While a case has generally been made for investing in closed-ended mutual funds allowing fund managers to be better able to manage fund inflows and outflows, Morningstar says that it may not be a sweet deal for the investors. Traditionally, the argument in favour of investing in closed-end funds is straightforward– the fund managers can operate their assets at full capacity given the stability. “The closed-end structure allows them to work with a stable pool of capital. Huge inflows would lead to the issue of cash deployment, a problem if valuations are steep,” Morningstar elaborates on this premise.
Notably, in case of an open ended fund, sudden outflows may result in the manager disposing off stocks he would rather hold. Further, a fund manager in an open-end fund is at times forced to buy or sell securities at inopportune times. “In a closed-end fund, since the investment horizon of the investor and fund manager are in sync, the fund manager will not have to contend with such a situation,” the report said.
However, despite the advantages of a close-ended fund, Morningstar points out that when stocks are available at great bargains, there are no inflows which will allow the fund managers to pick them up, unless they sell some of their existing holdings.
According to Morningstar’s report, the 3-year returns of closed ended funds don’t compare too well with their open-ended counterparts. “Since nothing speaks better than numbers, we checked to see if performance puts them in the bargain bin. Apparently, not,” says the report. A quick glance revealed that for Closed-ended ELSS funds, the peer group average came out to 13.9% as compared to open ended funds’ 15.01%. Similarly, in the small and midcap space, closed ended funds average 16.15% as compared to open ended peer average of 21.52%.
The bottomline, choose open-ended funds. “Invest in open-end funds after comprehending their investment philosophy. Ensure that they stick to their investment mandate. Look for track records, of the fund as well as the fund manager,” advises Morningstar.
However, investors can buy closed-end funds when the market is in the doldrums. “This sounds viable since your fund manager will pick up stocks trading way below their intrinsic value. But you bear the risk of assuming the market will be better placed when its redemption time,” says the report.