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What is Close Ended Mutual Fund – Feature & Tax Gains on Close Ended Funds

How do close ended mutual funds work? Read this guide on close ended fund schemes with detailed breakdown, working, advantages & their taxability.

Mutual funds offer various products to investors depending on their needs. Some investors prefer to invest in a lump sum rather than a systematic investment plan (SIP). Then many investors prefer to stay invested in the scheme for the long term. Close-ended mutual funds are a good choice for such investors. In this article, we will understand what is a close ended mutual fund, its features, and taxation.

What is a close ended mutual fund?

A close-ended mutual fund is open to subscription for investors only during the New Fund Offering (NFO) period. The fund manager invests the money collected during the NFO as per the scheme objectives. The investors are allotted the scheme units in proportion to their investment. The fund has a fixed duration, usually 3-7 years, during which an investor cannot redeem their investment with the fund house. The scheme assets are liquidated on maturity, and the money is returned to investors.

How do close end mutual funds work?

After the NFO closes, the scheme units are listed on the stock exchange. While an investor cannot redeem the scheme units with the AMC, they have a choice to sell them to another investor through the stock exchange. The scheme regularly declares the net asset value (NAV) of the units. The units may be traded either at NAV, a premium, or a discount on the stock exchange.

If there is heavy demand for the scheme units, an investor may be able to sell their units at a price higher than the NAV (premium). If there are very few buyers for the scheme units, an investor may have to sell their units at a price lower than the NAV (discount).

Advantages of close ended mutual funds

Some of the advantages of close-ended mutual funds include:

  1. Good returns: A close-ended fund manager doesn't face redemption pressure during the scheme's tenure. Hence, they can take long-term bets and stay invested till the investment theme plays out and creates maximum wealth for investors.
  2. Liquidity through stock exchanges: While the scheme doesn’t allow redemptions during the scheme tenure, its units are traded on the stock exchanges. So, if some investor needs to sell their holdings, they can sell them to another buyer through the stock exchange.

Disadvantages of close-ended mutual funds

Some of the disadvantages of close-ended mutual fund schemes include:

  1. SIP option is not available: An investor can invest in a close-ended scheme only during the New Fund Offering (NFO). At the time of NFO, the investor has to invest a lump sum amount. The systematic investment plan (SIP) mode is not possible in a close-ended fund.
  2. Long lock-in period and low liquidity: The scheme has three to seven years of a long lock-in period. The fund house redeems the units with the investors only on the scheme's maturity. If an investor needs money during the interim period, they have to sell their units through the stock exchange. The liquidity may be low, and the investor may find it difficult to find a buyer. Even if they find a buyer, they may have to sell the units at a discount to the net asset value (NAV).

Who should invest in close-ended mutual funds?

Investors who want to invest a lump sum amount for a long tenure, of say, five to seven years, should invest in close-ended mutual funds. There is a lock-in period with liquidity through the stock exchanges. So, if you want to invest for long-term financial goals such as building a fund for a child's higher education or your own retirement, you may consider investing in close-ended mutual funds.

How to invest in close ended mutual fundsAn investor can only invest in a close-ended mutual fund in the New Fund Offering (NFO). The investor should keep track of the fund house's announcement of NFO dates. Once the NFO opens, an investor can invest in the close-ended fund in a lump sum only. The systematic investment plan (SIP) mode of investment is not possible. If you want to invest post-NFO, you can buy units from an existing investor through the stock exchange.

Returns of close-ended funds

Let us look at the returns given by some equity close-ended mutual fund schemes.

Scheme nameAUM (Rs. crores)1-year3-years5-years
SBI Tax Advantage Fund – Series 330.5650.94%38.92%27.86%
SBI Long Term Advantage Fund – Series II33.7147.15%30.44%20.22%
Sundaram Long Term Tax Advantage Fund – Series II13.0329.66%19.60%15.44%
UTI Master Equity Plan Unit Scheme2,449.727.66%18.19%15.08%
Sundaram Long Term Micro Cap Tax Advantage Fund Series III80.7668.63%22.80%12.93%

(Source: https://www.mutualfundindia.com/MF/return/TopFunds)
Note: The returns are as of 12th Jan 2022. The returns are for direct plans with growth option. The one-year returns are absolute. The three and five-year returns are CAGR.

Taxation of close-ended funds

The taxation of close-ended funds is similar to that of open-ended funds. For taxation purposes, a mutual fund (close-ended) is categorised into two:

  1. Equity funds: A close-ended fund with 65% or higher equity holdings of the total assets.
  2. Debt funds: A close-ended fund that is not an equity fund is taxed like a debt fund

Taxation of close-ended equity funds: If you sell your equity mutual fund units before 12 months, the capital gain will be classified as short-term capital gain (STCG). The STCG will be taxed at 15%. If you sell your equity mutual fund units after 12 months, the capital gain will be classified as long-term capital gain (LTCG). The LTCG of up to Rs. 1 lakh in a year will be exempt. The incremental LTCG above Rs. 1 lakh in a year will be taxed at 10% without indexation benefit.

Taxation of close-ended debt funds: If you sell your debt mutual fund units before 36 months, the capital gain will be classified as short-term capital gain (STCG). The STCG will be added to your overall income and taxed based on your income slab. If you sell your debt mutual fund units after 36 months, the capital gain will be classified as long-term capital gain (LTCG). The LTCG will be taxed at 20% with indexation benefit or 10% without indexation benefit.
To start investing in close-ended mutual fund schemes as per your appropriate asset allocation, download the Glide Invest App from Google Play Store or Apple App Store and get started.

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