and studied. But in case of Pakistan this is still gaining popularity as any extensive research in this area is still needed. The data regarding mutual funds is also available and therefore can help in this study.
The advantages of mutual funds were highlighted in by SIPRA (2006). These are:
The reduction in investment risk due to diversification
Professionally managed by the experts in the stock market
Small investors can hold on to a diversified portfolio by the pooling of investment funds
In the start, mutual funds sector was in the hands of the Government of Pakistan through the National Investment Trust (NIT) and National Investment Corporation of Pakistan (ICP) but due to the bureaucracy that was present in most of the government organizations it could not perform as well as it was expected and then the Funds of ICP were taken in the hands of privatized sector and due to that strong growth was viewed in this era.
Several funds were introduced while the sector started to grow and it also initiated the attraction of investors due to the diversification it created by introducing investment vehicles that were mutual funds. By June of 2008, around 61 mutual funds were listed in the stock exchanges of Pakistan. And as the number of funds continue to grow it also will give path for more research in the time to come.
The research on the mutual funds industry was initially started in the US in 1900 when the impact on capital markets was taken into consideration. The available mutual funds data was used during that time to study this and that resulted in the formulation of the famous capital asset pricing model (CAPM), security market line and other portfolio related theories.
Jensen (1968) evaluated the ability to earn returns that was the result of prediction of security prices higher than the investors expected return on the same risk. He defined alpha. He was actually investigating the emerging efficient market hypothesis and he also wanted to find out if the historical returns of a mutual fund manager specified ability to outperform the market overall. A simple way to do this was to make a comparison of the annual mutual fund returns with the market portfolio returns. But this would not take into account the risk factor. Since in 1964 the Capital assets pricing model (CAPM) was also published by Sharp and it indicated that with the increase in the systematic return (beta) the portfolio’s expected return also increases.
According to the CAPM from one year to other portfolios may underperform or over perform the market randomly. And in the long run the performance of portfolio will then fall on the capital market line or under the capital market line.
So Jensen’s findings suggested that it was not possible with the mutual funds to predict the security prices so well to outperform a simple buy and hold strategy that was employed by any investor. Thus the fund can underperform even when the management fee expenses are not included. Thus the funds were not that much successful to trade that much so that they can fulfill and overcome their expenses like the brokerage expenses. The alpha defined by Jensen measures performance in a linear regression model where alpha is positive when extra returns are earned and vice versa.
The equation is as follows:
The model tells that with a random selection buy and hold policy one should not expect on average to do no worse than alpha=0 means no extra returns. Thus when the alpha is negative it shows that the ability of funds to forecast the security prices is not well enough to cover the research expense, management fee and commission fee expenses.
In 2006 Sipra and in 1965 Treynor worked to find such a portfolio measure that also includes risk and thus introduced the security market line. The security market line defines relationship between portfolio returns and market rates of returns and in it the slope of line measures the relative volatility. This is represented by beta.
Treynor came up with a ration known as Treynor ratio. It measures the returns that are in excess of what could have been produced through an investment that has no diversifiable risk. This measure is:
(Portfolio Return – Risk-Free Rate) / Beta
Here beta is the non diversifiable risk of portfolio, which is found by taking the covariance of the portfolio with the market portfolio and is then divided by the variance of the market return; the higher this ratio, the greater the performance of the portfolio.
In 2006 Sipra used the alpha defined by Jensen to evaluate mutual funds performance in Pakistan from the period of 1995 to 2004. Sipra and Treynor used another measure that was sharp measure. Sharp measure defined as:
This study showed that when on a comparison over ten years of the sharp index values of mutual funds and market portfolio no fund had a performance better than the market portfolio. The funds that had some better performance in the last five years did not have that in the early five years or the overall ten years. Jensen had some ability to beat the market in terms of performance by the funds. Treynor also measured around the same results and so the two measures showed consistency to some extent.
