Reflections on the Mutual Funds Industry

Mr. Khalid A. Mirza

Chairman

Monopoly Control Authority

(Key note speech at the 12^th Asia Oceana Regional Meeting of Mutual Funds Association of Pakistan)

Mr. Chairman, Ladies and Gentlemen,

I am indeed most grateful to you for affording me the privilege of sharing my thoughts on the mutual funds industry with such an august gathering. And thank you very much for your complimentary remarks. I am still not sure why I have been asked to speak on this occasion since whatever connection I had with the mutual funds industry as a regulator was in the dim and distant past, and in the current perspective, I really seem to be a “has been who never was”.  I almost feel like a trespasser or usurper who has taken the place that perhaps rightfully belongs to my distinguished regulatory successors. I suppose, in my oblique, half-Eastern half-Western, way I am trying to say that I am doubly grateful for this honor.

•  Frankly speaking, this is far too early in the morning for a so-called “key note” speech. Most keys come alive later in the day and it is difficult to strike a note of any kind so close to the crack of dawn! Here I am reminded of Oscar Wilde when somebody asked him if he could see him at 9 o’clock in the morning. His reply was: “No, I can’t! I don’t stay up that late!” To liven up the proceedings, I actually wanted to start with a joke on regulators, but then, I thought, I better not. Regulators are never amused by jokes on regulators, and also, nobody else regards them as jokes!

•  But jokes apart, in addition to my stint as a regulator, I was closely involved, as an IFC official, in the setting up of Pakistan’s first open-end mutual fund in the private sector of which you, Mr. Chairman, are the current, sitting Chief Executive, and also, much earlier, in the late sixties, as a junior officer in the erstwhile Investment Corporation of Pakistan, I had small role in the setting up of several closed-end mutual funds in the public sector, all of whom were recently privatized, and as it happened, it was your company, Mr. Chairman, that won the bid to take over their management.

•  In addition, as an official of the World Bank Group, I have been actively involved in the provision of technical assistance to several developing countries, including those in East Asia, to enable them to promote or strengthen the business of asset management, and also in the establishment of mutual funds in these countries. Thus, while I do have some “spotty” credentials on the basis of which I can speak on the subject of mutual funds or asset management, I really cannot pretend to have the practical experience, the wisdom or the sharp insights of the industry’s nitty-gritty aspects that are perhaps second nature to many eminent mutual fund practitioners that adorn this gathering. In considering my remarks, I would like you to please keep all this in mind.

•  Now, in the first instance, let us look at the overall global situation regarding financial markets and the position occupied by mutual funds. As you know, financial markets are in the process of momentous change prompted and catalyzed by the imperatives of globalization and the huge strides taking place in information technology, in particular the internet with its remarkable flexibility and endless, unfolding possibilities. And one can visualize that within a few years, not decades, neither capital markets nor banking will be the same as we know them today. The fact of the matter is that financial services are getting disintermediated, commoditized and globalized. Stock exchanges, as structured today, perhaps even stockbrokers, may well become dispensable and redundant very soon unless they adjust substantially to changing realities and are able to provide real services as well as liquidity to market participants. Banks, too, will not be able to escape being disintermediated by specialized and commoditized -- and, perhaps, global -- provision of the type of services that we recognize as banking.

•  It is also clear that today, the three operational forces dominating the global financial system are: first an increasing focus towards meeting client needs instead of product sales; second, an increasing emphasis on the alignment of operations to manage and mitigate risk; and finally, reliance on emerging, broad-based intra-industry utilities for trade processing, settlement, funds transfer etc. Based on these three drivers, the intellectual ferment in global financial circles is overwhelmingly about advisory services and client-specific or designer financial products, in line with what is called “client DNA”. The talk is also about sales of risk and risk-reward packages as opposed to products, and about the importance of scale as well as the out-sourcing of back-end functionalities to seek cost savings.

•  Now, of course, the question is where do mutual funds or the asset management business, as a whole, fit into all this? And secondly, why should we in developing countries, like Pakistan, be concerned about these international, possibly cutting edge, developments in our comparatively rudimentary situation? To answer the second question first, I believe we need to wake up to the fact that the forces of globalization and attendant cross border flows are becoming so strong that notwithstanding any barriers that may be placed, these forces and flows are likely to engulf developing countries. This is already starting to happen, whether we like it or not. We will have no alternative but to “think global” albeit we may continue to “act local” for a while. This year cross border flows are likely to be around 5-6 trillion dollars of which well over a trillion would pertain to investments in mutual funds. Obviously, it will be necessary for us to adjust our operational modalities and approach to take account of global developments and it would, therefore, make sense for us to forge and strengthen linkages with international asset managers as well as investment banks.

