of funds and tax-saving.

The genesis of close-ended funds
When equity markets hit a purple patch in 2003, fund houses capitalised on the same by launching equity fund NFOs. Most NFOs were of the open-ended variety. Fund houses were permitted to charge initial issue expenses (6% of corpus) to the fund and amortise the same over a period time. Initial issue expenses were largely used to meet marketing and distribution expenses. As a result, distributors were handsomely rewarded for their efforts in asset mobilisation.

A spanner in the works came in the form of a SEBI guideline that scrapped initial issue expenses on open-ended NFOs. Now, fund houses were required to meet NFO-related marketing and distribution expenses from the entry load; the norm was 2.25% of the sum invested. But close-ended NFOs were out of the purview of this ruling. While fund houses were permitted to charge initial issue expenses on close-ended NFOs, the trade-off was that they were prohibited from levying an entry load. The choice between initial issue expenses and entry load was a no-brainer. The result was a deluge of close-ended NFOs.

It would be unfair to paint all fund houses and close-ended NFOs with the same brush. Some close-ended NFOs did offer a truly innovative investment proposition. However, ignoring the marketing aspect would be naive.

The present scenario
It can be safely stated that close-ended funds are a forgotten breed now. Maybe, it had something to do with a subsequent guideline (January 2008), wherein SEBI decided that close-ended NFOs be treated on par with open-ended NFOs i.e. they would be permitted to charge an entry load and the provision to charge initial issue expenses was scrapped.

While close-ended funds may not feature on the priority lists of fund houses, it's a different scenario for investors. Several investors got invested in close-ended NFOs and continue to hold the same in their portfolios. Also, since then, markets have had quite a journey - an ascent to record highs, followed by a sharp downturn, and a recovery of sorts. It would be interesting to study how close-ended funds have fared so far.

The performance
Of the several close-ended funds launched in the 2006-08 period, 4 have a 3-Yr track record now. The following table shows how they have fared vis-à-vis comparable open-ended offerings from the same fund house and their respective benchmark indices.

	3-Yr (%)
Franklin India Prima	8.2
Franklin India Smaller Companies ©	6.6
CNX Midcap	16.8
HDFC Premier Multi-Cap	14.1
HDFC Long-term Equity ©	9.1
S&P CNX Nifty	15.2
ICICI Prudential Dynamic	18.2
ICICI Prudential Fusion ©	6.5
CNX Nifty Junior	18.7
Tata Tax Saving	12.6
Tata Tax Advantage 1 ©	14.3
BSE Sensex	14.6

(NAV and index data as on July 24, 2009. © indicates close-ended fund. NAV data sourced from www.amfiindia.com. Index data sourced from www.bseindia.com and www.nseindia.com. All data in CAGR terms)

As can be seen in the table above, close-ended funds have failed to match their benchmark indices over the 3-Yr period. Furthermore, with the exception of one fund, others have failed to match comparable open-ended funds from the same fund house. Even a cursory glance at performance of other close-ended funds (ones that have been in existence for less than 3-Yrs) will reveal that largely their performance is nothing to write home about.

It ain't over, till it's over
Critics might argue that the aforementioned funds need not be a representative sample of the entire close-ended funds category. Fair enough. But few would dispute that close-ended funds have failed to impress so far.

Fund houses are likely to justify the mediocre showing posted by close-ended funds on the grounds that these are early days. Given that most close-ended funds have a 5-Yr tenure, passing any judgement at this stage would be premature. Also, several funds have a provision for conversion into open-ended funds on maturity. Hence, should they fail to deliver in their close-ended avtaar, investors can continue to stay invested and exit the same at a more opportune time. While there might be some merit in the former argument (early days for funds), the latter certainly doesn't hold good.

Here's why - investments in close-ended funds were made on the premise that they would enable fund managers to make long-term investment decisions i.e. fund managers would not be weighed down by factors like redemption pressure and short-term market occurrences, that typically plague open-ended funds. When investors agreed to forsake liquidity (make a 5-Yr commitment) and bear initial issue expenses, the trade-off should have been a superlative performance. The least investors would expect is for close-ended funds to deliver a better showing than open-ended funds. And should close-ended funds fail to deliver, investors have every right to feel aggrieved.

