The feeling is mutual | The Daily Star
12:00 AM, September 01, 2008 / LAST MODIFIED: 12:00 AM, September 01, 2008

The feeling is mutual

THE SEC implemented revised mutual fund regulations on July 22. According to the amended rule, mutual funds are prohibited from issuing new shares either in the form of right or bonus shares to increase their capital bases.
The SEC also imposed restrictions on mutual funds asking them not to offer pre-emptive rights shares or private placement. This implies that mutual fund shares should be offered and sold to the public through brokers/dealers but not to a pre-selected buyer or a group of buyers.
The SEC's decision to amend fund rules brought numerous investors into the street as most of the mutual funds lost value (in some cases more than 20% in a single trading session) during that volatile market (late June to mid-July) and worried investors began demonstrating against the officials of SEC.
The SEC was forced to suspend mutual fund trading several times during that market turmoil. A group of investors filed a petition against SEC's decision to change mutual fund rules. As such, the High Court asked fund managers not to distribute dividends until the SEC resolves the issue.
To date, the total number of mutual funds in Bangladesh is below 20 and they account for less than 3% of our market capitalisation. The US is the largest mutual fund market in the world with approximately 25,000 funds and $12 trillion assets under management.
By definition, mutual funds are portfolios of different securities such as stocks, bonds, treasuries, derivatives, etc. Mutual funds pool money of both individual and institutional investors allowing the funds to achieve: (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. There might be varieties of mutual funds that differ in terms of their investment objectives, underlying portfolios of shares, risks and returns, fees and expenses, etc.
It should be noted here that mutual funds are widely known as open-end mutual funds in global capital markets. But most of the mutual funds in Bangladesh are close-end mutual funds. A close-end fund differs from an open-end fund mainly due to the fact that the number of shares in a close-end fund is fixed at its inception. Moreover, a close-end fund, unlike the open-end fund is traded in the stock exchange and priced intra-day. As such, price of a close-end fund is determined in the secondary market similar to individual stocks. Investors can also execute either limit or stop trade order in close-end funds' transactions.
On the other hand, the price of an open-end fund is its net asset value (NAV) which is computed once after the close of the stock exchange each trading day by taking the closing market value of all underlying securities of a fund plus other assets (usually cash) and subtracting all liabilities of the fund, and dividing the total net assets of the fund by total number of outstanding shares. Thus, there is only one price (i.e. NAV) for open-end mutual fund. Total net assets and the number of outstanding shares of an open-end fund may vary because of inflows (purchases of fund by investors) and outflows (redemptions of fund by investors) of money from the fund. This suggests that the number of shares in an open-end fund is not fixed.
It is worthy to mention here that a new type of security, widely known as "Exchange-Traded Fund" or ETF (a blend between open-end and close-end funds), was introduced in the US in late 1990s. ETFs are similar to close-end funds as these are exchange traded and priced intra-day and allow investors to buy or sell shares based on the collective performance of an entire portfolio. Since the prices of ETFs do not deviate much from NAV, they have greater advantages over the close-end funds. As such, many close-end funds were converted to ETFs. Since our capital market does not offer ETF as an investment vehicle, we will leave its discussion here and focus on close-end fund, the predominant source of mutual funds in Bangladesh, and its recent glitch.
Theoretically, a close-end fund neither redeems its existing shares nor issues new shares after its initial public offering. As such, a fixed number of close-end fund shares are traded in the stock exchange. Due to this fixed capital structure, fund managers do not worry about inflows and outflows of money from funds. Accordingly, a close-end fund manager concentrates in long-term capital investment and higher yields. However, under special circumstances, close-end funds are permitted to raise capital either by issuing preferred stock or taking short-term loans which are collateralised by the fund's original portfolio. The issuance of either right offerings, or bonus shares, or secondary offerings, or dividend reinvestments to increase the capital base of a close-end fund is considered to be detrimental to the fund as it may dilute fund returns.
Since close-end mutual funds in Bangladesh were previously allowed to issue new shares (whether in terms of right, bonus, or dividend reinvestments), this was inconsistent with the true definition and objective of a close-end fund. It is apparent that SEC took the right decision by amending the mutual fund rules. However, this raises some questions and concerns about the quality of our financial securities and capital market.
Finally, our capital market also lacks professional portfolio managers because of SEC's favoritism toward ICB and lack of private mutual funds. An ADB audit team in 2004 reported that ICB enjoys enormous facilities (e.g. non-payment of SEC fees, unlimited borrowing, undisclosed daily NAV, etc).
These extra-ordinary facilities are major impediments to the growth of private investment companies and a competitive mutual fund market in Bangladesh. As such, we also see no light at the end of the tunnel for a market for derivative securities.

The author is an Assistant Professor of Finance at State University of New York Institute of Technology.

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