•  As to the question how mutual funds will fit into this emerging paradigm for the global financial system, it is important, in the first place, to acknowledge the undoubted importance of mutual funds. This is obvious from the industry’s aggregate, world size of $ 21 trillion as against the world’s financial assets that at present total around $ 120 trillion. Four years ago the industry’s size was about one-third less i.e. $ 14 trillion. The hallmark of the industry has been innovation, its ability to utilize and leverage off information technology, and the professional acumen displayed by its managers. These strengths, and the investor confidence thus engendered, have more than made up for the scandalous late trading and market timing issues that recently beset the industry, particularly in the United States.

•  It appears that the evolving scenario of the world financial system that is characterized by disintermediation, commoditization, client-specific advisory services, and an emphasis on both risk management as well as economies of scale, actually provides ample scope for mutual funds to flourish. The industry continues to innovate and develop products of differing risk-reward profiles which are constructed to capture value in a variety of ways.   Obviously, such specialized fund products could not only be marketed to address varying investor needs at the retail level but can also be used as building blocks by investment banks to design portfolios aligned to, as they say, the client’s DNA.

•  In many developing countries, including several middle-income countries in Asia and the Pacific, the mutual funds industry has displayed considerable progress in recent years. Although Pakistan had an early start with the setting up of NIT in 1962 and subsequently the ICP mutual funds, for almost 40 years, until 2002, the progress made was lackadaisical at best. In fact, the industry suffered both as a consequence of poor management as well as Government intervention and the distortions thus induced. During the past five years, prompted by positive changes in Government policy and regulation, as also measures to privatize and allow new entrants, the industry has witnessed major improvements and enhancement.

•  The aggregate size of the industry that was Rs. 25 billion in 2002 has now grown to Rs. 190 billion, i.e. over $3 billion, which is spread over some 60 funds that are managed by 24 asset management companies. Rs. 145 billion are in open-end funds and the rest is in closed-end funds. The total assets under management are, however, only 2% of GDP or 5.8% of bank deposits or 6-7% of market capitalization. By way of comparison I might mention that India’s mutual fund industry is 6% of GDP, 13.4% of bank deposits, and around 10-12% of market cap, whereas in the United States mutual funds are about 70% of GDP, over 150% of bank deposits, and about 20-25% of market cap.  Also, it is noteworthy that the industry in Pakistan has come out with a fairly wide range of mutual fund products.

•  If I may say so, I believe the mutual funds industry of Pakistan deserves to be applauded and saluted for its excellent achievements. There are, however, several challenges to overcome! Both absolute and relative size of the industry remains rather small by international standards, its management is fragmented, its funding  mostly comes from institutions and not from retail investors, its IT endowment is weak, its human capital is poor, and it has to contend with a shallow pool of investable assets.

•  The question now is what should be done to enhance the mutual funds industry in order that it clearly plays its role of underpinning the financial markets and serves as an effective channel for mobilizing resources and allocating them to productive uses. This is not a perfect world, never has been, nor will it be! There will always be constraints and issues which will need to be addressed. If mutual fund managers are competent, they will know how to deal with difficulties and make progress but if they are not, they won’t. To say, for instance, that by once again permitting institutions to invest in National Savings instruments has posed inordinate difficulties for mutual funds is not very convincing since the returns on NSS instruments have been drastically slashed over the years, and in any case, mutual funds must target retail investors, not institutions, if they are to play their proper role. Actually, with banking spreads being 7-10% and mutual fund fees being 1½ to 2%, mutual fund managers have a lot of room to manoeuvre.

•  Nonetheless, I sincerely believe it is incumbent on our policy makers and regulators to adopt a progressive and enlightened view of mutual funds and to take such measures as are necessary so as to enhance the effectiveness of the industry as an important pillar of the financial system. Now, the question is what steps should they take or promote. To me, the several measures appear obvious:

   First, I really do not see why in reference to bank reserve requirements, permissible provident fund investments etc, policy makers should distinguish between government securities and mutual funds accredited with high, investment grade, ratings. As far as possible, let there be a level playing field between investing in mutual funds and in Government securities.

  Second, policy makers should adopt cogent measures to promote the provision of pension and retirement benefits to a substantial part of the population and clearly this would not be feasible without the involvement of competent fund managers.

