Mutual Fund Industry of Pakistan(2)

8/7/2019 Mutual Fund Industry of Pakistan(2)

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What is a mutual fund?

A mutual fund is a collective investment scheme, which specializes in investing a pool of money collected from many investors for the purpose of investing in securities such as

stocks, bonds, money market instruments and similar assets. A fund's portfolio is structuredand maintained to match the investment objectives stated in its prospectus.

One of the main advantages of funds is that they give small investors access to professionallymanaged, diversified portfolios of equities, bonds and other securities, which would be quitedifficult (if not impossible) to create with a small amount of capital. The income earnedthrough these investments and the capital appreciations realized are shared by its unit holdersin proportion to the number of units owned by them. Open-ended fund units are issued andcan typically be purchased or redeemed as needed at the fund's current net asset value (NAV)

per share whereas closed-end funds are listed on the stock exchanges and can be freelytraded.

Types of Mutual Funds (By Structure)Funds can be open-ended funds or closed-end funds depending on their structure.Open-ended FundsThese funds are in a continuous process of issuing shares/ units on demand and redeemingshares/ units on demand. The shares/ units do not trade on a market. The number of shares/units outstanding varies each time the net asset valuation calculation is carried out, which isdaily for most open-ended funds.

Closed-end Funds

Closed-end funds issue a specific number of shares. Their capitalization is fixed. The sharesare not redeemable, but are readily transferable and traded on either a stock exchange or theover-the-counter market. The price of a closed-end fund share fluctuates based on investor supply and demand. Closed-end funds are not required to redeem shares and have managed

portfolios.

Why Invest in a Mutual Fund?

1. Cost Efficiencies

The operating costs of a fund manager are lower due to the economies of scale of managing large portfolios. Mutual fund management can save on accounting fees, researchcosts, and brokerage fees, etc., due to the availability of a relatively large pool of resources.For example, the cost of managing a single Rs.lOOmn portfolio is less than the cost of managing 500 portfolios of Rs.200,000 each. Not only are costs lower, professional managersare less likely to make bad investment decisions by investing too much in a single security.

2. Expert Management

Due to paucity of knowledge, an average investor does not feel confident enough to decidewhich securities to invest in, a condition made worse as investment advisory services are notavailable to most investors nor are they familiar with this concept. Mutual fund managers aretrained investment professionals whose knowledge can provide greater risk adjusted returns.Successful timing and selection of stocks by mutual fund managers can maximise shareholder


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returns which investors may not be able to achieve on their own. The method of stock valuation and selection is a scientific process for which professionals use technical andfundamental analysis to identify stocks that have the best prospect of value appreciation.

Technical analysis entails scrutinising the historical stock price and volume movements that

help in identifying price patterns to assist in the forecast of future prices. Fundamentalanalysis, on the other hand, is based on the study of economic data such as earning prospects,dividends, product risk, return on equity, profit margin, expected growth rate in earnings,financial conditions, market share, patent protection etc., of a company to calculate itsintrinsic value. This intrinsic value is then compared with the current market value of thestock to make buy, sell, or hold decisions. Usually, an average investor does not have thetime or the expertise, as opposed to fund managers, to keep abreast of all the micro andmacro changes affecting stock prices.

3. Risk Diversification

Investors are averse to huge fluctuations in stock prices. A mutual fund can stave off this

barrier by providing broad diversification through the pooling of resources, a possibility notavailable to an individual investor. The portfolio theory suggests that as an investor spreadshis/her investment over a large number of stocks, the investment risk goes down. Stock pricesof various companies are less then perfectly correlated. Therefore, adding stocks that are nothighly correlated with each other results in a reduction of portfolio risk.

Investment risk arises from two sources - company risk and market risk. Company risk purports that something bad will happen to the company, therefore, its stock price will fall.This may be due to poor management of the company, a natural disaster such as fire or storm,human error, drop in demand of the product, etc. Company risk effects only one particular firm or industry but not all the stocks in the market.

Examples of company risk are Taj Company and Mohib Textiles where companies failed because of poor management resulting in huge losses to investors. Another example is that of Union Carbide, whose plant exploded in India in 1984, leaving thousands of people dead anddisabled. Yet another example is the oil spill in Alaska where Exxon ended up paying billionsof dollars to clean up the mess. Stock prices did not fall drastically in the case of UnionCarbide or Exxon as both companies had huge reserves to safeguard against such accidents.

Company risk can be reduced or even eliminated by owning a large number of stocks in the portfolio. If an investor holds a large number of stocks in the portfolio, and some of thesecompanies do not perform well, it will not affect the overall returns significantly. Financialanalysts suggest that company risk can be reduced drastically if an investor holds about 40

stocks in his/her portfolio. Since it is difficult for an average investor with limited resourcesto own and keep track of so many different stocks, investors can reduce investing in a mutualfund.

