How to make smart money with close-ended equity fu

Generally speaking, investing in the New Fund Offers of close-ended equity funds does not make a very prudent investment decision (assuming, of course, that there are similar open-ended funds available as alternative choices). This is so because:

• Market valuations are not cheap and hence one can expect high volatility, even though the long-term India growth story may still be attractive. In close-ended funds it is not possible to do SIP, which is a very important investment strategy today to reduce the volatility risk.
• If need be, you cannot easily exit. Either such close-ended funds trade at a discount if listed on the stock exchange. Or if AMCs offer exit through repurchase, it is available only on few select days in a year and at a high exit-load.
• In NFOs one ends up paying a higher cost vis-à-vis investing in a 3-5 year old similar fund.
• Further in NFOs, one doesn't have the benefit of assessing the past track record. While, this is no guarantee of future performance, it has generally been observed that poor-performing funds usually turn out poor performance in future too. So at least one knows which funds are NOT worth investing.
• Fund managers have done a great job of managing open-ended funds, despite the uncertainty of inflows & outflows. So the logic that a fund manager gets a chance to take a long-term view and give better performance may not always be true.

The disadvantage of close-ended funds, however, can be turned into a smart moneymaking strategy. Let's see how.

This strategy can work for the close-ended funds, which are listed on the stock exchange. As mentioned above, such funds usually trade at a discount to their respective NAVs.

While presently very few close-ended funds such as Morgan Stanley are listed, more such funds are expected to be listed as AMCs are nowadays launching mainly close-ended NFOs.

Let's take the case of Morgan Stanley Growth Fund. This is a typical well-diversified close-ended equity fund due for redemption in Feb 2009 at the then prevailing NAV. It has about 70-75% exposure to large caps and balance in mid/small caps. In terms of sectors, it is predominantly invested in technology, construction, financial services and basic industries. 

Similar funds in the open-ended category include HDFC Equity, HDFC Tax Saver, Fidelity Equity, Franklin India Flexicap, Reliance Equity Fund, Reliance Equity Opp. Fund and Templeton India Equity Fund amongst many others.

Now suppose you want to invest in a well-diversified equity fund, you could either invest in the Morgan Stanley fund or the normal open-ended funds. One can expect similar growth in their NAVs as they are similar funds.

The last 6-month, 1-yr, 3-yr and 5-yr returns from Morgan Stanley were 12.35%, 1.4%, 32% and 34% respectively (as on Apr 9th). As against this the average returns from some of the above-mentioned open-ended equity funds were 15%, 8%, 38% and 40% for similar periods.

Let's say the markets remain static for next 2 years and don't give any returns. In which case your return from the normal open-ended equity fund would be zero, but you would make Rs.5.41 per unit returns on the Morgan Stanley units (Rs.48.26 - Rs.42.85, which is and NAV - Market Price on Apr 9th) i.e. about 12.6% returns even when the market is flat.

Or let's say the market crashes by 10%. While, you will lose 10% in the open-ended equity fund, you will still make a profit of about 1.36% on your Morgan Stanley units. (In fact, unless the markets crash by about 11.2 % you will not lose money; in effect you have a kind of capital protection to that extent). (Note: For simplicity sake I have just calculated the absolute returns and not the annualized returns.)

On the upside, of course, you will in all probability make some additional gains from Morgan Stanley units since you bought them at a discount.

The assumption here is that the Morgan Stanley fund will deliver similar returns like any other open-ended equity fund. Given the past record, this is not at all an unreasonable assumption.

In fact, even with some underperformance, you will still make more money from Morgan Stanley units. In fact, the gains will be still higher as the entry load in a normal open-ended equity fund is 2.25%, whereas the brokerage rates at which you can buy Morgan Stanley units on the stock exchange will be around 1% or maybe even lower.

The only thing important point to keep in mind here is that you must have the investment horizon to hold the units till maturity. If you want to exit in between, you may not make any money as you too will have sell at the discount.

Of course, it goes without saying, that for any type of fund one should do an SIP rather than one-time investing to reduce the volatility risk.

The author is an investment advisor and promoter of wealtharchitects.in. He can be reached at sanjay.matai@moneycontrol.com