Another study was carried by Shah and Hijazi in 2005 on the mutual funds performance in Pakistan and it showed that the mutual funds industry in Pakistan outperform the market on the overall basis. The beta also showed that very defensive strategy was used in investing in the mutual funds of Pakistan. Sharp ratio and the Jensens alpha showed that some funds underperform and that was because of the lower diversification. If looked on a global scope then the industry witnessed a tremendous growth and which was the result of growth in the maturity of foreign capital markets as well as size of the mutual funds. The study therefore concluded that by mobilizing the savings of the individual investors through diversification i.e. offering variety of funds to invest in will help the mutual funds industry to grow further. It will also help the investors to compare the level of risk and return.
Most of the earlier researches emphasized on the measurement of mutual funds performance by doing a comparison of the funds and some index. For example, bond index for income funds or the index of capital market for equity funds. But from the last two decades this emphasis is measures are based on any one single attribute.
Dahlquist EngstrÄom SÄoderlind (2000) studied the relation between fund performance and more than one fund attributes such as size, past performance, turnover, expenses and trading activity. Estimated performance was used to analyze this relationship. The conclusion of the research was that good performance was observed in small equity funds, funds with high trading activity, funds with low fee, and in some cases funds with good history of past performance.
In 2000 the decomposition of mutual funds was done into several measures like selectivity, long term style based returns, style timing, expense ratio, transaction costs, and net return to the shareholders. In estimating the returns of the actively managed funds the tax impact has been ignored. It was thus found that on an overall level equity funds do outperform the market. But the non stock holdings underperformed and the expenses and transaction costs also increased that resulted in the underperformance of equity stocks. The mutual funds on the basis of their net returns outperform the market as they cover their costs well. Both studies held the same conclusion that was, the actively managed funds even after they are adjusted for the costs outperform the market.
The above studies mainly focused on the attributes like transaction costs and expenses. We now go towards observing on other attributes like fund size, book to market value, number of securities and funds flow turnover into or out of the funds.
Kothari and Warner(2001) estimated the performance of mutual funds on the basis of several funds characteristics as book to market, size, number of securities and turnover. The style characteristics of funds is one of the main performance measure that has the ability to detect the abnormal funds returns when they differ from the weighted value market portfolio and these returns are economically large in magnitude.
Daniel et al(1997) based the benchmark to measure fund performance on the characteristic of stocks. These benchmarks were actually of some passive portfolios against the held stocks and they were based on the basis of prior to market, market capitalization, and prior year return characteristics. Funds showed stock selection ability to some extent.
Carhart in 1997 took hold of the common factors in stock returns and mutual fund investment cost differences to explain the short term equity persistence. Irrespective of momentum it goes on to explain the basis of prediction in the mutual funds returns. Two models were used here to measure the performance. They are; Sharpe and Lintner Capital Asset Pricing Model and Carhart four factor model. For comparative analysis Fama and French three factors model was used. According to this study it was argued that, although the investment cost is earned back the top performing mutual funds but still most of the funds underperform by the magnitude of the investment expenses. The suggestion was that the funds with persistent poor performance should be avoided by the investor, the funds who have high returns the last year have higher expected returns more than average the coming year but not in afterwards so the transaction cost, expense ratios of investment cost, and load fees have a direct but negative effect on performance.
SIZE OF FUNDS:
In order to evaluate the mutual funds performance, the size of funds comes as an important and dominant factor. It also helps to explain the currency value of the investment in the mutual funds. Overall returns of a fund are directly related with the size of the fund. With the increase in the fund size, the fund manager can take the benefit of investing in diversified places like money market and capital market instruments. A mix relationship exists between size of funds and equity and bond market funds performance. This is due to the fact that the bond funds are relatively small in size as compared to equity funds that are relatively large.
Big funds can encounter certain problems like:
Agility: Whenever a large security is bought it drives up its price which can harm the returns on that fund. While whenever a large security is sold it drives down its prices. Thus large funds have to take the positions slowly or unwind to avoid causing the stock to move too much. Because if they are caught with a big holding then they cannot get out of it quickly.