Market risk affects the entire range of stocks through such variables as interest rates,inflation, budget deficits, government regulations, taxes, political and economic situation of the country, war, recession etc., but some companies tend to suffer more than others. For example, during a recession companies that deal in consumer goods such as cars get moreaffected than those that deal in necessities. This is because during a recession people may

postpone buying durables like a washing machine or a car but they do not postpone eatingfood or taking medicine. Mutual fund managers hold stocks that they feel have less marketrisk when they expect a recession or a downfall in the stork market- for some reason.


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Types of Mutual Funds (By Objective)

Open-ended or closed-end funds can be of several types; however the most basicclassifications are stock funds, income funds, hybrid funds or specialty funds. Further classifications evolve as each fund pursues diverse investment strategies for instance: IslamicEquity Funds, Sector Funds, Global Equity Funds, High Yield Debt Funds, AggressiveEquity Funds, Income Funds and so on.

Stock Funds

Income and Money Market Funds

Hybrid Funds

Pension Funds

Islamic Funds

Specialty Funds

Stock Funds

Stock funds invest primarily in stocks. A share of stock represents a unit of ownership in acompany. When companies profit, the stock may increase in value, or the company can passits profits to shareholders in the form of dividends. However, stock funds expose theshareholder to greater risk as returns are not fixed.

By buying shares of a stock mutual fund, the investor becomes a part owner of each of thesecurities in his funds portfolio. Where stock investments have historically been a greatsource for increasing individual wealth, even the most successful companies may experience

periodic declines in value. However, stocks have historically performed better than other investments in securities, such as bonds and money market instruments.

Stock funds are generally:

Aggressive growth funds invest in undervalued stocks with potential for capital

appreciation. Emerging market equity funds invest primarily in equity securities of companies

based in less-developed regions of the world.

Global equity funds invest primarily in worldwide equity securities, including those of U.S. companies.

Growth funds invest primarily in common stocks of well-established companies withthe potential for capital appreciation. These funds primary aim is to increase thevalue of their investments (capital gain) rather than generate a flow of dividends.


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Income equity funds seek income by investing primarily in equity securities of companies with good dividends.

Regional equity funds invest in equity securities of companies based in specific worldregions, such as Europe, Latin America, the Pacific Region, or individual countries.

Sector equity funds seek capital appreciation by investing in companies in relatedfields or specific industries, such as financial services, health care, natural resources,technology, or utilities.

Islamic stock funds seek shariah compliant equity securities.

Income and Money Market Funds

Income funds invest in portfolios consisting of debt securities, money market instruments,

CFS, spread transactions, ready future, direct deposits, etc. Money market funds makeinvestments in short term debt securities of a minimum investment grade and which have amaximum average duration of 90 days. Debt securities are issued when money is lent to thecompany, municipality, or government agency that issues the debt. In exchange for the use of this money, the issuer promises to repay the amount loaned (the principal; also known as theface value of the bond) on a specific maturity date. In addition, the issuer typically promisesto make periodic interest payments over the life of the loan.

Income funds that invest in debt securities are generally less volatile than stock funds and produce regular income. For these reasons, investors often use income funds to diversify, provide a stream of income, or invest for intermediate-term goals. Like stock funds, incomefunds have risks and can make or lose money.

Money market instruments are relatively stable because of their short maturities and highquality. Money market funds are good for short-term investment and savings goals as they

preserve the value of the investment while earning income.

Income and Money Market Funds are generally:

Corporate bond funds seek a high level of income by investing in corporate bonds of varying maturities.

Global bond funds invest in global debt securities of varying maturities.

Government bond funds invest their portfolios in government securities of varyingmaturities.

High-Yield funds seek a high level of current income by investing their portfolios inlower-rated corporate bonds.


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Mortgage-backed funds invest their portfolios in pooled mortgage-backed securities.

Islamic income funds invest in Islamic debt securities


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Hybrid Funds:

Hybrid funds invest in a mix of equities, bonds or money market in fixed or variable

allocations. Asset allocation funds seek high total return by investing in a mix of equities, fixed-

income securities and money market instruments. Allocation limits can be upto 100%in one asset class.

Balanced funds invest in a specific mix of equity securities and bonds with the three- part objective of conserving principal, providing income, and achieving long-termgrowth of both principal and income.

Islamic allocation or balanced funds see investments in a mix of shariah complaintequities or debt securities.

Pension Funds

Pension Funds are funds made up of sub-funds and created from the contributions made over regular intervals by the participants over their working lives. They include all income or investment returns earned net of fees, charges and expenses related to the management of theinvestments of sub-funds to provide for a regular income after retirement for the participant.

