The Mutual Fund Industry

Summarized by Hatim & Emadeldin

Definition of Mutual Funds

A mutual fund is a financial intermediary that pools the resources of many small
investors by selling them shares and using the proceeds to buy securities. It is one of the
means for developing a diversified portfolio where the pooled funds are managed by a
professional manager who then chooses the securities to invest in.

The Growth of Mutual Funds

At the beginning of 2010, nearly 16% of assets held by intermediaries were held by
mutual funds. What services these funds provide that has caused them to grow rapidly
over the last 20 years?.
First: Liquidity intermediation:
Investors can quickly convert investments into cash while still allowing the fund to
invest for the long term. Mutual funds allow investors to buy and redeem at any time
and any amount sometimes without fees for redemption (short term funds).
Second: Denomination intermediation:
Investors can participate in equity and debt offerings that, individually, require more
capital than they possess. The mutual fund allows small investors access to securities
they would be unable to purchase without the mutual fund, this is because most money
market securities are available in large denominations
Third: Diversification:
Investors immediately realize the benefits of diversification even for small investments
because risk can be lowered by holding a portfolio of diversified securities. Also the
mutual funds provide low cost way to diversify into foreign markets.
Fourth: Cost advantages:
The mutual fund can negotiate lower transaction fees than would be available to the
individual investor. Large block trades of e.g. 100,000 shares or more trade according to
different fee structure than smaller ones.
Fifth: Managerial expertise:
Many investors prefer to rely on professional money managers to select their
investments. These investors are willing to pay fees to let someone to choose their
stocks, despite the fact that: Research demonstrated that mutual funds do not outperform
a random pick from the market

Mutual Fund Structure

Investment companies usually offer a number of different types of mutual funds called
complexes. A complex is a group of funds under common management composed of

1
one or more families of funds. Advantage of fund complexes is that Investors can often
move investments among these funds easily and quickly without penalty
Mutual funds are structured in two ways:
A- Closed-End Fund. B- Open-End Fund.
A.
Closed-End Fund
A fixed number of nonredeemable shares are sold through an initial offering and are
then traded in the OTC market. Price for the shares is determined by supply and demand
forces. Advantage to managers: investors cannot make withdrawals and they get their
money through selling their shares. Problems: funds cannot take any additional
investment after the initial offering and they have to initiate a new fund
B.
Open-End Fund
Investors may buy or redeem shares at any point (increase the no. of shares). Price is
determined by the net asset value of the fund (calculated daily). Funds agree to buy
back shares from investors at any time. Advantages include liquidity and growth.
Mutual Fund : Organizational Structure
The shareholders, or owners, of the mutual fund are the investors. The board of directors
oversees the fund’s activities, hires the investment advisor, an underwriter, etc., to
manage the day to day operations of the fund.
Investment Objective Classes
There are four primary classes of mutual funds available to investors:
1)
Stock (equity) funds
2)
Bond funds
3)
Hybrid funds
4)
Money market funds
1-
Stock (equity) Funds
Other than investing in common equity, the stated objective of any particular fund can
vary dramatically.
A- Capital Appreciation Funds:

Seek rapid increase in share price

Not being concerned about dividends.

They are risky (focus on companies seeking rapid Growth- High technology
companies is an example)
B- Total Return Funds:

Seek a balance of current income and capital appreciation.

Include mature (dividends) and growth companies (share appreciation)

Less risky because they include large established companies
C- World Equity Funds:

2
Invest primarily in foreign firms. Allow investors easy access to international
diversification, other types in Value, Growth, a particular industry, etc.
2- Bond Funds
A- Strategic Income Funds:

Invest in a combination of corporate bonds

High level of current income.

Low quality but higher returns

Investors trade safety for greater returns
B- Corporate bonds funds: invest primarily in high-grade corporate bonds,
C- Government Bond Funds invest in Treasury, as well as government bonds. They are
default risk-free but low returns
D- Others include World Bond Funds, etc.

3-Hybrid Funds
Combine stocks and bonds into a single fund. Its objective is to provide an investment
that diversifies across different securities and different issuers of a particular security.
Despite this advantage investors prefer to hold separate funds.