  Third, regulators must pro-actively encourage innovation and new product development, and the promotion of mutual funds based on such products, as well as asset classes like derivatives, commodities or real estate, and also viable schemes to extract value from special situations that can be rolled out for investment by retail investors through the mutual fund structure.

  Fourth, there are certain obvious flexibilities which must be allowed to mutual funds which will not only be an operational boon for them but also serve to substantially reduce the deep discounts to NAV at which closed-end funds are currently traded. Within certain reasonable, prudential parameters, mutual funds should be allowed to hedge their positions through the use of derivatives, borrow and leverage their positions, sell short, lend securities, and also buy back there own certificates in the open market. At present, mutual fund mangers are handicapped by the inability to do all this. As a consequence, management of a fund’s portfolio suffers and this is reflected in the price of the fund’s certificates.

  Fifth, it is important to address the issue of governance of mutual funds, which, if tackled effectively, should also serve to reduce the deep discount to NAV suffered by closed-end mutual funds. Some form of accountability of fund managers to the fund certificate holders should be introduced through structures such as the convening of annual meetings of certificate holders, establishing advisory boards, or through other suitable ways. The code of conduct for mutual fund managers may need to be strengthened in line with international best practice. In particular, mutual fund managers need to adhere to sensible guidelines regarding representation in annual meetings and boards of investee companies, grant of proxies etc. Furthermore, most importantly, compliance procedures need to be strengthened with, among other matters, the appointment of independent compliance officers reporting directly to the Board.

  Sixth, I do not see any harm in permitting dedicated mutual funds catering to sophisticated investors only e.g. large institutional investors. It should be possible to permit the setting up of such mutual funds without prior regulatory approval, with only registration being required under a somewhat light regulatory regime. Savvy fund managers will thus be able to garner large amounts to manage and reap the benefits of economies of scale. Some professionals may even be able to start business by setting up such mutual funds, and having gained the necessary experience, move on to managing the usual retail mutual funds.

  Seventh, with the increase in size of mutual funds, regulators may need to re-visit the question of regulatory fees. In case this fee is determined to be excessive, it can be either appropriately reduced, or alternatively, the excess amount suitably deployed under trust arrangements, and in consultation with MUFAP, to develop the mutual funds industry, fund manager training, investor education etc.

•  Having dealt with what policy makers and regulators must do, let me very briefly, touch on a vexing question i.e. the paucity of investable securities, especially debt securities for money market and debt funds. It is a “chicken-and-egg” type situation with many corporates finding it somewhat difficult to issue debt securities in the absence of money market mutual funds, and on the other hand, there is a lack of such funds because debt securities are scarce.  Money market and debt funds, of course, fill the demand side of the equation, and it is in their interest, therefore, to encourage the supply side. And this is exactly what they should be doing! They should be pro-active in this connection and team up with investment banking outfits to promote the issuance of debt securities by corporates.

•  In an emerging market environment, mutual funds cannot sit back and wait for issuance of securities to be arranged by investment houses. Asset management companies in developing countries have to act as quasi-investment banks and promote the issuance of securities. I believe that if mutual fund managers are competent and business-like, they will find a way to ensure the availability of investable securities.

•  And lastly, insofar as MUFAP is concerned, it must conduct itself in a manner that is beyond reproach. It should not be parochial and should not let itself be dragged down to defending the narrow business interests of its constituents. Rather, it must be seen to be professional, sensible, above board, and wedded to the overall sound development of the financial system. It must take visible steps to ensure that mutual fund managers conduct their activities with integrity, act in investors’ interests, and remain both transparent as well as accountable. The aim should be that mutual funds get recognition as institutions that provide the vast majority of individual investors the most efficient and effective access to securities markets they can achieve. To succeed in all this, I feel it would be best if MUFAP is professionally managed by a duly empowered Chief Executive.

•  In developing countries, mutual fund associations as well as mutual fund managers, acting on their own, should be at the forefront in the struggle to –

·        Protect the investor,

·        Raise standards of corporate governance,

·        Improve disclosure standards, and

·        Curb the use of insider trading and other forms of market abuse.

•   I can assure you that if any mutual funds association proceeds in this manner and makes sincere efforts to realize these goals, it will not have to seek self-regulatory organization status; rather, it will have this SRO status thrust upon it by the regulators! I am confident MUFAP can do it. There are examples around the world of this for MUFAP to emulate. And later, MUFAP itself be an example for others. As the poet said:

        “ Lives of great men all remind us,

        We can make ourselves sublime,

        And departing leave behind us,

        Footprints on the sands of time.”

I wish you all Godspeed.

•   I would now be happy to try to answer any questions or respond to comments.