Unusual Valuation of Mutual Funds

With the stock market rallying stronger in the last few months, the inflated prices of mutual funds come to the forefront.

The DSE General Index was 3,356 on October 25, which is 17 percent higher since the rally started in July. The P/E (price to earnings) ratio of the market currently stands at 20x. The P/E was 18.4x in January 1 and 14.5x on January 1, 2007.

The P/E ratio indicates roughly the number of years of earnings it will take to recoup the price of the stock, not the original investment. Compare this to an alternative investment such as a poultry farm, and ask yourself if you are willing to wait that long.

Even when the index is at an all time high, one cannot say with certainty that stocks are overvalued. One can only draw conclusions based on a relative basis, such as stocks are overvalued compared to other assets, other markets, or other points in time.

Many variables are associated with stock pricing, including outlook for earnings, GDP growth, interest rate, inflation rate, money supply, other investment options. Most of these variables are interrelated, making an estimation of fair value very difficult.

However, one can state with absolute confidence that one class of securities in the local market is hugely overpriced. Closed end mutual fund units trade at a level that defies reason.

Currently 17 mutual funds trade at an average of 2.75 times their net asset value (NAV) and 75 times their earnings. We looked at a sample of 21 mutual funds in the Asia Pacific region and found they trade at 0.91 times or below their NAV. There is no reason for a mutual fund unit to trade at a price higher than its NAV.

NAV represents the net worth of a mutual fund unit. NAV on valuation date is the price of all securities in the mutual fund, less any liabilities, divided by the total number of mutual fund units. A mutual fund is the partial ownership of a basket of securities.

For simplicity, let us compare this with a basket of fruits. This basket contains six apples, a dozen bananas and six oranges. It costs Tk 170, Tk 90 and Tk 170 to purchase a dozen apples, a dozen bananas and a dozen oranges, and Tk 20 for a basket. Consequently, the fruit basket should cost Tk 280, which is its NAV.

If the fruit basket were traded in the stock market, will you pay Tk 300, Tk 400 or Tk 500 for it? According to the table, you will pay about Tk 750 or 2.7 times the NAV of the basket.

Are you not better off making your own fruit basket by buying individual fruits? Similarly, if you can replicate the basket of securities (mutual fund), by buying the same securities from open market, why will you pay more? Granted that the content of the basket is not public knowledge, however, if the fund manager changes the portfolio often between disclosure dates, the actual value is destroyed by high trading costs.

Sometimes it is argued that a premium over NAV reflects a reward for the fund manager for superior stock selection. In reality, the fund manager is already rewarded when an investor selects her fund and pays her the management fees.

I hear two other theories explaining the insane pricing of mutual funds in our market. Both point out the obvious -- “The Bangladesh market is different”.

One theory states the high valuation of mutual funds reflects a favourable disposition of the courts toward dividend and bonus shares. This argument misses the fact that dividends are paid from the NAV, and NAV drops by the same amount as the dividend paid.

Also, bonus shares do not create wealth out of thin air, but are a simple hogwash by rearranging capital that belongs to unit holders anyways.

The second theory states the high valuation of mutual funds reflects the advantage of special initial public offering allocation. Under the Securities and Exchange Commission rules, mutual funds are entitled to 10 percent allocation of any IPO. Newly listed securities appreciate by as much as 200 percent on the first day of trading, so surely this rule adds significant value to mutual funds.

Last year, the total value of all IPOs was approximately Tk 4.1 billion. Assuming 10 percent of this volume was allocated to 14 available mutual funds and new listings appreciated by 200 percent on average, the gain for 14 mutual funds would be less than 5 percent. This hardly justifies a 170 percent premium. In future, gain from this source will moderate as new mutual funds are launched.

Speculative pricing of mutual funds has reached such levels that launching of mutual funds has become a placement pursuit rather than an investment activity. As soon as a fund hits the market, units appreciate by 200 percent. The very blessed beneficiaries of IPO placement offload their allocation and realise windfall profits. Unfortunately, such speculative investment is a zero-sum game. When unit prices revert back to their NAV, a lot of people would lose their money and lose confidence in the utility of mutual funds. That would be a sad event for an investment vehicle such as mutual funds that bear so much potential in mobilising capital.

Unfortunately there is not much the government or regulators can do to determine what investors buy at what prices. There is no place for such intervention in a free market unless clear violation of the securities laws occurs.

Consequently, the only safeguard for investors is 'Caveat Emptor' or 'Buyer be Aware'. General investors appreciate the value of common sense -- no one buys a fruit basket for Tk 750 when it can be created for Tk 280, or pays for a poultry farm at a price that takes 20 years to recoup.

It seems only in the stock market does investor common sense take a leave. People buy overpriced stocks expecting to find 'bigger fools' than themselves, who would willingly purchase their stocks at an even higher price.

However, not knowing exactly when to sell, everyone in a heated market runs the risk of holding the bag and appearing the “biggest fool” when the music stops. While pricing a security, the only important parameter is its future earning power. The same goes for mutual fund units.