What investors must do
Investors would do well to appreciate that not every promising proposition translates into a sound investment avenue. On paper, a close-ended fund with a defined maturity horizon and corpus sounds like an interesting idea; however, with the benefit of hindsight, it can be safely concluded that not every close-ended fund will live up to the promise. This underscores the importance of seeking diversification and a track record while making investment decisions.

Also, investors must keep track of their close-ended fund investments. Be patient and give them adequate time to prove themselves. Despite this, if they fail to deliver, don't hesitate to exit them after taking into account factors like the exit load. Perhaps an alternative fund with a similar investment proposition might be a better bet.

Look who's talking!

Mutual funds are back with a bang! Pick up any newspaper and you are bound to come across a mutual fund related write-up or advertisement. Given the surge in equity markets, the performance of mutual funds has started looking up. And fund houses are sparing no effort (explicit or implicit) to spread the gospel of mutual funds. There are articles eulogising the impressive showing delivered by mutual funds in the recent past; also, the fact that the mutual fund industry now holds a record assets under management (AUM) size has been well-documented. Fund managers are busy giving out interviews highlighting how mutual funds will hold investors in good stead over the long-term. Dividends are being declared in a hurry by several funds to prove their prowess. Finally, some new fund offers (NFOs) have already been launched (more on this later in the article) and several others are on the way. All in all, it can be safely stated that mutual funds are back with a bang!

Circa October 2008
Not too long ago (October 2008 to be precise), the scenario was radically different. Equity funds had been hit hard by the sharp decline in equity markets; even 3-Yr performance numbers were in negative territory. Debt offerings like fixed maturity plans (FMPs) and liquid/liquid plus funds had come under the scanner on account of the liquidity crisis; questions were being raised about the quality of investments made by several funds. Simply put, mutual funds had become everyone's favourite 'whipping boys'. While all the criticism may not have been justified, some of it certainly was.

Interestingly, the response of fund houses to the demanding situation was rather curious. Most fund houses went into a 'silent' mode and simply chose not to react. When relationship managers were contacted for information about their funds, the standard response was, "everything is fine; there is nothing to worry about". Requests for one-on-one interviews with fund managers were either instantly turned down on the grounds that the fund manager was busy or stalled with the excuse - "we'll get back to you on this one". While some fund houses/fund managers were willing to go on record about the nature and quality of their fund portfolios, they were strictly in a minority.

Odd isn't it. In a time of crisis, fund houses, instead of communicating with investors to assuage their concerns, chose to go into hiding. And now, when the going is good, fund houses are acting like 10-yr old over-energetic blabbermouths who can't keep mum. That tells you something about fund houses, doesn't it?

As for the NFOs, at any sign of rising markets and a revival in investor interest, they make a comeback. Already, we have had a round of the 'target return' NFOs. Simply put, these are funds wherein there is an inbuilt clause for booking profits when a certain return (as specified by the investor) is clocked. In most cases, the profits are booked and invested in a debt fund from the same fund house. For investors who were ruing the fact that they didn't book profits when markets peaked in January 2008, only to see the value of their investments plummet subsequently, these NFOs struck a chord.

Here's a thought - is it prudent for mutual funds to book profits for investors or is that something investors should be independently dealing with after taking into account factors like their individual financial goals, the investment scenario and the performance of their investment portfolio as a whole. Also, let's not forget that regularly 'booking profits' for every individual investor at a fund level, just might force the fund manager to prematurely sell some quality stocks from his portfolio. This in turn, could be detrimental to the long-term interests of the fund.

But given the receptiveness shown by investors, fund houses were only more than happy to launch a slew of 'target return' funds. Some introduced the facility to book profits in their existing funds. Of course, the fact that even after booking profits, (on account of transfer of profits booked into a debt fund) there is no fall in the AUM of the fund house doesn't hurt the latter's cause. Rest assured, with the markets moving northwards at a brisk pace, it's only a matter of time before a number of NFOs hit the markets.

What investors must do
Given that fund houses have failed to distinguish themselves, it is fair to state that investors would do well not to blindly follow them while making investment decisions. Going forward, fund houses will try to entice investors by making them believe that all is hunky dory and now is the time to get invested lock, stock and barrel. Can't blame them, it's the AUM that translates into income for them. Hence, higher the AUM i.e. more investments made by investors, the better it is for fund houses.

