How can fund managers cope with a persistent bear market, regulatory difficulties and a lack of investor awareness?

Oct 26 - Nov 01, 1996

After the giant public sector mutual fund, the National Investment Trust (NIT), posted less than a11% dividend yield this year after consistently declaring a yield between 16% and 18% for the last five years, the confidence of the already shaky individual investor seemed even weaker. NIT has always attracted funds from the household investor, but now even they have been inundated with redemptions. The public sector Investment Corporation of Pakistan (ICP) which manages 25 funds with a total capital in excess of Rs 2.6 billion has also done well; but figures from last week show that rights issues from 17 of their funds were undersubscribed by about 45%. It comes as no surprise therefore, that at a time when much doubt is cast on the credibility of state run funds, the country’s private sector mutual funds, which, in contrast, have no proven track record, are all in the doldrums.

Of course, the experiences of both developing and developed countries have shown that the success of mutual funds is directly linked with fund managers' ability to attract money from the general public. The possibility of earning higher returns through the stock picking expertise of the fund manager has always been a strong incentive for the small household saver. But with deteriorating economic fundamentals and political instability pervading our markets, the retail investor is far less than adventurous, rating the safety of his money over and above any other considerations.

Private sector mutual funds, which have yet to establish credibility in the market are therefore not among the investors options. And of course, despite everything else, investors and depositors today do have a wide array of savings and income generating products and schemes in the country to choose from. Where does that leave the country's private sector mutual funds?


There are now a total of 13 private sector funds listed on the Karachi Stock Exchange (KSE), all closed end, and all trading below their par value, at a price as low as Rs 1.35 per share.

By definition, in a closed end mutual fund, the number of shares the fund can sell to the investors is restricted by the number of shares sold in the initial public offering of the fund. The amount of money available to the fund manager to invest therefore is limited at the outset, and investors can redeem their holdings in the fund at the current market price.

In comparison, an open end fund, of which NIT is the only one in the country, can sell an unlimited amount of shares to investors using the additional money to continually increase the size of the fund. Investors can redeem their shares at the net asset value of the fund at the given time, or as in the case of NIT, at the price determined by the State.

As a whole, Dr. Amjad Waheed, the Chief Operating Officer, a mutual fund is simply a group of stocks and other financial assets managed by trained investment professionals. Such a fund offers its shares to the public, who then become the owners of the fund. Typically, the fund advisor uses investors money to acquire stocks and bonds within the legal framework of the CLA. Investors invest in a mutual fund to purchase a single portfolio."

The total paid-up capital of the 13 funds, which account for just 4% of the market, is just over Rs 1.6 billion, and almost every fund is trading at a discount to its net asset value, the globally-used measure of a mutual fund's position. The net asset value is, in practical terms, the value of all assets held by the fund divided by the number of shares outstanding. According to the Mutual Fund Association of Pakistan's declaration of net asset values as at June 30, 1996, the Rs 400 million Khadim Ali Shah Bukhari Premier Fund was trading at the largest discount (46%) to their net asset value.

What has gone wrong?

The recent regulatory scandal at Asia's largest fund, Jardine Fleming Investment Management in which a senior director routed lucrative deals into his personal account and caused investors to lose more than $ 19.3 million, reveals important implications for the rest of the Asian mutual fund industry.

Transparency and strong, convincing regulation are of paramount importance in the generation of public confidence. Investors have to trust their fund managers and with the general public's penchant for panic, a bad image is not easy to overcome.

Not only is it essential for investors to understand how credible their fund manager is and how his decision making process works, but operations must be completely transparent. The fashionable attachment of mutual funds to brokerage houses poses an important problem in this regard. In practical terms there is not a distinct enough line distinguishing the fund from the brokerage house and this leaves open the potential for conflicts of interest. While there are restrictions on business being routed through group brokers, this can easily be sidestepped by involving a third party broker. Furthermore, fund managers have no regulatory pressure which can prevent a situation like that at Jardine Fleming. They can easily siphon profitable trades to their personal accounts and bad deals to the fund's account. But Zahid Q. Noorani, the Chief Executive of the KASB Premier Fund did not think this was reasonable, " Firstly we cannot do our own broking for the fund, and in any case, we are a very large financial institution. We are hardly about to risk our reputation and corporate image by doing something like that." Moral pressure, or image protection are not however, good enough; nothing convinces markets like adequate regulation, and that is exactly what is needed. Once fund's are required to make full and regular disclosure, through periodic declarations of net asset values, the status of their portfolio and the size and recipients of broking income, this problem will largely be mitigated.