Basic Structure

A participant starts his fund by choosing when to start saving, the amount to save and whatinvestment allocation scheme to pursue based on his return and risk preferences. The

participant also selects his retirement age which can be any age between 60 and 70 years.Upon retirement, the participant can withdraw upto 25% of the accumulated amount tax-free.However any withdrawals over 25% are subject to tax under Income Tax Ordinance, 2001(Refer to Section: Withdrawals).

The remaining amount is reinvested in an approved annuity plan (monthly income plan) froma life insurance company of the participants choice or entered into the income payment planto withdraw the remaining amount in monthly installments till the age of seventy-five yearsor earlier, after which the remaining amount can be used to purchase an annuity from a lifeinsurance company of his choice.

How to Start:

A participant can start his pension fund with an asset management company or a lifeinsurance company with a minimum amount as set by the company. The company sets up anindividual pension account from the time of receiving the first contribution, and subsequentlyall further contributions are added to this account. The participant has to further select anallocation scheme, according to his/ her risk and return requirements, which is used to invest

the account into sub-funds in a fixed ratio. The company usually offers a choice of Equity


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sub-fund, Debt sub-fund and Money Market sub-fund and the participant can makeallocations from two or more of these funds.

Allocation Schemes

Allocation schemes and their criteria is set by the SECP and published in the offeringdocuments of funds. Allocation schemes range between aggressive and conservative levels

based on the higher or lower share of investment in the equity sub-fund as specified below:

Allocation Scheme Debt Sub-Fund Equity Sub-Fund Money Market Sub-Fund

Aggressive Min 20% Min 65% NilBalanced Min 40% Min 35% Min 10%

Conservative Min 60% Min 10% Min 15%Very Conservative Min 40% Nil Min 40%

Generally aggressive schemes have the potential to offer higher returns at the expense of higher risk; this relationship reverses as the investor moves towards more conservativeschemes. Each company provides investors advice on the risk and return profile of their investment choice. However the following relationships hold true in general:

Allocation Scheme Investment Goals Risk & ReturnProfile, Investment

Horizon

Investor Lifecycle

Aggressive Maximize capitalgrowth

High return/ high risk:long

Early to middle workingage

Balanced Maximize total return

i.e. capital growth andincome

Moderate return/moderate risk: long to

medium

Early to middle workingage

Conservative Maximize total returnwith emphasis on

capital preservation

Low returns/ low risk:medium to short

Middle to retirement age

Very conservative Maximize regular income and capital

Very low risk: short Post-retirement


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preservation

Participants may also make choices based on their personal attitude towards risk. The pensionfund manager is required to ensure that the allocation scheme agreed with the client isadhered to and the portfolio is rebalanced incase the ratios change. Changes should only bemade as and when requested by the client.

Withdrawal

Pension funds mature at the retirement age specified by the participant at the time of openingof the account which can be between 60 and 70 years. Pension funds can also be withdrawn

prior to retirement age due to permanent disability or death of the client or simply an earlywithdrawal by the participant.

Withdrawal ProcedureThe participant is required to submit the retirement application to the company at least thirtydays before the chosen date of retirement. This form should specify the selected date of retirement and the selected benefits options. In the event that the participant is planning towithdraw more than 25% he must also provide his tax details for the last three years as thiswill be used for calculating his tax on the withdrawn amount in excess of 25%.On the date of retirement as selected by the participant all the units of the sub-fund in hisindividual pension account will be redeemed. The redemption is to be based on the net assetvalue at the retirement date (if that day is a dealing day otherwise on the next dealing day).The amount due is credited to the participants individuals pension account.

The cheque for the amount is mailed to the participant/ his bankers, (if so instructed) withinsix business days provided that all the details relating to the participant are complete. Theremaining amount (if any) can be invested in the in an income payment plan offered by thesame company or any other registered pension fund manager, whereby he can withdraw fromthe remaining amount in monthly installments till the age of seventy five years or earlier,after which the remaining amount can be used to purchase on annuity from a life insurancecompany of his choice.

The participant can also choose to directly invest the remaining balance, after retirement,with a life insurance company in an approved annuity plan. Please note that all investmentafter retirement will be subject to applicable income taxes.

Withdrawal due to Permanent Disability of Participant

In case of permanent disability (Please see Voluntary Pension Rules, 2005 for details) the participant has to submit a medical report from an SECP approved medical board and thefunds are then retired on the same conditions that would apply to a standard retirement

procedure.

