What is Closed End Mutual Fund? Types of Investments in Closed-End Funds & Who Should Invest in it?

Closed-end mutual funds are a specific type of mutual fund with a fixed tenure and a set number of units. These funds cater to investors looking for structured investment options with clear timelines and professional fund management.

Unlike open-ended funds, closed end mutual funds lock in investments until maturity, making them ideal for investors who prefer a disciplined approach to wealth creation. Let’s explore closed-end mutual funds, their features, benefits, and how you can invest in them.

What are Closed-Ended Funds?

A closed end mutual fund is a mutual fund that issues a fixed number of units during its New Fund Offer (NFO). Once the subscription period closes, these units are traded on stock exchanges, and the fund operates with a predefined maturity period. These units are made available to investors during a New Fund Offer (NFO).

Once the NFO concludes, no new units can be issued, and existing ones can only be traded. These funds have a pre-determined maturity period, and investors can redeem their holdings only at the end of this tenure.

Example: SBI Long Term Advantage Fund Series I – Closed-End Mutual Fund

SBI Mutual Fund, launched a closed-end scheme called SBI Long Term Advantage Fund Series I. During the New Fund Offer (NFO), the company issued 1 lakh units priced at ₹10 each, raising ₹10 lakh.

Post-Subscription and Listing

Once the NFO subscription closed, these units were listed on the stock exchange, making them available for trading. Investors can now buy or sell these units on the exchange, and their prices fluctuate based on market demand and supply dynamics, similar to how stocks trade.

Maturity and Investment Period

The fund has a maturity of 10 years with at least 3 years of fixed investment, meaning investors are committed until 3 years unless they sell units on the secondary market. At the end of maturity, the fund redeems the units based on the NAV (Net Asset Value) at that time.

For example, if the NAV grows to ₹44.41 per unit, investors who held on to their units since the NFO will earn a substantial capital appreciation compared to the original ₹10 issue price.

As of December 30, 2024, the NAV of SBI Long Term Advantage Fund Series I – Direct Growth is ₹44.40, marking a strong return trajectory. The fund has delivered:

• 1-year return: 26.13%
• 5-year CAGR: 25.41%

Selling Units and Secondary Market Dynamics

While holding until maturity provides tax-saving benefits under the ELSS category, Investors seeking liquidity can sell their units on the stock exchange. However, secondary market prices may differ from the NAV due to supply-demand factors. For instance, during a bullish market phase, units could trade at a premium to NAV, while bearish conditions might lead to discounts.

Consider an investor who bought 1,000 units during the NFO for ₹10,000. After two years, the NAV has grown to ₹44.41. If the investor decides to sell on the exchange at ₹45 per unit, they realise a profit of ₹35,000, excluding transaction costs. Alternatively, if held until maturity, the final NAV will determine the actual gains.

This example illustrates the operational mechanics and potential benefits of investing in closed end mutual funds like SBI Long Term Advantage Fund Series I.

Pros and Cons of Closed-End Mutual Funds

Closed-end mutual funds come with their own set of advantages and drawbacks, making it essential for investors to evaluate both sides before making an investment decision.

Pros of Close-Ended Mutual Funds

• Realisation of Long-Term Goals: Closed-end funds are structured for investors with long-term objectives. The locked-in nature ensures investments remain undisturbed, aligning with disciplined financial planning.
• Potential for Capital Appreciation: Units of closed-end funds are traded on stock exchanges, and their prices may rise due to high demand, offering capital gains to investors.
• Liquidity Through Stock Exchange: Although units cannot be redeemed directly with the fund house, they can be bought or sold on stock exchanges, providing an alternative form of liquidity.
• Professional Management: These funds are actively managed, allowing fund managers to deploy stable assets towards high-growth opportunities.

Cons of Close-Ended Mutual Funds

• Lack of SIP Option: Lack of SIP Option: Closed-end funds require lump-sum investments during the NFO period. This increases the initial financial burden on investors, making it less flexible compared to open-ended funds that allow small periodic investments. Investors who prefer periodic investing might consider alternatives and can estimate returns with the HDFC SIP Calculator.
• Dependence on Fund Managers: The performance of a closed-end mutual fund is significantly tied to the fund manager’s decisions. If the manager’s strategies fail to adapt to changing market conditions or their expertise does not align with the fund’s objectives, it can adversely impact returns. This reliance can make investors vulnerable to the fund manager’s judgment and decision-making skills.
• Market Risk: The prices of closed-end fund units fluctuate based on market demand and supply. During periods of low demand, the market price may fall below the NAV, leading to potential losses for investors who trade their units before maturity.