Some researches conducted on the mutual funds gave certain results. Like a research suggested that the increase in fund size has the benefits of providing more resources for research and thus results in lower expense ratio and therefore there are advantages of scale. While some studies suggests that a large asset base is responsible for eroding funds performance because of liquidity or price impact. Whereas in the case of a small fund, it can employ all its resources to work on the best idea but in the case of a large fund the lack of liquidity forces it to not invest in the not so good ideas and thus it can erode the fund performance.
A hypothesis was also tested that fund size erodes performance and that is because of trading costs associated with the liquidity and price impact. Due to this hypothesis it was found that fund size matters for some funds while for others they do not significantly affect the performance.
The impact of fund size can be high on the performance especially if the funds contain a higher number of lagged assets. The fund’s performance is inversely correlated with its lagged assets under management. Hence, it is therefore important to control for fund’s family size to find a sizeable impact of fund size on its performance.
Liquidity refers to the ease at which a security can be bought or sold.
Mutual funds due to their large size are plagued with this problem of liquidity due to the large blocks of stock that they must sell. These problems are known as the market impact costs that mutual funds have. These are basically the premiums that must be paid to buy stocks above the market price. Thus are the concessions for the seller below the market price in order to accommodate the large size of the positions that they need to trade.
One way to avoid the loss in mutual funds by this liquidity problem is to limit the size of funds so that their individual security positions are less than the market capitalization of those companies in which they tend to invest.
The rate of turnover for a fund is basically a percentage of funds holdings that have varied over the previous years and it therefore provides an idea of the period till which the manager holds on to a stock. Funds turnover rate is calculated by the fund accountants by dividing the total purchases or sales (whichever is less) by its average monthly assets during that same year. This maths can be translated easily as: A fund trading 25% of its portfolio over a year would hold on to that stock for around four years, on average.
Although it might seem simple but turnover rates have their peculiarity. For example there is a dramatic change in the asset base of a fund (denominator of the turnover ratio) it would then give a false impression of the trading activity of that fund. If the trading pace is not changed by the manager then the turnover ratio will fall as assets rise. Equally, a falling asset base can drive up the funds turnover ratio.
Turnover can provide you with the knowledge of the trading activity of a manager but reading too much of the turnover rate of a fund is not recommended, especially for bond funds. In a broader sense, buy-on-hold managers will be having a lower turnover rates than the managers who are trading on short term factors. And usually manager with very high turnovers are seen to practice aggressive strategies. In bond funds however mostly managers make use of cash management strategies to drive up the turnover rates. It is therefore not unusual to see turnover rates of 300% or above and that even in funds that are not predominantly aggressive.
Take an example of a stock fund that would have a lower turnover ratio, but in comparison a bond fund will have a high turnover whether it is actively or passively managed and that is because active trading is an innate quality of bond investments. An aggressive small cap growth stock fund will usually experience a higher turnover than a large cap value stock fund.
If all the other things are equal than investors should be in favor of funds with low turnover. Because funds with higher turnover would then result in higher brokerage fee, transaction fee and that would decrease the fund returns. Moreover, the higher the portfolio turnover in a fund, the more expected it is that it will generate capital gains for short terms and they are taxable at the ordinary income rate of investor.
The mutual funds turnover ratios will be varying around the years. But the usual range can be reviewed by taking a look at the figures over some consecutive years.
Unlike equity stocks where there is additional risk involved (that of market risk); mutual funds are safer as they are diversified as they involve funds of a large number of people. Also the main advantage of diversification is that even if there is loss or mismanagement in one stock the overall risk factor is minimized due to the remaining funds.
Investments in mutual funds are for longer term durations and the magnitude of rise and fall sector-wise is also less as compared to stock funds that too in the case of a poor management team.
If trading among the funds is way too frequent there is a penalty imposed on the investor by the open-ended funds.