Withdrawal due to Death of Participant

Incase of death of a participant, the nominees (as identified by the nomination form) arerecognized as having any title to or interest in the balance held in individual pension Accountof the deceased. In case no nominations have been made, the executors, administrators or


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succession certificate holders of the deceased participant are recognized as having title to theaccumulated balance of Individual pension account of the deceased participant

The nominee(s) can:

Withdraw his share of the amount subject to the conditions laid down in the IncomeTax Ordinance, 2001; >

Transfer his share of the amount into his existing or new individual pension accountto be opened with the pension fund manager, according to the Voluntary PensionSystem Rules;

Use his share of the amount to purchase an approved annuity plan on his/ her life froma life insurance company, only if the age of the survivor is fifty five years or more; or

Use his/ her share of the amount to purchase a deferred approved annuity plan on hislife from a life insurance company to commence at age fifty five years or later.

If any amount in excess of the allowable amount is withdrawn as cash by the nominee(s),then tax will be deducted before making any such payments.

Procedure incase of Death of Participant

The units will be redeemed on the dealing day on which the intimation of death of the participant is received in writing and transferred to the individual pension account of the deceased.

Each of the nominees as nominated in the nomination form shall be required to submit

retirement application to the company. The total amount in the individual pensionaccount of the deceased participant will then be divided among the nominatedsurvivor(s) according to the percentages specified in the nominations form.

Early Withdrawal

A participant can redeem all or part of the units in his individual pension account beforeattaining the retirement age. However, such redemptions will be subject to deduction of income tax at his/ her average tax rate for the last three consecutive years. Participant mustsubmit the early redemption form to the company for an early withdrawal to take place,accompanied by the documentary evidence for the taxable income and tax paid by the

participant for the last three years to enable the company to determine the average tax ratewhich is required to be deducted. The redemption will be at the net asset value at the close of the dealing day on which the request, complete in all respects, is received. The amount iscredited to the individual pension account, from which the redemption payment shall be madeafter deducting the applicable tax, as required. The redemption amount shall be paid by directtransfer to the participants designated bank account or a crossed cheque/ draft for the amountwill be dispatched to the registered address of the participant.


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Tax Issues - Tax RateThe tax rate that is applied to the redemption money in case of early withdrawal or in case of withdrawal in excess of 25% (regular retirement, permanent disability or death) is calculated,according to the Income Tax Ordinance, 2001, as follows:

A / B %

Where:A is the total tax paid or payable by the person on the persons total taxable income for thethree preceding tax years; andB is the persons total taxable income for the three preceding tax years.

Tax CreditParticipants can avail tax credit for contributions made to pension funds in each tax year as

per the Income Tax Ordinance, 2001.

Procedure for Claiming Tax Credit

A participant who is employed can provide documentary evidence of contributions madeduring each tax year ending on June 30 to their employers who may then make adjustmentsof tax credit admissible from the tax to be deducted from salary. A self-employed participantmay claim the tax credit at the time of filing of his tax return for each tax year ending on June30. The participant may claim a tax rebate depending upon the amount of his contributionsfor that tax year and his applicable taxes.

Insurance

The pension fund management company usually offers insurance with the pension account,

however the terms and conditions for each facility vary and the person seeking to open a pension fund account can obtain more information from the company.

Fee Structure

Pensions funds charge a minimum fee for their services and are allowed by SECP amaximum front-end fee (sales charge) of 3% of all the contributions received from any

participant of the pension fund and an annual management fee of 1.5% of the average of thevalues of the net assets of the pension fund calculated during the year for determining the

prices of the units of the sub-funds. However, these rates are subject to further change bySECP.

Participants are also not charged front-end fee in the event of the transfer of the individual pension account from one pension fund manager to another pension fund manager.

Islamic Pension Funds

Islamic pension funds operate in the same way as other pension funds however allinvestments made for Islamic pension funds must be Shariah compliant.

Rules Governing Pension FundsVoluntary Pension System Rules, 2005Income Tax Ordinance, 2001.


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MODERATE-LEVEL RISKS

Mutual funds considered moderate-risk investments may be found in at least the eight typescategorized below.

1. Income funds2. Balanced funds3. Growth and income funds4. Growth funds5. Short-term bond funds (taxable and tax-free)6. Intermediate bond funds (taxable and tax-free)7. Insured government/municipal bond funds8. Index funds.

HIGH-LEVEL RISKS

The types of funds listed below have the potential for high gain, but all have high risk levelsas well.

1. Aggressive growth funds2. International funds3. Sector funds4. Specialized funds5. Precious metals funds6. high-yield bond funds (taxable and tax-free)7. Commodity funds8. Option funds

Figure below depicts three types of mutual fund portfolios structured according to risk level.You may wish to use this as a guide to building a portfolio based on your level of risk tolerance. The percentages of each type of fund recommended in the portfolios reflect areasonable degree of diversification, balance, and risk level as indicated.