4- Money Market Mutual Funds

Open-end funds that invest only in money market securities. They do not charge fee for
purchasing or redeeming shares. They have minimum initial investment. The yield
depends on the performance of the purchased security. Commercial papers and
certificate of deposits are the major components of these funds. Offer check-writing
privileges. Investors fled to MMMF despite the fact that these funds are uninsured while
banks are insured. Main reason is that the risk of MMMF is small and the money is
invested in money market securities that have a very low default risk. Confidence in
MMMF was shaken during the credit crisis

Index Funds
A special class of mutual funds that do not fit into any of the categories discussed so far.
The fund contains the stock of the index it is mimicking. For example, an S&P 500
index fund would hold the equities comprising the S&P 500.
Traditional mutual funds pay fees to a professional manager to select the stocks or
bonds to a portfolio. As investors we want the benefits of mutual fund investing without
paying costs to managers and this is what an index fund does. That is to say Index fund
contains the stocks in the index so these funds have lower fees than actively managed
funds. Some argue that these funds outperform most fund managers.
Fee Structure of Investment Funds
Load funds (class A shares) charge an upfront fee for buying the shares.
Deferred load (class B shares) funds charge a fee when the shares are redeemed.

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No-load funds do not charge this fee. If the particular fund charges no front or back end
fees, it is referred to as class C shares.
The purpose of loads is to compensate sales brokers and to discourage early withdrawal
of deposits (in case of deferred load funds)
Other fees charges by mutual funds include:
Contingent deferred sales charge: a back end fee (at redemption paid to professionals)
that may disappear altogether after a specific period.
Redemption fee: another name for a back end load
Exchange fee: a fee (usually low) for transferring money between funds in the same
family.
Account maintenance fee: charges if the account balance is too low.
12b-1 fees: are deducted from fund asset to pay marketing, advertising, and
commissions.

Regulation of Mutual Funds

Regulations should require:

Independent directors must constitute a majority of the board.

Independent directors select and nominate other independent directors.

Legal counsel to the independent directors must also be independent.
What is the practice in Sudan?

Conflicts of Interest in the Mutual Fund Industry:

Investor confidence in the stability and integrity of the mutual fund industry is critical.
However, the usual problems of asymmetric information and the principal-agent
problem arose, leading to abuses on the part of fund management.
Mutual Fund Abuse:
Late trading: allowing trades after 4:00 pm to trade at today’s 4:00 NAV instead of
tomorrow’s price. This is illegal under SEC regulations.
Market timing: taking advantage of time zone differences for determination of NAV.
This is not illegal under SEC rulings.
Government Response to Abuses

Require more independent directors

Hardening the valuation rule: this addresses the late trading problem, but not
market timing.

Increased and enforces redemption fees: fees to discourage market timing by
additional fees for short-term redemptions.

Increased transparency: hits operating practices, directors, investment managers,
compensation arrangements with brokers, etc.

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 Empirical studies

The Development of Mutual Funds around the World

Leora Klapper, Víctor Sulla and Dimitri Vittas
One of the most interesting financial phenomena of the 1990s was the explosive
growth of mutual funds. In their study LVD argued that mutual funds grew
explosively in most countries around the world during the 1990s. Equity funds
predominate in Anglo-American countries and bond funds in most of Continental
Europe and in middle-income countries. The global growth of mutual funds was
fuelled by:
1)
The increasing globalization of finance and expanding presence of large
multinational financial groups in a large number of countries.
2)
The strong performance of equity and bond markets throughout most of the
1990s.
3)
A third factor was probably the demographic aging that characterizes the
populations of most high and middle-income countries and the search of
financial instruments that are safe and liquid but also promise high long-term
returns by growing numbers of investors.
Mutual funds offer investors the advantages of portfolio diversification and professional
management at low cost. These advantages are particularly important in the case of
equity funds where both diversification and professional management have the potential
to add value. For bond and money market mutual funds, the main advantage is
transactional efficiency through professional management.
One of the distinguishing features of mutual funds is a high level of operational
transparency relative to other financial institutions, such as banks and insurance
companies. Also unlike them, mutual funds do not assume credit and insurance risks
and thus do not need to make subjective provisions against non-performing loans or to
create actuarial reserves against future insurance claims. Mutual funds invest in
marketable instruments and are able to follow a “mark to- market” valuation for their
assets.
Fund investors bear the investment risk, but they rely on the advertised investment
strategies of mutual fund managers for making their selections. So for their successful
operation and development, mutual funds require a robust and effective regulatory
framework so that investors need to be protected from fraudulent behavior on the part of
mutual fund managers .
Mutual funds also require well-developed securities markets with a high level of market
integrity and liquidity.