The sole difference involved in trading in mutual funds and equities is the required amount of information for trading. Like mutual fund managers, for a balanced portfolio, individual equities need fundamentals (facts about a company) and technicals (future price prediction based on the past price of a stock). Also in mutual funds, less knowledge is required about individual stocks as compared to trends of the market.
NET FLOWS INTO FUNDS:
It is easily understandable that if net flows are positive, it means that the fund size is growing, which will furthermore boost up the capital markets where that money will be placed and minimizes the chances of manipulation and vice versa if the net flows are negative. Jonathan B. Berk (University of California, Berkeley and National Bureau of Economic Research) and Richard C. Green (Carnegie Mellon University) formulated a simple rational model of portfolio management that provides a natural standard against which the relationship between returns and fund flows can be evaluated.
Rational model of active portfolio management has three features:
- Investors competitively provide capital to funds.
- Managers have differential ability to generate high returns, but face declining returns to scale in positioning their ability.
- Investors learn about managerial ability from past performance and direct more capital towards funds with superior risk-adjusted performance.
- There are two significances of the Green and Berk model:
- Greater capital inflows should be experienced by funds having high ability managers
- For higher ability funds even, diminishing returns to scale combined with the inflow of new capital inflow of new capital leads to erosion of superior performance over the passage of time
The fee arrangement of a mutual fund can be categorized into two important parts:
Management fee, (B) Load Charges
Management fee: Management fee is computed as a fixed percentage of the average net assets supervised by the company for offering work place and professional management, including all administrative services and accounting.
Load charges (non-management expense): The non-management expense or load charges are sales commissions described as “front-end loads” (sales bills when you purchase) or “back-end loads” (sales bills when you trade). “No-load” funds, as the name implies, do not have front-end or back-end sales charges. These fees are for laboring the circulation and selling of the funds.
All mutual funds have charges and expenses that are paid by investors. These costs have to be account for as they are significant and affect the ROI. Therefore it is essential for all investors to calculate their returns after netting of all such fees and charges. The charges and fees are generally cited in the offering documents and the fund booklet printed by the Asset Management Company (AMC).
All expenses are articulated as the percentage of average daily net assets of the fund. The management fee for the fund is generally similiar to the contractual investment advisory fee that is charged for the management of a fund’s investments. Non-management expenses mostly would be the percentage of the fund’s profits shared with fund managers. Mostly these are flat-rates applied to the average net asset value (NAV) of the fund. Hence the fee structure is an important determinant of the performance of a fund. Further it can be stated that the fee structure is a function of the fund management expertise and past performance. Research suggests that fund managers charging higher fund management fees are also the ones who generate abnormal profits for the investors and therefore for those very few fund managers it is justifiable to charge a higher fee. However, there are also evidences that high-fee funds do not perform as well as low-fee funds.
Investment advisory fees, distribution expenses, marketing, transfer agency costs, brokerage fees, legal and custodial fee, and accountants fee are also some regular fund operating costs that are not necessarily associated with any particular investor transaction.
Fees and expenses vary from fund to fund. So a fund with high costs must achieve and perform better than a low-cost fund in order to generate the same returns.
MUTUAL FUNDS IN PAKISTAN:
PAKISTAN MUTUAL FUNDS TOTAL NET ASSETS:
In a lesser time, Pakistani Mutual Fund industry has gained popularity and growth. There has been phenomenal growth in both total net assets and number of funds of the mutual fund industry. Total net asset value is basically a measure of the investments in the mutual fund industry therefore this depicts the invested capital in the industry. The net assets of the industry have grown from PKR 21,070 million in 2001 to PKR 199,699 million in 2010 registering a growth of 848%.Also the number of funds has grown from 38 in 2001 to 135 in 2010 depicting a growth of 255%.
According to the above graph, the performance of Pakistani mutual funds grew phenomenally in year 2007, jumping almost twice its size in year 2006 and continued to grow in 2007, but failed to show a similar trend in year 2009 and 2010.