On the other hand, investors need to be a lot more pragmatic. They should not get carried away by all the hype being whipped up by fund houses. Instead, they should use the downturn and despondency that they witnessed and experienced not too long ago, to make a fair evaluation of their risk-taking ability. This can help them determine what portion of the investment portfolio should be allocated to mutual funds. While no one would dispute the ability of well-managed mutual funds to add value to investors' portfolios, there is certainly a need to guard against making investments in a reckless manner.

Do your mutual funds stand the test of character?

'In times of adversity, true character is revealed' - that's an adage relevant not only to humans, but also investment avenues like mutual funds. Any analyst worth his salt will vouch for the fact that in rising markets, it is hard to distinguish the men (proven and invest-worthy funds) from the boys (also-rans). Buoyed by conducive market conditions, even mediocre funds can deliver an extraordinary performance. Often the mantra is - take on above-average risk and ride the wave.

But when the tide turns (as it has over the past 12-14 months), a fund's mettle is truly tested. The last few months have been particularly interesting. With the markets hovering around the 8,000-point mark, despondency had all but set in. And then came an uptick that took everyone by surprise. Speculation regarding 'the worst being over' and 'the commencement of a recovery' was doing the rounds. But alas, the victory celebrations seem to have been interrupted by the impending election results and the possibility of another hung parliament.

If you are an investor, it can be safely stated that these aren't happy times. The uncertainty is certainly not helping. But all is not lost. On the contrary, this is an opportune time to evaluate your mutual fund portfolio.

The evaluation needs to go beyond the obvious i.e. how a given fund fared on the downside. Sure, the latter is important and will play a significant part in the process. However, an equally vital evaluation will pertain to identifying the fund's 'true character'.

Each fund has a professed investment style; in mutual fund parlance, this is referred to as the fund's positioning. Say Fund A in your portfolio may be positioned as a mid cap fund. Now is the time to determine if the fund manager has walked the line and adhered to the stated investment style i.e. irrespective of the market conditions, does the fund continue to be invested in mid cap stocks in line with its investment objective/positioning.

There will be a case for raising a red flag if you come across the professed mid cap fund making substantial investments in the large cap segment, simply because the latter has been less impacted during the downturn.

Then there are funds which state that they will be fully invested at all times i.e. they will refrain from taking cash calls. This investment style often flows from the philosophy that fund houses are custodians of investors' monies for investment purpose as opposed to holding cash (making investments in current assets).

The red flag scenario: A fund house which believes in holding portfolios that are fully invested at all times, performs a volte-face and holds a substantial portion of its portfolios in cash to minimise the brunt of falling markets.

Hybrids i.e. balanced funds and monthly income plans (MIPs) are often referred to as tools of asset allocation, on account of investments in both equities and debt. Theoretically, by diversifying across asset classes, hybrids are better equipped to safeguard the investor's interest when a given asset class hits a rough patch. When equity markets run into rough weather, a balanced fund can score over a conventional equity fund on account of its debt holdings.

Now is the time to find out if the hybrids in your portfolio are playing their part as required. Failing to do so (say a balanced fund that insists on being largely invested in equities akin to a conventional equity fund) defeats the purpose of investing in a hybrid.

Why it is vital to conduct the aforementioned exercise
Wondering why it is vital to conduct the aforementioned exercise (incidentally, the above list is not a comprehensive one; these are some among several tests that can reveal a fund's true character). Another question could be that some of the 'red flag' scenarios were aimed at protecting investors' interests. Hence the same should not be held against the fund house. Here's why this argument doesn't hold good.

A fund is not an 'end', it is simply a 'means' to achieve an end. In other words, the fund should find place in a portfolio because it can play a specific part. And the part played by the fund is inextricably linked to its nature/unique characteristics. Should the fund deviate from its defined character, there's a fair chance that the portfolio might fail to deliver on expected lines and in turn, the investor may fail to achieve his financial goals.

What you must do
As an investor, you must ensure that you are invested in funds that have a defined character and a reputation of not having deviated from the same. Furthermore, once the investments are made, a review of the funds' performance (including adherence to their stated investment style) must be made. The financial planner/mutual fund advisor will have a critical role to play in the review process; expectedly, the same must be conducted on an ongoing basis over a period of time. The advisor will be equipped to distinguish minor aberrations from significant deviations. And given the challenging investment scenario we are faced with at present, the resolve of even the most resolute fund houses and fund managers is likely to be tested. Hence, the importance of conducting a thorough review now!