Imagine you’re a research analyst evaluating a potential investment in a fixed maturity plan (FMP). The FMP is structured as a close-ended scheme with a 5-year tenure. A client, perhaps an individual who participated in our discussion on the “PASS Investment Adviser (Level 2)” workbook, asks about the liquidity if they needed to exit after just six months. Your immediate thought should turn to the fund’s structure: open-ended versus close-ended.
This distinction is paramount when assessing an investment’s liquidity, as it dictates how easily and at what price you can redeem your investment.
Open-ended funds, like most mutual funds in India, allow investors to buy or sell units on any business day at the prevailing Net Asset Value (NAV). This continuous offering mechanism provides high liquidity, as the fund house is obligated to redeem your units. In contrast, close-ended funds have a fixed maturity period and issue a limited number of units during their initial offering period.
While they can be traded on stock exchanges like shares, their liquidity is often significantly lower, depending heavily on market demand and supply for those specific units. This can lead to trading at a discount or premium to the NAV.
For an investment like the 5-year FMP mentioned, being a close-ended product, the investor faces a critical liquidity challenge if they need to exit prematurely. Unlike an open-ended fund where redemption at NAV is guaranteed, exiting a close-ended fund before maturity typically involves selling units on the secondary market. The price you fetch will depend on buyer interest, which can be scarce for a specific FMP, especially if it’s a niche product or if market conditions are unfavorable.
This means the investor might have to accept a significant discount to the NAV or may struggle to find a buyer at all, leading to a substantial loss of capital beyond any market fluctuations.
Therefore, when evaluating investment alternatives, the first step after understanding risk and return is to ascertain the liquidity profile. Is it an open-ended scheme offering daily redemption, or a close-ended product with limited exit options before maturity? This knowledge directly impacts the suitability of the investment for clients with varying liquidity needs. A client requiring access to funds within a short timeframe would find a close-ended product with a long lock-in period, like the FMP in question, highly unsuitable, regardless of its projected returns.
Nuance
Check Your Understanding
An investor holds units in a close-ended equity fund with 3 years remaining until maturity. The fund is currently trading on the exchange at a 10% discount to its NAV. If the investor wishes to exit immediately, what is the most likely outcome regarding their capital realization?
Which of the following investment products generally offers the highest liquidity for an investor seeking to exit within a week?
This is a companion read for Section 19.2 — Attribute portfolio performance and Evaluation of investment alternatives from PASS Investment Adviser (Level 2) by Akhilesh Gururani, available on Amazon Kindle.
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