Profit from discounts in closed-end funds
They are sometimes available on the exchanges at a discount of 30-40 per cent to their net asset value
In India, closed-end mutual funds are much less popular than their open-end counterparts. That’s because it is difficult to exit these funds in case an investor needs money in the middle of the fund’s tenure. While the lack of liquidity in these funds can be a bane for existing investors, it can spell opportunity for others willing to grab the opportunity and buy these units.
Mutual funds are either open-end or closed-end. The former are open for investment and redemption from the mutual fund house at all points of time and can exist for perpetuity. Closedend funds, on the other hand, exist for a specified time period that is usually announced at the time of their launch. Since they have a specific tenure, fund houses do not buy and sell units in these funds on a regular basis. To ensure that the investor does not have liquidity problems, the units are listed on the stock exchanges. This may seem to be a good thing but it comes with its own set of problems. Liquidity woes Existing investors who want to liquidate their units in a closed-end mutual fund before the end date need to go to the stock exchange and trade their units with some other investor who is willing to buy them. This may look like a simple task as most investors are familiar with stock trading. But, there are two problems that investors end up facing. The first is that it often takes a long time to get rid of the units as there are very few investors willing to buy them. Hence, traded volumes tend to be low in these funds.
The other more acute problem is that the investor usually gets a value that is far lower than the net asset value (NAV) of the fund. Ideally, these funds should trade on the exchanges at around the NAV. But in many cases, they trade at a discount to the NAV, which could be as high as 30-40 per cent. This is a huge figure and can take a toll on the plans of the investor who would end up getting a far lower amount from the sale than he had anticipated. Opportunity for buyers? What is a problem for one investor can be an opportunity for another. A buyer of these mutual fund units can make a killing in these circumstances. All that he needs to do is buy the units at a discount and then wait till the end of the tenure when the market price of the units converges with the net asset value. While this may seem like a simple strategy that anyone can execute, it is not so, and many slip-ups can happen between the purchase of the units and the end date.
The most common reason due to which calculations go awry is that the markets can tumble and the value of the fund can take a knock. The investor would want to earn a return from the fund’s performance and not just benefit from the discount on the fund. If the NAV of the fund declines, the investor would find that at the end of the day he does not have much returns to show for his efforts. The only consolation is that since the units were bought at a discount to the NAV, the investment enjoys a cushion. Despite the fall in the value of the fund, the investor may not end up making a loss.
Many investors do not look at the market situation or the fund’s portfolio when investing in these funds. They focus exclusively on the discount, which is not the right way to go about investing in these funds in the secondary market. Being alert and looking at all relevant details can save the investor a lot of anguish later on.
Often, the date of maturity is a long way away, and this has the potential to distort the picture for the investor. If he focuses only on the absolute return, he might not give adequate importance to the time value of his money. To get a better picture for periods of more than one year, he needs to consider the annual return from the fund. Take an example. Suppose that there are three years to go before the fund’s tenure comes to a close. The investor ends up with a total return of 20 per cent over this period. The absolute return figure may look high, but when it is converted to annual return, the investor may not feel too happy about the fund’s performance. Locked in Many investors looking at closedend funds do not take the time period of the investment into account. They expect quick returns. But this may not happen if the fund’s tenure ends after a time. In that case, they may have to settle in for the long haul. The gap or the discount will close only on the end date, though it will begin to narrow as the date approaches.
The higher the discount, the greater the chance that the time to maturity is a long way away. Investors need to factor in the lockin. If they do not do so and they require their money, they will find it difficult to exit these funds quickly. The same issue of discount that they saw as an opportunity earlier will now become a bane for them as they are the ones now trying to offload their units on the exchange.