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Aim of the paper: The paper uses aggregate data on total fund assets from a cross
section of 40 developed, developing and transition countries to study the structure and
growth pattern of mutual funds in different countries and analyze the determinants of
mutual fund growth. The data cover the period 1992-98

Factors contribute to the growth of mutual funds:

The growth of mutual funds is likely to be determined by a number of factors.

First the level of income and wealth of the residents of a country, the
relationship between per capita income (used as an indicator of economic
development and wealth) and holdings of mutual fund assets (expressed as a
percentage of national income) is not always positive.

The availability or not of substitutes as well as complements also greatly affects
the growth of mutual fund assets. For example bank deposits account is close
substitutes of money market mutual funds.

The interest rate spread between bank deposits and money market funds would be
expected to play an important part in determining the demand for money market
mutual funds.

Well-developed markets for bonds and equities is needed for the mutual funds
successful operation, as their demand would depend on their cost efficiency in
offering portfolio diversification and professional management.

The regulation of the investments of pension funds and insurance companies
could also affect the growth of mutual funds. The impact of contractual savings
institutions on mutual fund growth would be smaller in countries where they are
compelled to invest in government bonds. In contrast, freedom to invest in mutual
funds or “funds of funds” would stimulate the development of the mutual fund
industry.

Return differentials are also affected by tax policies and financial regulation. As
in many countries investment in mutual funds receive tax incentives.

In several countries, including in particular the United States and France, the
growth of money market mutual funds has been stimulated by the imposition of
tight restrictions on the interest rate that banks could pay on retail deposits.

A factor of major importance that would be of universal relevance and would
explain the growth of mutual funds in many countries is the advent of electronic
technology and the concomitant large reduction in the cost of operating a large
number of accounts and an even larger volume of transactions. This has made
mutual funds, especially money market funds, more competitive vis-à-vis
banks.

A final factor that may affect the growth of mutual funds in a particular country
is the “proximity” of a better developed or tax advantaged overseas center
offering mutual fund investments to foreign investors. The countries with
large offshore business, such as Luxembourg, Ireland and Switzerland in

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 Europe or Hong Kong and Singapore in Asia, have a negative effect on the
growth of mutual funds in their neighboring countries.
TYPES OF MUTUAL FUND:
There are five main types of mutual fund: equity and bond funds that predominantly
invest in equities or bonds; balanced funds that have more balanced portfolios of both
equities and bonds; money market mutual funds that specialize in short-term
instruments; and finally funds of funds that mainly invest in other mutual funds.
Some types of funds are subdivided into several other categories. Thus, equity funds
may be classified by sectoral or geographic specialization, by investment objective,
and by class of investor (institutional or retail, with or without front loads, etc.). Bond
funds are mainly divided into short-term and long-term funds.

DETERMINANTS OF MUTUAL FUND DEVELOPMENT:

The growth of the mutual fund sector, like any other sector of economic activity, is the
result of the interaction of demand and supply. In general, the same factors that
influence the demand for mutual funds also shape their supply. These factors include:

The level of income and wealth is, or should be, a major determinant of the demand
for mutual fund investments, but income and wealth also affect the supply of such
services through their effect on market infrastructure and presence of skilled
professionals.

Similarly, securities market development is an important factor in stimulating the
demand side but also helps promote the supply of mutual fund services.

The availability or shortage of suitable financial instruments is a constraining factor
for the growth of mutual funds in many countries.

Regulatory restrictions can also play an important part, either in impeding or in
stimulating the growth of mutual funds.

Tax rules also tend to have a large impact.

To ascertain the significance of different factors that may explain the growth of mutual
funds, this paper estimates an empirical model that regresses the size of the mutual fund
sector, given by the level of net assets in relation to national income, on a number of
independent variables. They include among the explanatory variables indicators of the
level of economic development, securities market development and efficiency, financial
stability, and regulatory effectiveness as well as relevant return variables. They do not
include tax rules

GDP per capita is used as an indicator of economic development. Many studies have
shown that financial intermediaries tend to be larger, more active and more efficient
in high income countries (Demirguc-Kunt and Levine 1999).