Portfolio Allocations Based on Risk Levels

LOW-LEVEL RISK CONSERVATIVE PORTFOLIO

50%Govt.

Treasu


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ryBillFunds

50%MoneyMarketFunds

MODERATE-LEVEL RISK CAUTIOUSLY AGGRESSIVE PORTFOLIO

40%Growth &IncomeFunds

30%Govt.BondFunds 20%GrowthFunds


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10% IndexFunds

HIGH-LEVEL RISK AGGRESSIVE PORTFOLIO

25%AggressiveGrowthFunds 25%International Funds 25%Sector Funds

15% HighYieldBondFunds

MEASURING RISK

As you become a more experienced investor, you may want to examine other, more technical,measures to determine risk factors in your choice of funds.

Beta coefficient is a measure of the funds risk relative to the overall market. For example, afund with a beta coefficient of 2.0 means that it is likely to move twice as fast as the generalmarket both up and down. High beta coefficients and high risk go hand in hand.

Alpha coefficient is a comparison of a funds risk (beta) to its performance. A positive alphais good. For example, an alpha of 10.5 means that the fund manager earned an average of 10.5% more each year than might be expected, given the funds beta.


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Interest rates and inflation rates are other factors that can be used to measure investmentrisks. For instance, when interest rates are going up, bond funds will usually be declining, andvice versa. The rate of inflation has a decided effect on funds that are sensitive to inflationfactors; for example, funds that have large holdings in automaker stocks, real estatesecurities, and the like will be adversely affected by inflationary cycles.

R-Square facto r is a measure of the funds risk as related to its degree of diversification.

The information is supplied here merely to acquaint you with the terminology in the eventyou should wish to delve more deeply into complex risk factors. The more common risk factors previously described are all you really need to know for now, and perhaps for years tocome.

One caveat is in order, however. There is no such thing as an absolutely 100% risk-freeinvestment. Even funds with excellent 10 year past performance records must include in their

literature and prospectuses the following disclaimer: Past performance is no guarantee of future results. However, by not exceeding your risk tolerance level, you can achieve a widesafety and comfort zone with mutual fund portfolios such as those shown in Figure above.


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SOURCES OF PROFIT GENERATION :A mutual fund can generate profits from three different sources, which are:

Dividend Capital Gains Appreciation of Share Price

Dividend:Mutual fund generates income from dividends received from other joint stock companies whose shares the fund holds. A mutual fund uses this dividendincome to distribute dividend to its own stock holders.Capital Gains:As discussed earlier the portfolio manager changes the portfolio of the fund withthe passage of the time and also with the changes in economic and businessconditions. So due to the sale and purchase of shares, the mutual fund generatescapital from the sales/ purchase of stocks. The capital gain generated by themutual fund is also used to pay dividends to the investors of the fund.Appreciation of Share Price:Mutual funds also increase the wealth/investment of their shareholder throughappreciations of share price of the mutual fund. For example if the subscription

price of a mutual fund is Rs.11.00, and after a period of seven months the pricegoes upto Rs.18.00, thus the investor gets a profit of Rs.7.00 if he sell the mutualfund's shares in the market.

Advantages of Mutual Funds:

M utual Funds substantially lower the investment risk of small investorsthrough diversification in which funds are spread out into various sectors,companies, securities as well as entirely different markets. It is always theobjectives of a fund manager to maximize a funds return for a given levelof risk, however the dangers of "over-diversification" are always prevalentwhich would inevitably lead to a reduced return on the portfolio.

M utual Funds mobilize the saving of small investors and channel theminto lucrative investment opportunities. As a result, mutual funds addliquidity to the market. Moreover, given that the funds are long terminvestment vehicles, they reduce market volatility by offering support to

scrip prices.

M utual Funds are providing the small investor access to the whole marketwhich individually, would be difficult to achieve.

The investors save a great deal in transaction cost given that he has accessto a large number of securities by purchasing a single share of mutualfund.

The investors can pick and choose a mutual fund to match his particular needs.


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Disadvantages of Mutual Funds:

As such there is no major disadvantage attached to the mutual funds. However,the possible disadvantages could be:

Economic and Business Conditions: As the business and economicconditions do not remain constant, the mutual fund may face somedifficulties in future. Especially if the manager does not shuffle theinvestment portfolio with the passage of time, or some other major unforeseen disaster/event changes the investment scenario.

Portfolio Managed by Managers: Portfolio of a mutual fund is managed by the portfolio managers due to which the investor has no say in theaffairs of a mutual fund.

