In the last one year mutual funds have rediscovered closed-ended schemes. Closed-ended schemes as the name suggests are essentially schemes in which an investor can invest only during the new fund offer period.

After the new fund offer period of the scheme is over no money can be invested into the scheme. Other than this the investor can only exit the scheme at certain longish intervals like once every quarter or six months.

The general logic given when launching a closed-ended scheme is that the closed-ended structure helps the fund manager take a long-term call on stocks. In an open-ended scheme there is constant danger of investors opting out of the scheme.

When investors opt out of a scheme money has to be paid to them. This money is paid by selling stocks that the fund manager has already invested in. Given this danger of investors opting out of an open ended scheme the fund manager has to deploy money in liquid stocks.

Liquid stocks are usually large cap stocks where the chances of appreciation are not huge. So if the fund manager has to generate better returns he has to invest in small- and mid-cap stocks, where the chances of appreciation are usually better.

The danger in case of small- and mid-cap stocks is that they do not have great liquidity, i.e. exiting these stocks at times can be a problem. Since closed-ended schemes have an exit option every quarter or six months, there is usually less redemption pressure and, hence, the fund manager can take a long-term call on mid- and small-cap stocks. The investors thus can hope to earn greater returns.

But a lot of closed-ended schemes launched during the course of the last one year are not really closed-ended as far as exiting the scheme is considered. Some of these schemes have a daily, weekly or a monthly exit option. This makes them very similar to an open-ended scheme which one can exit at any point in time.

Hence the bogey of fund managers being able to make a long-term call on small- and mid-cap stocks if the scheme is closed-ended, really doesn't hold these days. Hence why are closed-ended schemes so popular with mutual funds?

There are two reasons for the same.

1. In case of a closed-ended scheme, the mutual fund can get the investors to pay the initial issue expenses that it incurs towards launching the scheme. Initial issue expenses are the money that goes towards marketing, advertising, printing, registrar expenses, bank charges, et cetera while launching a new scheme.

In a closed-ended scheme a mutual fund is allowed to charge initial issue expenses of up to 6% of the amount raised to the investor.

What this means in simple English is that if the mutual fund is able to raise Rs 1,000 crore (Rs 10 billion) in a scheme then the mutual fund can charge the investors investing in the scheme up to Rs 60 crore (Rs 600 million) to meet its initial issue expenses.

Hence, all the cost of launching a new scheme is borne by the investor. What this also means is that a lesser amount of money gets actually invested.

The mutual fund does not need to spend a single penny from its own pocket. This also helps the mutual fund offer greater commissions to its distributors to give them an incentive to push the new scheme more than what they normally would.

This is the real reason behind launching closed-ended schemes.

In an open-ended scheme, the mutual fund is not allowed to charge the initial issue expenses to the investor. It is only allowed to charge an entry load which can go up to a maximum of 7%. But these days due to competition among mutual funds, the entry load is largely 2.25% and it is highly unlikely that any mutual fund will be able to charge more.

So mutual funds prefer to launch closed-ended schemes in which the investor bears the expenses of launching it.

2. Other than this, regulation now requires trustees of a mutual fund to certify that the scheme being launched is different from the schemes that the fund house already has on offer.

Given this, the fund house cannot just launch a scheme similar to an existing scheme by giving it a different name. So the easiest way to get around the problem of a scheme being similar to an existing one is to make it a closed-ended scheme.

Investors should thus stay away from closed-ended schemes. With a high-charge structure, a lesser amount of money is invested. Other than this it is not possible to invest in a closed-ended scheme through the systematic investment plan route, which is the best way to invest for the retail investor.