Last Updated on July 10, 2019 by Gopal Gidwani
As investors, we want the best returns on our investments. Moreover, if you are a fixed income investor and your risk tolerance is low, returns become an even more sensitive subject.
Mutual funds are an attractive investment option to grow your wealth. When you decide to invest in mutual funds, you come across three broad types of mutual funds – equity funds, debt funds and hybrid funds. In this article, we are going to talk about debt funds and its categories.
For new investors who do not know what are debt funds, these are a type of mutual funds that invest in fixed-interest generating securities. These include corporate bonds, government securities, treasury bills and other money-market instruments.
When we invest in debt funds, they can either be open-ended or closed-ended. Read on to know more in detail.
What are Fixed Maturity Plans?
Fixed Maturity Plans (FMPs) are an example of closed-ended debt funds. A closed-ended fund collects money from investors through a New Fund Offer and locks it for a fixed tenure. This period can be as short as 1 to 3 months or as long as 3 years or more. Closed-ended funds are available for purchase and redemption only for a brief interval. On the other hand, an open-ended debt fund is available for investment and redemption throughout the year.
How are open-ended debt mutual funds better than FMPs?
Let us look at the factors which make open-ended debt funds a better choice than FMPs.
- FMPs defy the logic of mutual funds. This is how: Based on the tenure of the FMP, a fund manager can invest in multiple fixed-income instruments in a manner that they all mature around the same time. This gives investors an indicative rate of return of their investment plan. However, a mutual fund is a market-linked product. It provides market returns, and they can never be predictable. If the FMP gives investors the impression that the returns are predictable, it defies the very essence of the market-return product by creating a false sense in the minds of investors.
- When you invest your money in a FMP, the money gets locked for a fixed tenure till the plan matures. Even though stock exchanges list these FMPs, their trading volumes are very low. In reality, there are hardly any trades that take place on those FMPs. Thus, there is almost no liquidity once you decide to invest in an FMP. Even if you need the money, you may not have the option to withdraw it.
- Another area where open-ended debt funds perform better than FMPs is portfolio risk. If you invest in an open-ended debt fund and the portfolio suffers inadvertently, you can take corrective action immediately since the mark to market happens quickly. However, for FMPs, even when you invest in the same fund house with the same underlying securities, you would not be able to take any corrective action. This is because the asset management company does not mark to market immediately.
- Since FMPs come with a short interval for purchase and redemption, they have a brief window period to get the papers and bonds matching the maturity of the FMP. This can result in a skewed portfolio. For example, an open-ended mutual fund scheme does not hold more than 2% to 3% of a single security. But for FMPs, the holding in an individual security can go as high as 25%.
Conclusion
The bottom line is, FMPs are closed-ended debt funds, which can give an indicative return by matching the investment profile of the fund with the maturity period of the FMP. However, open-ended debt funds are available for redemption and investment throughout the year. This is unlike FMPs, which are only available for a specified interval.