Capital market development is represented by the total value of listed domestic
equities and issued bonds in relation to national income.

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
Market efficiency is measured by two indicators: the equity market turnover ratio
(which measures the value of traded shares divided by market capitalization) and the
value of traded shares in relation to national income.

Return variables are likely to have a large effect on the growth of different types of
funds. Equity mutual funds and the demand for equity investments more generally
are likely to be negatively affected by high real interest rates on bonds and bank
deposits. If investors can earn high real returns on less volatile instruments, they
would be less likely to invest in equities and equity mutual funds.

They include additional variables that highlight the overall level of country
development.

First, they include an indicator of the development of the banking sector,
measured by the ratio of commercial bank assets to the combined total assets of
commercial banks and the central bank.

Second, they include indicators of financial system development and
structure (Beck Et al. 2000), which distinguish between market-based and
bank-based financial systems.

Third, they include the openness to international trade and foreign
investment, as proxied by the share of exports and imports in relation to
national income.

Forth, they include the ICRG index of country risk, which indicates the
overall confidence of investors in local markets.

Finally, they include the importance of high-tech industries, measured by the
share of high-tech exports to total exports. We expect a positive correlation
between this variable and the growth of mutual funds, especially in high-
income countries.

Finally, they include legal and governance variables. Common law countries tend
to have more transparent and more reliable accounting systems and to provide
stronger protection of the rights of outside investors.

They also include two governance indicators, Voice and Accountability and
Regulatory Burden. These variables measure the consistency and accountability of
government policy, including the existence of independent media to monitor the
performance of regulatory agencies, and the impact of regulatory policies.

The main findings of the paper

The main findings are as follows:

A strong relation between mutual fund and capital market development – both the
value of traded equities and bond market development are highly significant.

We also find a significantly positive impact of accountability, restrictions on the
remuneration of retail deposits, market-based systems and lower political risk.

Real interest rates, market volatility and systemic crises are significantly negative and
market return has the right sign, but is insignificant.

8

There are also some interesting differences in the results between high- and middle-
income countries. For example, in developing countries per capita income is
significantly positive and real interest rates are significantly negative, but both
variables are insignificant in developed countries.

The result shows the relationship between equity funds as a percentage of GDP and
country characteristics. Lower market volatility and greater market liquidity is very
significantly related to the size of total equity funds in developed countries. They
also find a significantly positive coefficient for developed common law countries. In
addition, they find for all countries a positive relationship between equity funds and
the development of the bond market.

The result shows also the relationship between bond funds as a percentage of GDP
and country characteristics. In developing countries, they find a strong relationship
between per capita GDP, lower interest rates, and higher market development and
bond fund development. In developed countries, the strongest relationship is with
restrictions on retail deposits. In both sets of countries we find a strong negative
effect of common-law. The positive relationship with civil- and Germanic-law
countries may be associated with lower levels of equity market development as an
alternative investment.

Finally, the paper shows the relationship between money-market mutual funds as a
percentage of GDP and country characteristics. In developing countries, we find that
higher GDP per capita and more developed bond markets are associated with more
developed markets. They also find that restrictions on retail deposits have a strong
explanatory power in the case of money market mutual funds, especially in high-
income countries.

CONCLUSION:
In general, we find that mutual funds are more advanced in countries with better
developed and more stable capital markets (reflecting investor confidence in market
integrity, liquidity and profitability and a greater supply of investable securities). We
also find that equity funds dominate in Anglo-American countries and bond funds in
most of Continental Europe and in middle-income countries. In developed countries,
investors are concerned with market microstructure; for example, equity funds are
significantly smaller in countries with higher market volatility and weaker accounting
standards. In comparison, in developing countries macroeconomic factor appear most
important; for example, bond fund development in developing countries is significantly
related to higher GDP per capita and lower interest rates. However, in both developed
and developing countries, lower country risk and higher investor confidence leads to
greater fund development. In addition, restrictions on competing savings products may
have acted as a catalyst for the development of money market and (short-term) bond
funds.

