Mutual fund dilemma: Uncertainties and our concerns

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Suborna Barua
Bangladesh has a very small market for mutual funds. As reported earlier in a contemporary, currently 17 mutual funds trade at an average of 2.75 times their net asset value (NAV) and 75 times their earnings. It also said that a sample of 21 mutual funds in the Asia Pacific region is traded at 0.91 times or below their NAV on average. Till now, 19 mutual funds together account for less than 3% of our total market capitalisation with combined assets of less than Tk 20 billion. However, this small market is not happy at all at this moment.
A very serious but interesting debate has been looming for the last couple of weeks regarding mutual funds in Bangladesh. The SEC implemented revised mutual fund regulations on July 22 that prohibited the mutual funds from issuing new shares either in the form of right or bonus shares to increase their capital bases. After this amendment faced writ petition from investors, The High Court on November 09, 2009 allowed mutual funds to raise their size by issuing bonus and rights, without curbing the securities regulator's absolute power to determine which funds would be eligible to expand the capital base although this verdict was suspended hours after the announcement giving the SEC adequate time to appeal. On the following day, the benchmark Dhaka Stock Exchange (DSE) General Index (DGEN) gained 17.41 points or 0.51 per cent to close at 3428.89, which was a new high. The broader DSE All Shares Price Index (DSI) moved up 14.38 points or 0.50 per cent to close at 2871.75 while DSE-20 blue chips index rose 10.24 points or 0.44 per cent to close at 2313.01. Although the market move was led by the mutual fund on that day, following days were worse in the market, and the issue in the high court is still pending creating uncertainty among thousands of innocent general investors.
Close end vs. open end funds: As everyone knows, mutual funds offer investors: (i) economies of scale by reducing costs and increasing investment returns; (ii) divisibility and diversification; (iii) active management with superior stock picking and market timing; (iv) reinvestment of dividends, interest and capital gains; (v) tax-efficiency; and (vi) buying and selling flexibility. Two major classes of mutual funds are closed end and open end. In Bangladesh, all 19 mutual funds are closed end in nature.
A closed-end fund is a publicly traded investment company that raises a fixed amount of capital through an initial public offering (IPO). The fund is then structured, listed and traded like a stock on a stock exchange. It raises a prescribed amount of capital only once through an IPO by issuing a fixed amount of shares, which are purchased by investors in the closed-end fund as stock. Unlike regular stocks, closed-end fund stock represents an interest in a specialised portfolio of securities that is actively managed by an investment advisor and which typically concentrates on a specific industry, geographic market, or sector. The stock prices of a closed-end fund fluctuate according to market forces (supply and demand) as well as the changing values of the securities in the fund's holdings.
Contrary to the closed end funds, an open end mutual fund does not have restrictions on the amount of shares the fund will issue. If demand is high enough, the fund will continue to issue shares no matter how many investors there are. Open-end funds also buy back shares when investors wish to sell. Globally, the majority of mutual funds are open-end. By continuously selling and buying back fund shares, these funds provide investors with a very useful and convenient investing vehicle. It should be noted that when a fund's investment manager(s) determine that a fund's total assets have become too large to effectively execute its stated objective, the fund will be closed to new investors and in extreme cases, be closed to new investment by existing fund investors.
Closed end funds should announce rights and bonus: As explained earlier, Open end funds can increase their capital base issuing new shares whenever they want. But closed end funds cannot do the same. Closed end funds cannot issue new shares. These funds can only expand their capital base by issuing bonus or rights, and no new shares can be issued or redemption of old shares can be done. This is the uniform definition of closed end mutual funds and accordingly practiced worldwide. Asset management companies from the Wall Street to Bombay are managing for years following this uniform definition. Morgan Stanley defines clearly, "Close ended funds cannot issue new units except through a bonus or rights issue. Hence, unit capital of open ended funds can fluctuate daily. In the case of close ended schemes, new investors can buy units only from the secondary market." Even our neighbouring country India has the same provision and the growth of mutual fund industry is substantially mentionable there.
Interestingly, the SEC in Bangladesh is not much positive in allowing the mutual funds to follow this globally accepted practice. The SEC is going to appeal against the verdict of the High Court. We do not perceive any problem in allowing such provision which is practiced globally.
