TAMING THE SHREWD

BETTER REGULATORY FRAMEWORK REQUIRED TO SAFEGUARD INVESTORS' INTEREST

SHABBIR H. KAZMI
Feb 09 - 15, 2009

Mutual Funds operating in Pakistan can be divided into two categories i.e. Open end and Close end. In open end funds there is constant purchase and redemption by the unit holders. The size of assets under its management goes up or down due to like/dislike of investors. These funds regularly release NAV. As against these, a close end fund has a stipulated paid up capital and its shares, like any other scrip are traded at the stock exchanges. Investors hardly have any idea about the performance unless periodical reports are released.

Modaraba companies operating in Pakistan can also be called close end fund. However, these operate under different regulatory framework, which is based on Shariah covenants. Over the years modarabas have been managed as business entities and have been undertaking variety of activities which include medium term financing, trading and manufacturing. Since these entities are run under stringent Shariah compliance environment, their income is free from the element of Ribah.

Mutual funds on the basis of their investment can be divided into various categories i.e. equities, fixed income, money market, balanced and Islamic funds. As the names indicate equities funds mostly investment in the shares of listed companies. Fixed income funds generally invest in debt instruments. As the name denotes money market funds invest in money market instruments. Balanced funds have diversified portfolios, which may include equities, debt instruments, money market instruments etc. Islamic funds can also be divided into similar categories but they cannot invest in the shares of the companies or instruments where element of Ribah is predominant.

It is often said that small investors should not invest directly in the shares of listed companies. Because, an average person has limited information and expertise and putting all the eggs in a basket may result in huge losses in case of any mishap. As against this mutual funds are managed by a team of professional and have diversified portfolio. Therefore, probability of making substantial capital gains and earning good divided income is high.

Having said this it is also necessary to identify some Inherent weaknesses of mutual funds. Some of these are specific to Pakistan and others are globally identified contentious issues. In Pakistan mutual funds have very high dependence on corporate clients and high net worth investors. While this helps in expanding size of the fund distressed selling by a couple of big clients may result in heavy redemption causing liquidity crunch and panic sale of assets.

Another common observation is that sponsors of most of the funds are financial institutions and brokers. These entities have floated funds to exploit 'another investment option'. The funds have been floated when the financial institutions were suffering from 'surplus liquidity' and brokers also have access to low cost fund. However, during the recent crisis banks were the first to pull out their money from the funds. Funds could withstood redemption pressure to a certain extent but latter on have to suspend sale and redemption.

One of the fallout of banks and brokers sponsoring mutual funds is parking of bad investment in mutual funds. Banks mostly maintain huge investment portfolio. However, in the bullish market most of them also became 'day traders' and the greed to make capital gains touched insanity. This infected the investment portfolio.

Similarly, brokers also started taking positions, in violation of their basic mandate. Technically, they are the facilitators and the source of their income is brokerage commission. However, brokers have very cunningly convinced the government to exempt capital gains tax free. This provides them an opportunity to also take positions. However, they have also been parking their bad investments in mutual funds.

Following a bad business model focusing corporate clients, limited outreach and failure in developing retail distribution network has put the funds at disadvantageous position. The result is that investment of small investors in mutual funds has remained very low, except a few funds.

Interest of small investors has remained vibrant is Islamic funds mainly because they cater to a niche market and also because they have formed alliance with banks for the distribution of their products. The size of mutual fund sector in Pakistan is very small as compared to developed countries, even India.

One of the reasons for smaller market size is lack of awareness among the masses about the benefits of investing in mutual funds. To begin with people have little knowledge about the equities market and the general perception is that investing in shares of listing companies is a zero sum game. Investors have burnt fingers in repeated equities market crises. However, they also have short memory and greed lure them back in it.

Interestingly, lately the central bank has expressed its intention to take over the duty to regulate mutual fund sector. The reason for this paradigm shift is the philosophy of development of financial conglomerates in Pakistan. Since commercial banks have emerged to be the major sponsors of modarabas, leasing companies, asset management companies, brokerage houses and insurance companies, the central bank believes that it should also regulate and oversee these entities. However, the idea has been vehemently opposed by all the players.

Sponsors of mutual funds strongly believe that since around the world mutual funds are mostly regulated by the apex regulators of the equities market, the same practice should also be followed in Pakistan. While one may not like to enter into the debate regarding who should regulate mutual funds, the bottom line is regulatory framework in Pakistan has to be improved. The experience so far shows that regulators often prove to be toothless and boneless, which gives a chance to the players to operate in gray area.