Do we need mutual funds?

Now that the Security Board of Nepal (SEBON) has passed the Mutual Fund Regulation and Assets Management Companies (AMC) are being founded, it is worth debating if the Nepali investment landscape needs mutual funds? I am almost tempted to say no. My key tenet for saying so is because mutual fund industry is probably nearing the expiry stage as other emerging investment products like Exchange Traded Funds ( ETFs), Unit Investment Trusts ( UIT) are seriously giving the industry a run for their money.

OBSOLETE VALUE PROPOSITIONS?

The value propositions offered by mutual funds are now becoming obsolete with new developments. For instance, the most important value driver of a mutual fund is the stock picking expertise. Probably, when mutual fund was launched 60 years ago, this provided considerable value. However, with the current developments, the investors have ready access to pink papers, business TV channels and websites, and with the current level of information access, the added value of stock picking expertise is probably waning off.

The second value proposition of mutual fund is decent returns and diversification of your portfolio. The former benefit, to some extent, is neutralized by the heavy entry loads and the management cost. Further, mutual fund history in US and India has evidenced that barring few exceptions, vast majority – approximately 80 percent – of the funds have underperformed the average return of the stock market. The most plausible reason I can think of is management costs, diversification and fund managers’ misjudgment of the market. The cost of diversification is that your return will be just average; the flip side of diversification being high returns in any particular asset will be averaged out.

SHALLOW MARKET

Mutual funds typically invest in equity stock though there are various variants like Income Fund, Specialty Fund, Index Fund, Money Market Funds, etc. The equity market in Nepal is too shallow for a mutual fund to deliver enhanced value for the investors. It is not rocket science to determine which stocks to buy. For instance, I recently used a portfolio management company for investment in equity market while I also simultaneously made my own investments. While the portfolio management company researched into financial performance and other analysis to buy stocks, I did the same with little research. Yet, the end result is similar, if not same; thanks to the shallow market and limited opportunities.

Though investors in the advanced world are losing interest in mutual funds, it will be a big value addition to the rudimentary investment Nepali market. Mutual funds are no spring chicken to the astute Nepali investors and the challenge to Asset Management Companies is to make it an investment of choice rather than an investment option for lack of choice.

The options for Income Fund is practically nil with very limited fixed income products. There is no bond market in Nepal and virtually Bank/FIs deposits are the only fixed income options, which do not require much expertise for making investments. Thus, the value addition of stock picking expertise is severally challenged by the shallow investment options of the Nepali investment market.

One of the implicit costs of mutual fund is ‘market impact cost’ – an additional cost incurred when the fund’s buy or sell order itself changes the prices of the stocky. Typically, mutual fund purchases/sells large block of stocks and thus the market will change in response to that. This will be even more prominent in the Nepali market where the market is shallow and to make matters worst, market impact cost is not something that can be found in the fund’s financial statement.

COMPETITION

The principal behind mutual fund is to beat the market though rarely has any mutual fund beaten the market. On the other hand, the idea behind an ETF is to replicate the performance of the market and offer broad market exposure, tax efficiency and lower operating costs. There are many other reasons why ETFs, UITs, etc are growing popular as an alternate investment vehicle. Similarly Unit Linked Insurance Plans (ULIPs), though not free from controversy, offer additional value of insurance along with added equity element and anecdotal evidence point out to growth of these products at the cost of mutual funds.

FAR-REACHING BENEFITS

Yet, despite all these shortcomings of the industry, the product and the market, introduction of mutual funds in Nepal will have a far-reaching impact. First, I see it as paving path for other financial products like ETFs and UITs, which are expected to eventually supplant the traditional mutual funds. With the rise of new set of middle class opening to the commodity investment culture, commodity mutual funds ( if these are allowed by SEBON) is expected to add good value considering that understanding of this market is scare to many. Similarly, a money market mutual fund will allow the retail investors to tap the Treasury Bill market that is quite out of reach for the retail investors. The ‘hassles’ and ‘paperwork’ an investor has to go through can also be overcome by investment through a AMC.

I used the portfolio management services primarily for logistic reasons. Notwithstanding the growing information access and implementation of Central Depository Services, it is not logistically possible for me to keep track of dividends, bonus, right shares and thus ‘logistic support’ could be a good value addition. And given our capital convertibility constraints, probably the most important breakthrough will be that a fund can invest in foreign security market (subjectively allowed by SEBON), thus giving Nepali investors a chance to get a slice of foreign stocks. The corollary to this will be that SEBON could allow foreign institutional investors to invest in the Nepal Stock Market, which will add to the vibrancy of our own market. Though it remains to be seen how effective this would be, I believe, this is a meaningful initiative and a step toward opening up of our economy.

Though investors in the advanced world are losing interest in mutual funds, it will be a big value addition to the rudimentary investment Nepali market. Supply and demand, the regulatory environment, performance of the product and the market in general will determine the sustainability of the products and what emerges from thereon. Mutual funds are no spring chicken to the astute Nepali investors and the challenge to AMCs is to make it an investment of choice rather than an investment option for lack of choice.

We all have certain investment needs, risk appetite and tolerance for volatility (and loss). Depending on the route we take, the ride can be bumpy or steady and the curves sharp or placid. But even a hardened investor would agree that you should not run a marathon without stretching a bit. As for the cash rich, aggressive investors (interested in exotic stuffs, thrive in going short, love leverage and own a villa with a yacht in Bahamas), they should look out for hedge funds; mutual funds will probably bore them.

Writer is Acting Managing Director, BMI Bank Qatar Branch

Michael.Siddhi@bmibank.com