Secondly, fund managers should be well qualified to do compose a portfolio that the average investor will be unable to do; our regulation in this area too, is inadequate. Experience in managing a fund and a full understanding of what involves is something which the regulators need vigorously to monitor. To have been a broker and advised on investments is one thing, but to be a custodian of public money, in much the same way as a commercial bank, is quite another.

In the same context, as one market analyst pointed out, " stock picking and investing in listed securities has largely been a somewhat random process, based on market sentiment rather than sound fundamentals. The actual use of decision making models is almost non-existent, and a skill which fund managers here need to acquire." With the access that these private sector funds have to high quality market research, this should not be a difficult task.

Performance and the stock market

Private sector funds have bloomed primarily in the last two years, with several coming on line just last year. So far, the companies have generally been unable to attract investment in particular from individual investors, and have largely posted losses for their brief period of operation.

In terms of numbers, mutual funds have performed dismally; the KASB Premier Fund posted a Rs 46 million pretax loss for the half year ended December 1995, while the Security Stock Fund, posted a Rs 12 million loss for their first eighteen months of operation ended June 30, 1995 and a net after tax loss of Rs 597,202 for the year ended June 30, 1996. Another company, the Rs 100 million, Confidence Mutual Fund posted a Rs 511,360 after tax loss for the year ended June 30, 1996.

And in all cases, dividend income represented a minimal portion of total income. In the case of Confidence Mutual Fund, dividend income made up only 3.4 % of total income contributing Rs 641,175, the Security Stock Fund had a total income of Rs 10.2 million of which 9.1%, or Rs 934,207 was dividend income, (although this figure is up from 6.13% last year) and in the KASB Premier Funddividend income made up 9.7% or Rs 2 million of total income.

This can be attributed in large part to the persistent bear market of the last two years. Although most mutual funds were listed during this down period, the slide has continued unabated.

Needless to say, mutual funds, anywhere in the world have a crucial role to play in an economy’s capital markets, and the difficult crunch conditions in Pakistan’s markets have made it impossible for these funds to register any meaningful gains. During the last year, the KSE-100 index has fallen from the mid 1600 levels to the mid 1300 levels today.

Regulatory Issues

This, however, is not the only problem. Mutual funds have not, until recently, received adequate attention from the government. Therefore, regulation has been developed with little consideration of its practical effects. As Noorani of the KASB Premier Fund said, " Regulators have so far been overwhelmed by all the issues faced in the running of mutual funds. Now the Corporate Law Authority has made this sector a priority, and we have to set the impetus for growth now, by tackling regulatory and other problems at this early stage."

To this end, private sector fund managers have recently formed the Mutual Funds Association of Pakistan (MUFAP), which, according to the chairman of the association, Zaigham M. Rizvi, has been formed for "self regulatory purposes". The Association has, in recent days taken up several issues with the government.

Firstly they claim that since a fund does not operate like a standard manufacturing concern, but invests on the behalf of investors in listed equity and debt securities, they should be exempt from the 0.5% turnover tax levied on all companies (including mutual funds) incorporated under the Companies Ordinance 1984. The Association claims that "the main intention of the turnover tax was to tax the gross receipts for the sale of goods and services."

Secondly, MUFAP asserts that mutual funds not only pay withholding tax on the dividend income they receive from their portfolio holdings, but when they themselves declare dividends, shareholders pay this tax as well. This incidence of "double taxation therefore discourages investors because the logic of investing in a mutual fund is lost." says Rizvi.

He went on to say that, the current legislation requires that investment advisors hold 10% of the outstanding shares of the mutual fund. "This discourages the launching of a series of funds as the capital is tied up in every fund that is launched. By launching a series of funds, competition for investment returns is increased," Rizvi said. Some analysts however, do not completely agree, "If a investment advisor who launches the fund is required to hold part of his initial investment, this will provide an added incentive for prudence in the management of the fund. "

Next, mutual funds incur significant expenses during incorporation and the initial public offering. These expenses are paid initially by the investment advisor and reimbursed over a five year period. MUFAP has represented that funds should be allowed to amortize the preliminary and other expenses to the issue for tax purposes and hence these expenses should be deductible from the final tax liability of a fund.