MUTUAL FUND RANKING METHODOLOGY

Mutual fund industry in Pakistan has shown impressive growth in recent years. Its acceptanceas a useful tool to deploy funds is on rise amongst both individual and corporate investors.However, at the same time, the increasing number of asset managers as well as funds hasnecessitated the need of an independent opinion on their performance. PACRA follows acomprehensive approach to rate the two distinct ingredients of the mutual fund industry asset managers and funds.

These two are rated on separate scales. While the asset manager rating seeks to determine the professional capacity of asset managers, the rankings/ratings of mutual funds aim to highlightrelative positioning of a particular fund with reference to certain identified parameters.PACRA has so far developed three different products for ranking/rating mutual funds, giventhe varying nature of these funds and the different investment consideration and informationrequirement of investors. The main product, mutual fund performance ranking (commonlyreferred to as Star Ranking), is applicable to a large number of funds categories and focuseson relative actual recorded performance of a mutual fund. The other two products namely,funds stability rating, and funds capital protection rating are applicable to income andmoney market funds, and capital protected funds, respectively.

PROCESS OVERVIEW

Every mutual fund investor has a distinct set of investment objectives and preferences. Theyall usually have unique risk-return perception and investment horizons that make it difficultto capture these preferences in a single yardstick, using which investment decisions can bemade. PACRA Mutual Fund Performance Ranking

(Star Ranking) attempts to address this investor need. The star ranking provides an initialscreening criterion to investors. The ranking is a purely quantitative measure, avoiding any

biases. It is based on historical returns of a fund relative to other funds in similar category.PACRA has defined different fund categories each having distinct characteristics andrankings of funds in a particular category are comparable. The ranking methodology is


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designed in a manner that the star ranking of a fund conveys a sense of how skillfully thefund has been managed; that is, the relative star rankings of two funds in a category should beaffected more by manager skill than by market circumstances or events that lie beyond thefund managers control. PACRAs mutual fund ranking, therefore, provides a usefulyardstick to existing and potential investors and facilitates their investment decisions.

PACRA assigns two types of star rankings i.e., a star ranking based on funds performanceduring the trailing 12 months; and a long-term star ranking based on funds performanceduring the trailing 36-months. These rankings are presently done on two cut off periodsending; i) June 30, and December 31. However, as the industry matures further, PACRA mayenhance the time period of performance review for long-term star ranking, most likely to fiveyears compared to existing practice of three years, and may also increase the frequency of updates to quarterly basis.

DEFINING A CATEGORY

Fund categories define groups of funds whose constituents are similar in their risk factor exposures so that return comparisons are meaningful. Moreover, the observed returndifferences among funds relate primarily to security selection, or to variation in the timingand amount of exposure to different elements affecting the category. Each of these, over time,may be presumed to exercise a skill-related effect.

The following considerations apply while assigning a fund to a particular category:

Funds are grouped by the type of investments that dominate their portfolios.

In general, funds in the same category can be considered reasonable substitutes for the purposes of portfolio construction.

Category membership of a fund is based on long-term portfolio composition philosophy for the fund as disclosed by its asset manager.

PACRA, after a detailed evaluation of mutual funds in Pakistan, has identified the followingcategories (separate subcategories in respect of open and closed end funds has to bemaintained):

Equity Fund: A fund that at least invests around 50% of its net assets in equities atall times.

Balanced Fund: A fund that carries a mix of interest-based and equity securities andat least invests around 30% of its net assets in equities at all times.

Income Fund: A fund that invests in interest-based instruments / securities aaverage maturity of its assets is more than 90 days at all times.

Money-Market Fund: A fund that invests in money market and other short-terminterest based instruments / securities including spread transactions. The weightedaverage maturity its assets is less than 90 days at all times.

Asset Allocation Fund: A fund that can invest in any class of asset in any proportionaccording to criteria set in its offering document


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To summarise, the star ranking is strictly a quantitative measure and funds are rated withintheir respective categories. The ranking exercise measures performance of funds in a risk andreturn combination and then funds are ranked accordingly on the basis of their performance.It is important to note that a funds particular star ranking is with reference to its category andconsequently, rankings are comparable only in the same category.

