The Local Mutual Funds Industry

Recently we observed a heightened interest in the country's capital market surrounding mutual funds. Four new mutual funds have been launched since January 2007 with a target to raise Tk 2.55 billion. Another six mutual funds will be launched within the year and are expected to raise Tk 12 billion.


Most of these funds are sponsored by private financial institutions and offer an alternative to Investment Corporation of Bangladesh (ICB) mutual funds. Mutualisation of investors' fund is an old concept. Initially the goal was to create a large pool allowing investment in large projects. The advancement of investment theories in the 1950s and 60s and an understanding of the benefits of diversification added to the popularity of mutual funds.

Economic growth in developed countries after World War II led to a rapid growth in individuals' savings, which further encouraged a demand for better investment options. As of 2008, worldwide investment in registered mutual funds stood at $21.7 trillion. Although asset under management (AUM) declined from its 2007 peak of $26.2 trillion, this still amounts to a cumulative annual average growth rate of 10 percent over 85 years.

A mutual fund is usually a collection of a few separate companies. At the core is the fund itself whose sole purpose is to raise capital from investors and disbursement of the capital. The ownership of the fund is divided into many units, which are owned by individual investors. The fund is overseen by directors or trustees and managed by a fund manager or an asset management company (AMC). The AMC makes the investment decisions and is paid a fee for its services, usually a percentage of the total AUM.

A security broker executes trade for a fee. A custodian or trust company holds the securities for the fund. There are countless variations of this simple model depending on investment style, asset mix, size of the fund, fee structure, and inclusion or exclusion of new investors.

Net asset value (NAV) of a fund unit represents the share of assets (less any liability) of each unit. There is no reason for a fund to trade above or below its NAV except for temporary or liquidity reasons or unless the NAV calculation is grossly erroneous.

The simple model of the mutualisation of individuals' funds offers a number of advantages. An average trade by a mutual fund is much larger than that of an individual's portfolio lowering overall transaction costs, asset diversification in a large portfolio is easier to attain and mutual funds can spread the cost of investment research over many investors.

The proliferation of institutional investors (mutual funds, private funds or retirement funds) brought some secondary benefits to the investment management industry, like institutional investors through large shareholding can exert strong influence to improve corporate governance of businesses and because of their large resources, institutional investors can take position in unconventional assets. This improves portfolio diversification and aid global capital flow.

The Securities and Exchange Commission (SEC) is responding well to the growth in institutional funds by formulating regulations and guidelines for the AMCs. Based on my experience in the mutual funds industry and my review of the prospectuses of the four latest mutual funds, I shall point out a few issues that are important, requires attention, and needs to be addressed for a healthy growth of the industry.

Expenses and management fee
A fund pays all its expenses and a fee to the AMC from its assets. Size of the expenses and fees affects the performance of a fund. Funds are free to choose their fees subject to the competitive environment. Of the four funds, annual fees ranged between below 1 percent (Grameen Mutual) to 2.5 percent (two ICB NRB) before expenses. The three funds managed by ICB AMCL anticipate annual expenses up to 4 percent of the NAV. Taken together, management fees and expenses can cost as much as 6 percent annually. In comparison, investors in advanced countries pay about 2.5 percent in management expense ratio (MER). Bangladeshi AMCs charge a 'formation fee' between 1 percent and 5 percent at inception, which does not have a parallel in other markets. Because of compounding, high management fees and costs make a sizable dent in the total savings, as shown in the table below. Hopefully management fees will eventually decline as competition grows. For now however, should the funds be allowed to charge high fees simply because they can? I am not recommending regulation of fees, but some balance must be achieved by exact and prominent disclosure of the fees and expenses.

Credentials of a portfolio manager
In the investment management industry, portfolio managers are highly regarded for their knowledge of the profession and the high standards they practise. Portfolio managers must clearly understand and practise certain duties including the duty of care, duty of diligence and duty of a fiduciary. Managers in advanced markets undergo extensive training and licensing requirements. I understand that the SEC of Bangladesh grants a license to an AMC based on the credentials of its professional staff. The following questions should be answered to make the process transparent: is there a clear guideline that states who can be presented by an AMC as a portfolio manager? To what standards should a portfolio manager be held, and how are these standards enforced? The regulator and the market participants should also develop training and licensing programmes for mutual funds distributors, portfolio managers and other market participants. These programmes should focus on industry knowledge and the regulatory, legal and ethical aspects of the business.

Fund objective/style and benchmark
Based on the skills and strength of the AMC, mutual funds adopt an investment style and choose a benchmark based on the style. Fund performances are evaluated with respect to the benchmark. Because of a shallow market, the four listed mutual funds did not specify an investment style. They also did not offer a benchmark that could be used to evaluate their performance. The use of a broad index such as the DSE/CSE indices would assist investors' selection of a mutual fund.

Performance standards
Seasoned investors look at the past performance of a mutual fund when selecting a fund. Standardisation of performance reporting is necessary as AMCs can otherwise paint a rosier picture of their performance by cherry-picking the investment interval and other variables. It is important to establish the basic rules of performance reporting while the industry is still young. The SEC can look at various industry organisations and regulatory bodies that have established uniform performance measurement standards. The CFA Institute advocates use of the Global Investment Performance Standards (GIPS) and makes it publicly available.

Use of unlisted securities a nd their valuation
The last issue of concern is the inclusion of unlisted securities in mutual fund portfolios. All funds allow inclusion of unlisted securities. For our four funds, as much as 50 percent of the securities can be unlisted.

Calculation of the NAV
Valuation of unlisted securities poses a problem as they do not provide a daily closing price. The stated policy for valuation of unlisted securities, including the frequency, process and oversight by trustees, is not very transparent. In other words, AMCs are giving themselves a wide berth in valuing unlisted securities. Impact of the valuation is still more important as calculation of the NAV determines the management fees.

Disclosure of holdings
None of the AMCs make any promise about regular disclosure of their fund holdings. Registered mutual funds in advanced markets are required to disclose their holdings at least quarterly. This disclosure enables investors to monitor whether and how a fund is complying with its stated investment objectives. If a fund consistently trades in unlisted securities, lack of quality and liquidity of such securities can dramatically affect the risk profile of the fund. A mandatory policy of disclosure of portfolio holdings, especially unlisted securities, can reduce such risks.

The author is an investment analyst and the head of research of a Canadian national brokerage and can be reached at AHCapCorp@live.com.