NUMBER OF AMCS IN PAKISTAN:
There has been a steady growth in the number of AMC’s in Pakistan as depicted from the graph below:
As shown by the graph, the number of AMC’s continue to grow till 2007. Then they reduced after it especially in 2008 due to downfall some AMC’s collapsed.
NUMBER OF MUTUAL FUNDS IN PAKISTAN:
As shown in the graph the number of mutual funds increased since its inception in 2001, they decreased somewhat in 2004 but then continually increased over the years.
TYPES OF FUNDS:
In Mutual Fund Industry of Pakistan, there are two generic types of fund available i.e. closed ended and open ended funds. As per the graph, open ended funds’ total net asset value is far greater than the net asset value of closed ended and pension funds. But both funds have shown remarkable growth in the last six years. This is in line with an increase in depth of stock market in term of both number of listed companies and their market capitalization. The Total Net Assets Values of open ended funds are greater due to its unique features as they can be easily repurchased or redeemed at any time unlike closed ended funds which are priced at market value determined by demand and supply.
According to the graph, the only dominating fund type is the open ended fund when we talk about Pakistani mutual funds’ performance. Closed ended funds failed to get an equivalent investment platform due to lack of information available to the investors regarding the secured returns provided by the closed ended funds as compared to the open ended funds. Reason for closed ended funds being comparatively secured is that the fund managers are restricted to the portfolio that they are provided with that in turn reduces the chances of arbitrage or speculative activities performed by the fund manager as was the case in open ended funds.
The reason for such an appreciation for open ended funds is that the investors find it feasible to earn great profits, though on high risks, in a very short time. Although the risk associated with the scripts in a particular fund is properly taken care of by diversification methodology even then it is riskier as the fund manager may involve in speculative activities or even look for an arbitrage opportunity available, hence, exposing the fund to a non-diversifiable risk with an impact far greater than the one associated with the portfolio itself.
Pension funds, however, remained stagnant throughout the period under observation. Reason being that these funds are restricted only to the employees of any particular organization. Hence, the portfolio base always remains small compared to either closed ended of open ended funds. Also the size of the pension funds remains stagnant throughout its life as organizations normally invests in fixed income securities in order to visualize constant returns.
OPEN END EQUITY FUNDS:
These types of funds are invested in the stock market providing investors to reap benefits from returns as high as the stock market can provide. However, there is high volatility and risk involved in such investments and hence only those groups of people are involved who have the desire for high risk and can therefore invest for longer terms. Equity Funds are comprised of diversified Equity Funds, Index funds and Sectoral Funds. Diversified Equity Funds invest in several stocks across different sectors while the sectoral funds which are basically specialized Equity Funds and the difference between the two of them is that the sectoral funds restrict their investments and that is available only to shares of a particular sector and therefore, are more riskier than Diversified Equity Funds. The investment of Index funds is passively and it is only in the stocks of some particular index and thus the fund performance would move along with the index movements.
The above graph suggests that there was a dip in the growth of the total net assets of this fund in 2002 as compared to 2001. It then took and increasing trend the following year through 2007 after which the graph started declining from 2008 and onwards due to volatility in the equity market.
OPEN END INCOME FUNDS
Some mutual funds also invest in bonds. Income mutual funds provide with a broad exposure to bonds and it has the facility to do this without having to purchase the bonds. Such funds are therefore used by several investors to provide diversification from stocks or in the other sense to provide some current income. Bonds investing is a bit more implicated than stocks investing that is basically because the bond market is quite different. Retail investors usually depend on brokerage bond desk for trading purpose. By using a mutual fund of fixed income the investors can acquire an investment in bonds without actually purchasing the bonds directly
From the above graph it can be seen that since its inception in 2004, the fund has seen a growing trend till 2008 after which it has started to decline.