Performance Evaluation of Mutual Funds in Pakistan

In Pakistan Mutual Funds were introduced in 1962, when the public offering of NationalInvestment (Unit) Trust (NIT) was introduced which is an open-end mutual fund. In 1966another fund that is Investment Corporation of Pakistan (ICP) was establishment. ICPsubsequently offered a series of closed-end mutual funds. Up to early 1990s, twenty six (26)closed-end ICP mutual funds had been floated by Investment Corporation of Pakistan. After considering the option of restructuring the corporation, government decided to wind up ICPin June, 2000. In2002, the Government started Privatisation of the Investment Corporation of Pakistan. 25 Outof 26 closed-end funds of ICP were split into two lots. There had been a competitive biddingfor the privatisation of funds. Management Right of Lot-A comprising 12 funds was acquired

by ABAMCO Limited. Out of these 12, the first 9 funds were merged into a single closed-end fund and that was named as ABAMCO Capital Fund, except 4th ICP mutual fund as thecertificate holders of the 4th ICP fund had not approved the scheme of arrangement of Amalgamation into ABAMCO capital fund in their extra ordinary general meeting held onDecember 20, 2003. The fund has therefore been reorganised as a separate closedend trustand named as ABAMCO Growth Fund. Rest of the three funds were merged into another single and named as ABAMCO Stock Market Fund. So far as the Lot-B is concerned, itcomprised of 13 ICP funds, for all of these thirteen funds, the Management Right wasacquired by PICIC Asset Management Company Limited. All of these thirteen funds weremerged into a single closed-end fundwhich was named as PICIC Investment Fund. Later on the 26th fund of ICP (ICP-SEMF)was also acquired by PICIC Asset Management Company Limited. The certificate holders inextraordinary general meeting held on June 16, 2004

Approved the reorganisation of SEMF into a new closed-end scheme renamed as PICICGrowth Fund. The Securities and Exchange Commission of Pakistan subsequently authorisedPGF on July 30, 2004.Initially there was both public and private sector participation in the management of these

funds, but with the nationalisation in the seventies, the government role become moredominant. Later, the government also allowed the private sector to establish mutual funds. Currently there exist Thirty-three funds by the end of Financial Year 2005.

Twelve open-ended mutual funds are: public sector, 01; private sector, 11;

Twenty-one close-end mutual funds in Pakistan are: public sector, 0;

private sector, 21.


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Performance evaluation of mutual funds is important for the investors and portfolio managersas well. Historical performance evaluation provide an opportunity to the investors to assessthe performance of portfolio managers as to how much return has been generated and whatrisk level has been assumed in generating such returns. In this way the investors can alsocompare the performance of fund managers.

On June 2004 the net asset value of close-end mutual funds was Rs 48 billion and open-endfunds net asset value was Rs 63.86 billion. Whereas on June 1997 thenet asset value of closed-end mutual funds was Rs 04 billion and open-end mutual funds net asset value was Rs25 billion. Total net assets value in 1997 was Rs 29 billion and at the end June 2004, raised toRs 112 billion. There is a big increase of investment (entrusted amount) in this sector since1997 to 2004 which necessitate the performance evaluation of funds free of manipulation.

In

the last few years mutual fund industry has shown significant progress with reference tosaving mobilisation and important part of the overall financial markets. But still we are far

behind the developed countries mutual fund industry. Growth in mutual funds worldwide is because of the overall growth in both the size andmaturity of many foreign capital markets.These nations have increasingly used debt and equity securities rather than bank loans tofinance economic expansion. The Pakistan economy can prosper because of the benefits of

new investment opportunities arising from economic reform, privatization, lowered trade barriers and rapid economic growth.


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Individuals throughout the world have the same basic needs that are education for their children, health, good living standard and comfortable retirement. In our country where

people are religious minded, mostly they avoid bank schemes for investments, if they are provided an investment opportunity which suits the religion, we can mobilise savings from

masses which may be laying an idle money at present. By doing so we would be able toimprove the living standard of our countrymen through economic prosperity. This can beachieved through the introduction of different species of mutual funds and their performance.The success of this sector depends on the performance and the role of regulatory bodies.Excellent performance and stringent regulations will increase the popularity of mutual fundsin Pakistan.

RESEARCH METHODOLOGY AND EMPIRICAL RESULTS

The SampleAfter 2002, mutual fund industry in Pakistan has witnessed significant changesand growth interms of private sector participation, divestment of public sector funds.At present we have 33funds21 closed-ends, out of which 09 are the infantcommenced in between 2003 and 2004some of which emerged due to divestment andthen merger of ICP funds while others arenewly introduced. We have 12 open-endfunds, out of these funds 10 funds are infant, whichintroduced in between 2003 and2004. As we are concerned with survivorship bias controlleddata, ICP funds which nomore exist at the end of June 2004 and merged into other funds areexcluded from theresearch sample and other funds which have life of two to three years havealso beenexcluded from the evaluation. Rests of 14 funds out of total 33 funds have lived alonglife and still operative which serve our research purpose.


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Sources of DataAnnual reports of equity and balanced funds for the period from 1997 to 2004have been usedfor data collection. For this purpose different sources have beenused; Asset ManagementCompanies of the funds, Stock exchanges, SECP andinternet. Data for Treasury bills rate wascollected from Statistical Bulletins of StateBank of Pakistan.