Bonus issuance is fairly common among the mutual fund issuers. The news about bonus issues is normally received positively by shareholders. The same goes for units of mutual funds. Bonus is normally given when the Net Asset Value (NAV) of the fund is at respectable levels. Let's look at some examples of such rights issues. Launched in September 1986, UTI Mastershare -- one of India's largest funds, has been a consistent performer with 17 years of uninterrupted track record of dividends. There have been two rights issues and three bonus issues since inception as can be found from its statistics: 1986-87: 8% 1987-88:13% 1988-89:18% (Rights 1:2), 1989-90:18%, 1990-91:18%, 1991-92:18% (Bonus 1:2), 1992-93:18%, 1993-94:20% (Bonus 1:3 and Rights 1:1), 1994-95:16%, 1995-96:16% (Bonus 1:5), 1996-97:16%, 1997-98:16%, 1998-99:16%, May 2000:16%, October 2001 : 10% (Association of Mutual Funds in India, 2009). Let's take a look at the history of such closed end mutual funds. In the Western markets, investors had poured record-breaking sums of money into mutual funds in the 1990's so far, and closed-end funds were also enjoying an infusion of new capital. From 1990 - 1992, Of the 11 rights offerings in the last two years, four required five rights to purchase one share. The Mexico Fund required only three rights to buy one share; the fund with the most stringent standard, the Royce Value Trust, required 20 rights to buy one share. These funds were raising millions of dollars by initiating "rights offerings," invitations to current investors to buy additional shares. Rights offerings, which were virtually unheard of among closed-end funds in the 80's, are rapidly spreading. Four offerings came to market last year and seven so far in 1992. Until about 1981, most closed-end funds sold at steep discounts to their net asset value. To reduce the huge discounts, fund managers began buying back shares on the open market. In the USA and the world, today's flurry of rights offerings is the opposite of that share-buyback trend. Many closed-end funds now sell for small discounts or for premiums. With demand for fund shares strong, managers are inviting investors to buy even more shares. The funds increase capital through rights offerings because under law they cannot otherwise sell shares at less than net asset value.
Looming uncertainties and our concerns: Current performance of the mutual funds in the secondary market of Bangladesh has not yet been noteworthy. The return is well below the annualised market return of approximately 29% in the Dhaka Stock Exchange. On the contrary, investors have gained around 350% of returns on the last six mutual funds participating in their Initial Public Offerings (IPO) even if those investors had sold them within the next three months after the first day's trade. This situation has motivated many investors to participate in the private placement and IPO of the mutual funds in the recent years. It has attracted a good number of investors with a substantial amount of investment although the larger portion of the investors were not able to participate due to limited supply. Realising this high demand-supply gap in the private placement and IPO, in the recent times, there have been many new issuers of mutual funds who have already finished the formalities with the regulators, and many others whose proposals are on the board positively. This is essentially a strong signal for the development of an organic capital market, offering a safe alternative investment avenue for the investors that really can reduce the excessive and aggressive dependence on equity stocks.
But things have become a little bit difficult at the same time. Although at the pre-IPO or IPO phase, investors are profiting well, the secondary market for mutual funds has remained much less profitable. Since investors are not really impressed by the marginal performance of the mutual funds; they feel reluctant to put money in them in the secondary market. Many of the investors have complained of waiting too long for a point difference benefit or facing forced sale to avoid further loss and recover he opportunity loss. Therefore, the consequence is clear. A dull secondary market for mutual funds has been restricting investors from taking advantage properly, and thus making more and more investors negative towards them. Less demand in the secondary market is essentially making the IPOs or Private placements much less attractive since investors at these stages fear losing money, or even illiquidity of their investment. A couple of potential fund issuers have recently expressed a fear of illiquidity for their potential new fund issues. This is quite rational and almost inevitable.
At this stage, a globally accepted and traditionally practiced issue like issuance of bonus and rights by mutual funds can be very crucial to protect the market from becoming unattractive to the investor. The question is yet not clearly answered why the SEC is reluctant to allow the funds to do so. Or why the SEC has to go to court to decide on such an issue which has been practiced globally for ages? Whatever the answers are, this decision is extremely important for the current market condition for the mutual funds. An unattractive market may go down severely, destroying the confidence and expectations of the general investors, if the decision becomes negative from the High Court. To save the market and help it keep on track with global practices, and considering the investors' psychology and the future of mutual fund market, the decision deserves to be in favour of the investors. May the SEC realise it.
The author is a lecturer, School of Business and Economics, United International University, and Director, FinCap Analyst and Advisory Services Limited. He can be reached at subornobarua@gmail.com