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 The Determinants of Mutual Fund Performance:
A Cross-Country Study*
MIGUEL A. FERREIRA1, ANTONIO F. MIGUEL3, and
SOFIA B. RAMOS3

The paper studies the determinants of the performance of open–end actively managed
equity mutual funds in 19 countries. The paper aims to study how the performance of
equity mutual funds relates to fund characteristics and country characteristics around the
world. Fund characteristics; include fund size, age, fees (initial charges, annual charges
and redemption charges), management structure, and management tenure. Country
characteristics include variables such as economic development, financial development,
familiarity and investors’ protection, as potential determinants of the cross-sectional
differences of fund performance. Finally, they analyze whether the mutual fund
geographic zone of investment influences its performance by splitting our sample into
three subsamples: domestic funds, foreign funds, and global funds.

1) Determinant of mutual funds performance:

The study decomposed the factors affecting funds performance into fund characteristics
(size, age, fees (initial charges, annual charges and redemption charges), management
structure, and management tenure) and country characteristics (economic development,
financial development, familiarity and investors’ protection)
1-1) Fund characteristics:
Fund characteristics include:
1.1.1)
Fund size: Several studies attempt to answer questions as to whether fund size
affect investors' selection abilities. However empirical results conclude different
results, while some shows positive relation between size and performance, others
shows negative relation, as for example Indro et al (1999) argue that as funds
become larger marginal returns become lower and so funds suffer diseconomies
of scale.
1.1.2)
Fund age: Fund age provides a measure of the fund’s longevity and manager’s
ability. The effect of age on performance can run in both directions. We may
argue that younger mutual funds will be more alert but, on the other hand, several
studies show that they suffer from their youth as they usually face higher costs
during the start up period. Bauer, Koedijk, and Otten (2002) find that the
underperformance may be explained by the exposure of younger mutual funds to
higher market risk while they invest in fewer titles. Due to small size, young
mutual funds’ returns and ratings are also more vulnerable to manipulation.
However some studies shows younger age funds perform better than the older
ones.

10
1.1.3)
Fund fees: We can identify a substantial variety of charges or fees, including
administrative, management, advisory, exchange, load, redemption, and
exchange. In this paper, we isolate three different types of charge: annual charges
(ACHARGE), initial charges (ICHARGE), and redemption charges
(RCHARGE). The empirical evidence on the relationship between mutual fund
returns and fees is mixed. Using a sample of U.S. mutual funds, Ippolito (1989)
finds that funds with higher management fees perform better. However, others
find a negative relation between fees and performance. Gruber (1996) finds that
expenses are not higher for top performing funds, and that the expense ratio for
the top performing funds goes up more slowly over time than the expense ratio
for the bottom performing funds.
1.1.4)
Management structure: While individual managers are not subject to group
polarization, teams of decision-makers have more resources, resulting in a higher
number of alternatives for specific decisions, which can help to decrease
uncertainty. Accordingly, funds managed by a team will perform better than those
managed by an individual manager [Prather, Middelton, and Cusack (2001)].
1.1.5)
Management tenure: As a measure of managerial experience, we can argue that
managers with longer-tenure would perform better than others and, consequently,
investors would prefer to invest in funds run by experienced managers. Manager
tenure may also be associated with lower fees paid by investors, given that
experienced managers might be more efficient when analyzing and processing
information [Filbeck and Tompkins (2004)]. However, Peterson et al. (2001)
refer that, on average, departing managers underperform two years prior to
departure and they also present higher portfolio turnover and management fees.
Besides, despite suffering from inexperience, managers that run a fund for a
shorter period are usually more alert and have more incentives to perform better.
Chevalier and Ellison (1999) find no significant relationship between mutual
funds performance and management tenure.