VariablesVariables picked for the performance evaluation of mutual funds are netincome after taxes of funds, net asset value, number of certificates/shares outstanding,earning per certificate andnet asset value per certificate/share, monthly returns ofKSE 100 index. Six months Treasury

bill rates. Return of fund was calculateddividing return per certificate by opening net assetvalue per certificate. Return percertificate was calculated dividing fund income after taxes bytotal number ofcertificates outstanding for the year. Net asset value per certificate wascalculated bydeducting total liabilities from total assets of the year or by takingshareholdersequity. Return of a fund may also be calculated dividing net income after taxesof a fund by opening net assets of the fund for that year.

Methodology and Empirical ResultsThere are four models which are used worldwide for the performance evaluation of mutualfunds (1) Sharpe Measure (2) Treynor Measure (3) Jenson differential Measure (4) FamaFrench Measure. We have used first three measures excluding Fama French Measure. Thereason for not using Fama French Model is that for this model we needed data on book tomarket ratio for all companies listed at KSE from 1997 to 2004 which could not be madeavailable.

The Sharpe ModelIn 1960 William F. Sharpe started to work on portfolio theory as thesis project. He introducedthe concept of risk free asset. Combing the risk free asset with the Markowitz efficient

portfolio he introduced the capital market line as the efficient portfolio line.

The model given by Sharpe, 1 we can proceed further to use it for the determination of expected rate of return for a risky asset, which led to the development of CAPM capital asset

pricing model. Through this model an investor can know what should be the required rate of return for a risky asset. The required rate of return has a great significance for the valuation of securities, by discounting its cash flows with the required rate of return.

In order to determine which portfolio offering the most favourable risk/return trade-off, we

compute the ratio of the historical returns in excess of the risk-free rateto the standarddeviation of the portfolio returns. The portfolio offering the highest reward/risk ratio then isthe only risky portfolio in which investors will choose to invest. Using average returns of the

portfolio uses Sharpe ratio to measure ex-post portfolio performance.


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Jensen Differential MeasureJensen in 196 9 introduced alpha () in the capital asset pricing model to measure theabnormal return of a portfoliothat is difference between the actual average return earned bya portfolio and the return that should have been earned by the portfolio given the marketconditions and the risk of the portfolio. Jensen measure is calculated as follows:

This measure has great appeal for practitioners as has been derived from the capital markettheory Jensen differential measure applied on the data of mutual funds for the period from1998 to 2004, the result shows (Table 3) thatalthough few funds show negative alpha but on overall basis funds industry alpha is positivealpha of 6.03. Positive alpha of the mutual funds is an indication that the funds outperformthe market proxyKSE 100 index by 0.86

percent per annum.

results of descriptive statistics Table 4, show that in the last seven years from 1998 to 2004mutual funds, on average earned return of 15 percent with the standard deviation of 13.8

percent, whereas market return in this period was 19.5 percent with the standard deviation of 40.5 percent which indicates the controlled risk of funds. Therefore Sharpe ratio of funds is0.47 (as compared to market which is 0.27) risk premium of per one percent of standard

deviation which represents reasonable risk premium. This investigation also proves funds better performance to the market.


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CONCLUSIONThis paper provides an overview of the Pakistani mutual fund industry and investigates themutual funds risk adjusted performance using mutual fund performance evaluation models.Survivorship bias controlled data of equity and balanced funds is used for the performanceevaluation of funds. Mutual fund industry in Pakistan is still in growing phase. Result shows

that on overall basis, funds industry outperform the market proxy by 0.86 percent. They areinvesting in the market very defensively as evident from their beta. Mutual Fund industrysSharpe ratio is 0.47 as compared to market that is 0.27 risk premium per one percent of standard deviation. Results of Jensen differential measure also show positive after cost alpha.Hence overall results suggest that mutual funds in Pakistan are able to add value. Where asresults also show some of the funds under perform, these funds are facing the diversification

problem. Worldwide there had been a tremendous growth in this industry; this growth inmutual funds worldwide is because of the overall growth in both the size and maturity of many foreign capitalmarkets, we are far behind. The need of an hour is to mobilise saving of the individualinvestors through the offering of variety of funds (with different investment objectives). Thefunds should also disclose the level of risk associated with return in their annual reports for the information of investors and prospective investors. This will enable theinvestors to compare the level of return with the level of risk. The success of this sector depends on the performance of funds industry and the role of regulatory bodies. Excellent

performance and stringent regulations will increase the popularity of mutual funds inPakistan.

Mutual Fund Industry of Pakistan(2)

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