OPEN END MONEY MARKET FUNDS
An open end mutual fund is one that invests only in money markets. This type of fund invests in short term debt securities like TBILLS (Treasury Bills), COD (Certificates of deposits) and commercial papers. The major goal is the protection of principal escorted with modest dividends. The net asset value of funds remains at a constant of $1 per share to further simplify the accounting process thought the interest rates do vary. Money markets are highly liquid investments and thus they are often utilized by the financial institutions to store money that is not invested right now. Dissimilar to bank accounts, in the money market accounts most of the deposits are not insured by FIC. And the risks are extremely low. Though money market funds are one of the safest types of funds but it is still very much possible for them to fail. But it is pretty unusual. The biggest risk in the case of money market funds investment is the inflationary risk that can counter the return on funds; therefore it can erode the purchasing power of money invested by the investor.
From the graph it is seen that since inception in 2003 till 2008 there is a growth in the net assets of the fund following a huge dip in 2009. But unlike the previous it again picked up pace in 2010 and is still continuing to do so.
OPEN END BALANCED FUNDS:
Balanced funds are thus that merge the stocks and bonds in investment pool and provide with a moderate or low risk. Although low risk might seem good but it is also combined with lower rate of returns, this would mean that if you go for investments having lower risks then your investment won’t earn that much too. Therefore it has to be decided in advance that how much risk you are able to cater before investing money.
The above graph suggests that there was growth in the total net assets of this fund since 2001 through 2008; after which the graph started declining from 2008 and onwards
OPEN END ASSET ALLOCATION FUNDS:
This fund provides the investors with a portfolio that is either fixed or variable mix of three major asset classes that are bonds, stocks and cash equivalents. A specific amount of asset classes are maintained by some asset allocation funds over time and others change the composition of this proportion in reaction to any variation in the investment or money markets.
The graph below shows the total net asset value of asset allocation funds that includes conventional and Islamic fund. Particularly, during the year 2008, there has been rapid growth in asset allocation Conventional as well as in Islamic funds. However, growth tends to decline in the following year due to the underperformance of mutual fund industry in Pakistan.
OPEN END CAPITAL PROTECTED FUNDS:
Capital protected fund is a fund that guarantees that you get your initial investment back after a certain period. Thus it is a type of mutual fund that would guarantee the investor that he would get at least the initial investment back and in case of any capital gains they are added up too. If they are held for a contractual term then they are known as capital protected funds. The main idea of this type of funds is that you will be open to the elements of the market returns and that is because the funds is able to invest in the stock market too, but you still have the protection and safety of the principal as it is guaranteed.
Capital protected funds are a new phenomenon in the mutual fund industry of Pakistan mainly because Pakistani mutual fund industry is still in growing phase and it is developing progressively with the introduction of new types of funds. Capital protected funds have been introduced in the year of 2007, since then its Total Net Asset Value of bond funds has increased each subsequent year. An increasing trend or growth can be noted in this type of fund chiefly because this is considered a safe avenue of investment when equated with all other mutual funds available. Market situation have been very unstable since the end of year 2007 and this has forced investors to invest their money in funds that offer higher stability. The success of conventional capital protected funds has also encouraged asset management companies to introduced Islamic capital funds.
As seen in the above figure an increasing trend can be noted each succeeding year depicting that the capital protected funds maintains the investor confidence.
Pension Funds – Global Perspective
Pension funds are means for individuals to save for their retirement encompassing a broad array of savings plan from social security to individual contribution defined or benefit defined company plans
Pension funds represent the third largest global pool of private capital available for lending or investment purposes after commercial banks and mutual funds.
Pension Funds in Pakistan
Like most countries of the world, Pakistan has weak provisioning for pensions. Pakistani’s mainly rely on their future generations to provide for them during the retirement period. A huge segment of the people has no pension provisioning and is completely dependant on the joint family support system.
Aim/ Purpose of the Pension Fund
The chief aim and objective of the pension fund is to offer a flexible retirement savings plan for people with personalized inve
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