Types of Investments in Closed-End Funds

Closed-end funds can cater to diverse investment preferences, focusing on either bonds or equities.

1. Bond Closed-End Funds

These funds primarily invest in bonds, making them less risky but susceptible to interest rate fluctuations. For example, rising interest rates may reduce the market value of the bonds the fund holds.

2. Equity Closed-End Funds

These funds invest in stocks and are subject to market dynamics. The fund’s value depends on the performance of the underlying companies and broader market conditions.

How to Invest in Closed-End Funds?

Investors can subscribe to closed-end mutual funds during the NFO period. Here’s how:

• Through Stock Exchanges: Investors can purchase units during the NFO period or trade them on exchanges after listing. To invest:
  • Open Demat account and trading account.
  • Search for the closed-end fund units listed on the stock exchange.
  • Place a buy order at the desired price.
  • Use the SIP Calculator to plan your investment amounts for different time horizons.
• Directly Through AMCs: Visit the AMC’s website during the NFO period. Complete the application form, submit KYC documents, and transfer funds online.

Features of close-ended funds

These funds possess distinctive characteristics:

How do Close-Ended Funds Work?

Closed-end funds operate through a structured investment lifecycle, which includes three key stages:

• Subscription Stage (NFO): During the New Fund Offer (NFO), investors can subscribe to the fund at a fixed price, typically ₹10 per unit. For instance, the ICICI Prudential Fixed Maturity Plan launched its NFO in 2020, offering units to investors looking for a secure, long-term investment option.
• Trading Stage (Market Listing): After the NFO closes, the fund’s units are listed on stock exchanges, allowing investors to buy or sell at market prices. These prices fluctuate based on demand and supply. For example, an investor who subscribed to a closed-end equity fund at ₹10 might see the market price rise to ₹15 during a bullish phase, offering potential capital gains.
• Maturity Stage (Redemption): At the end of the fund’s tenure, investors can redeem their units at the prevailing NAV. This ensures that they receive the fair value of the fund’s underlying assets. For instance, if the NAV of a bond fund is ₹12 at maturity, investors will receive this amount per unit.

Closed-End Mutual Funds vs Open-End Mutual Funds

Here is the difference between close-ended and open-ended mutual funds.

Example of Closed-End Mutual Funds

Note: NAV as of December 30, 2024

Evaluate Closed-End Funds Before Investing

When considering closed-end funds, it’s essential to evaluate multiple aspects to make an informed decision:

1. Risk-Adjusted Returns: Analyze the potential returns of the fund against its risk level. For example, an equity-oriented fund may offer higher returns but comes with increased volatility.
2. Asset Allocation and Portfolio Quality: Look at the fund’s asset composition. A diversified portfolio minimizes risks, while concentrated investments in a single sector may lead to higher volatility.
3. Fund Manager’s Performance: Examine the historical performance of the fund manager with similar schemes. Consistent returns indicate a strong understanding of market dynamics.
4. Peer Comparison and Benchmarking: Compare the fund’s performance against its peers and benchmarks, such as the Nifty 50 or S&P BSE Sensex.
5. Tax Implications: Understand the tax treatment of gains from closed-end funds. Long-term capital gains (LTCG) in equity funds are taxed differently than debt funds.
6. Cost of Investment: Review the expense ratio of the fund. A high expense ratio can eat into returns, especially in funds with moderate performance.

A Mutual Funds Return Calculator can help estimate expected returns based on various assumptions.

Who Should Invest in a Closed-Ended Mutual Fund?

Closed-end funds are not for everyone. They cater to specific investor profiles:

1. Long-Term Investors: Investors with a horizon of 3-5 years or more benefit the most, as these funds are designed for long-term wealth creation.
2. Sector-Specific Enthusiasts: Those seeking exposure to niche sectors, like renewable energy or infrastructure, can use closed-end funds to gain targeted exposure.
3. Disciplined Investors: The lock-in period ensures that investments remain intact, making these funds suitable for investors who might otherwise be tempted to withdraw prematurely.
4. Risk-Tolerant Investors: Market volatility can impact fund prices significantly. Investors with the ability to tolerate these fluctuations and wait for maturity find these funds beneficial.