Other issues

Some analysts have suggested, that the fund managers’ compensation is excessive when compared with international standards. Pakistani fund managers receive a 2% a year flat fee ( to be reduced to 1% after five years) plus half of all payouts in excess of 20%. As Arif Habib, the President, KSE pointed out, "this mechanism ensures a minimum return for the managers even if the fund is in loss and does not cost them anything if they do not perform. . . managers should be entitled to a fee only if they perform."Market participants, of course, strongly disagree- " in relation to the costs funds incur, at this point in time, this is not at all excessive." one fund manager said. This is one reason why fund managers are keen to launch a series of funds; they can then take advantage of economies of scale and the heavy initial expenses and advisory and administrative costs will be distributed.

Currently, the " Asset Management Companies Rules-1995" provide the legal framework for the registration of open end funds, and the "Investment Companies and Investment Advisors Rules-1971" provide the regulation for the registration, floatation and management of close-end funds. MUFAP, according to Rizvi, was set up as a self-regulatory organization for the industry to ensure compliance and facilitate voluntary disclosure, transparency and an adequate reporting process.

Aside from the seminar method of increasing investor awareness, MUFAP has also required that funds declare their net asset values on a quarterly basis. This will give investors a true picture of the real value of a fund and assist in the decision making process. The net asset value of the 13 funds is Rs 1.2 billion and their market value is Rs 838 million; a discount of abut 30% to their NAV.

Both Rizvi and Noorani have suggested that the investment scope of mutual funds be widened to include quoted securities like the government treasury bills and federal investment bonds in addition to their permitted options in listed equity and debt instruments. In order to diversify portfolio holdings, reduce risk ad create a balanced portfolio, Rizvi said, the range of investment options should be broadened. In addition to quoted securities, certificates of investment will also provide a gross return and liquidity combination.

The Managing Director of the Jahangir Siddiqui Balanced Fund, Habib-ur-Rehman, said that two thirds of his fund’s portfolio was in fixed income securities, since current market conditions prevented heavy investment in the KSE. And, "we have only invested in those companies with a record of divided payments," he said. Rehman also said that he expected a total income of Rs 12 million, a net income of Rs 9 million after a Rs 3 million provision in the diminution of investments for their first year of operation. After deducting Rs 8.5 million as expenses, and a pretax profit of Rs 0.5 million.

One fund manager said, "mutual funds just do not offer a viable option to investors. The way things are now, I just cannot advise anyone to put their money in a fund."

And while this pessimism may be well-founded in the current times, as Salman Rasheed, Head of Research at Fortune Securities, a local securities analysis company said, " the sector is still in its infancy stage. To assess the true potential of a mutual fund, a minimum three year track record is needed. So It really is too early to draw any solid conclusions."

Why invest in a mutual fund: market participants speak

  • Provides liquidity

  • Provides investors with portfolio management expertise

  • Provides investors with risk diversification

  • Provides stability to stock market

  • Mobilises savings by attracting funds from small investors

Declaration of NAV's as on 30 June 1996

Name of Co		Paid-up	Year of	NAV's	Market
 			capital	registr-			Price
					ation			(Rs min)


KASB Premier Fund 	400 		1995 		9.03 	4.90 
Dominion Stock Fund 	50 		1994 		7.89 	5.40 
Security Stock Fund 	100 		1994 		7.89 	5.40 
BSJS Balanced Fund 	150 		1996 		9.99 	9.65 
Al-Meezan Mutual Fund 	250 		1996 		10 	-- 
Confidence Mutual Fund 	100 		1995 		9.95 	7.60 
Safeway Mutual Fund 	30 		1995 		4.65 	6.90 
Asian Stock Fund 	100 		1994 		8.74 	4.75 
First Capital Mutual Fund 150 		1995 		-- 	3.75 
Golden Arrow Fund 	81.50 		1983 		-- 	2.90 
Tri-Star Mutual Fund 	50 		1992 		-- 	1.50 
Growth Mutual Fund 	100 		1992 		-- 	1.50 
Prudential Stock Fund 	60 		1990 		-- 	2.25 
Total 			1621.50 


Funds Approved for Public Offer

					Date of Approval 
Prime Mutual Fund 			April 1994 
Fidelity Investment Mutual Fund 	November 1994 
SCL Alpha Fund 	`		June 1995 
Genesis Pakistan Fund July 1995