1-2) Country characteristics:

1.2.1)
Economic development: Economic development is defined as a sustainable
increase in living standards of certain country or region inhabitants and it is
associated with higher per capita income and better education and skills, as well
as with more developed industries and more incentives for innovation and for
new investments. We expect higher GDP per capita to lead to higher mutual
funds performance.
1.2.2)
Financial development: A more developed financial market can have some
advantages for fund performance because of higher liquidity and lower
transaction costs. They suggested three variables to capture financial
development; the first one is the market capitalization of listed companies

11
 (MCAP) that captures the relative size of the stock market of each country.
Second, they consider the turnover ratio (TURN), defined as the ratio of the total
value of stocks traded to the average market capitalization. This variable is a
measure of trading activity. Data on these two variables are from the WDI
database. The third variable is country trading costs in basis points (TCOST).
1.2.3)
Familiarity: Familiarity may be intended as a cheap source of information. The
extent of investment might be due to investors being more or less familiar with
the markets. There is substantial evidence on the relation between familiarity and
higher performance. More familiarity-based investment allows investors to earn
higher returns than they would have otherwise earned if they had hedged. We
identify two classes of familiarity variables that can potentially influence the
performance of mutual funds. The first variable is the proportion of countries that
have a common national or official language with each given country (LANG).
The second variable is the average distance between a country’s capital to all
other countries’ capitals, measured in kilometers (DIST). We expect to find a
positive relation between familiarity and fund performance.
1.2.4)
Investor protection: Differences in laws and regulations can affect investor
behavior. Investors will be reluctant to invest in markets where their rights are not
properly protected. La Porta et al. (1997) note that countries with poor investor
protection have significantly smaller debt and equity markets. They also observe
that the quality of the legal system is important for the enforcement of contracts
and also captures the government’s general attitude toward business. They use
two different variables to proxy for investor protection. The first variable is a
dummy variable that identifies the origin type of the country’s legal system
(COMMON) that equals one if the origin is English common law, and zero
otherwise. The English common law provides better legal protection to investors
when compared to the German and French civil law system. The second variable
is a disclosure quality index (DISCLO), a measure of transparency (higher
implies more transparency). They expect to find positive relation between
investors protection variables and mutual fund performance.
1.2.5)
Other variables: We also include two other country-level variables, the
country’s mutual fund industry age (IAGE), and the average correlation between
a country’s market return and all other countries’ returns (CORR). We
hypothesize that the older the industry, the more efficient the market will be and
that may lead to better performance. The age of industry is measured in number
of years since the first open-end fund was sold in the country. The correlation
coefficient is a proxy for the diversification potential. Diversification tends to
offer investors potential gains; so, the more diversified mutual funds portfolios
become, the stronger their performance would be.

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2) Empirical result and conclusion:

This study examines the relation between mutual fund performance, fund attributes, and
country characteristics. Data on mutual funds is drawn from the Lipper Hindsight
database that covers mutual funds around the world. The final sample includes 10,568
open-end actively managed equity funds from 19 countries for the 1999-2005 period.
We consider several fund attributes as potential determinants of fund performance: size,
age, fees, management structure, and management tenure. In addition, we also consider
country characteristics as determinants of mutual fund performance: economic
development, financial development, familiarity, and investor protection.

The results show that:


Funds size is positively related with fund performance. Larger funds perform better
suggesting the presence of significant economies of scale in the mutual fund
industry worldwide. This finding is consistent among domestic and foreign funds,
and in several other robustness tests.

Fund age is negatively related with fund performance indicating that younger funds
tend to perform better. This finding seems mainly driven by the samples of foreign
and U.S. funds. When investing abroad, young mutual funds seem to offer investors
higher returns.

Additional tests show that fees (annual and initial charges) are positively associated
with performance. If fees are seen as the price that uninformed investors pay to
managers to invest their money, when paying higher fees investors are paying the
benefits associated to that investment, and obtain better performance.

Mutual funds managed by an individual manager perform better. The possible
benefits associated with team-management funds are exceeded by the costs.

Management tenure is positively linked to performance. This finding supports the
hypothesis that the benefits of management experience outweigh the costs, such as
lack of effort or attention.
Country characteristics are able to explain mutual fund performance more than
fund attributes.

There is a positive relation between mutual fund performance and the country’s level
of development.

The relation between performance and financial development is particularly strong in
the case of countries with high trading activity and low transaction costs. The level
of economic development is of particular importance for domestic funds.

Familiarity arguments explain the performance of foreign funds as they obtain better
performance when investing in countries geographically close and that share a
common language.

Finally, funds located in countries with strong legal institutions and investor
protection, tend to perform better.

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