Reasons to use closed-end funds in your portfolio

Closed-end funds offer distinct advantages that make them a strategic addition to investment portfolios:

• Focused Investment Opportunities: Closed-end funds often target specific themes, such as green energy or emerging markets, allowing investors to align their portfolios with these trends.
• Diversification: These funds provide exposure to diverse asset classes, including bonds, equities, and hybrid instruments, helping to balance overall portfolio risk.
• Price Opportunities in Secondary Markets: The trading of units on stock exchanges allows investors to capitalise on price differentials, buying at a discount to NAV during bearish phases.
• Structured Approach: The predefined maturity period encourages disciplined investing and provides a clear roadmap for financial goals.
• Access to Professional Expertise: Fund managers bring their expertise in asset allocation and market timing, which can be particularly valuable for novice investors.
• Potential Tax Advantages: Depending on the fund type and holding period, investors may benefit from favourable tax treatments compared to other investment options.

What is the Taxability of close-ended mutual funds?

The taxation of capital gains from closed-ended mutual funds is determined by their holding period and asset allocation.

Recent updates in the Union Budget 2024-25 have introduced new tax structures, making it important for investors to understand these changes before investing in or redeeming mutual fund units.

Here’s a detailed breakdown of the updated tax treatment for equity, debt, and hybrid funds.

Taxation of Equity Mutual Funds

Short-Term Capital Gains (STCG)

If equity mutual fund units are held for less than 12 months, the gains are categorised as short-term capital gains. The latest budget has increased the STCG tax rate from 15% to 20%, making short-term equity investments more expensive for investors.

Long-Term Capital Gains (LTCG)

For units held for over 12 months, the gains qualify as long-term capital gains. Recent changes include:

• Tax-Free Limit: Gains up to ₹1.25 lakh annually are now tax-free, an increase from the earlier ₹1 lakh limit.
• Revised Tax Rate: Gains exceeding ₹1.25 lakh are taxed at 12.5%, up from the previous 10%.
• Removal of Indexation: The benefit of indexation, which allowed investors to adjust purchase prices for inflation, has been removed. This means the entire gain is taxed without any inflation adjustment.

Taxation of Debt Mutual Funds

Short-Term Capital Gains (STCG)

Debt fund units held for less than 36 months fall under short-term capital gains and are taxed as per the investor’s applicable income tax slab. This remains unchanged in the updated tax regime.

Long-Term Capital Gains (LTCG)

For debt fund units held for more than 36 months, the following changes have been introduced:

• Revised Tax Rate: LTCG is now taxed at a flat rate of 12.5%, up from the earlier 10%.
• No Indexation Benefit: The removal of indexation means that gains are taxed on the full amount without accounting for inflation.

Additionally, mutual funds with over 65% debt allocation are now considered long-term investments after a reduced holding period of 24 months. These funds will continue to be taxed according to the investor’s slab rate for short-term gains and at 12.5% for long-term gains.

Things to consider before investing in close-ended mutual funds

Investing in closed-end mutual funds requires careful consideration due to their unique structure and characteristics. Here are the key factors to keep in mind:

• Fund Objectives and Strategy: Understand the investment goals of the fund. Closed-end funds often focus on specific themes or sectors, like infrastructure or emerging markets, which may or may not align with your financial objectives.
• Lock-In Period and Liquidity Constraints: Closed-end funds come with a fixed lock-in period, during which redemption is not allowed. While secondary market trading provides some liquidity, prices can be volatile and may not reflect the Net Asset Value (NAV).
• Market Conditions: Assess the broader economic and market conditions before investing. For instance, a fund focusing on equity might perform better in a bullish market, while a bond-oriented fund might be ideal during economic downturns.
• Fund Manager’s Expertise: Since closed-end funds rely heavily on the fund manager’s strategies, review their past performance and experience. A skilled manager can optimize returns despite market challenges.
• Exit Strategy: Plan for redemption or secondary market trading well in advance, considering price fluctuations and tax implications.

Conclusion

Closed-end mutual funds represent structured investment vehicles offering focused exposure to market opportunities. Understanding their features, benefits, and limitations enables investors to make informed decisions aligned with their financial objectives. While these funds require longer commitment periods, they provide professional management and strategic market access through their fixed-tenure structure.