Mutual funds at a crossroads

Abdullah-Al-Rezwan (Fuad) and Nahiyan Nasir

If you go to Kolkata and observe closely, you will find quite a few billboards on mutual funds. This is nothing unique. In fact, you are more likely to experience the same thing in most major cities around the world. Regardless of whether you are in the top 1% or just a middle class person earning steady income, wealth management affects us all. With the ever-increasing life span of the population in most of the developed and developing world, the issue of wealth management is set to gather even greater interest in coming days. As fixed deposits in banks do not provide a robust return after adjusting the effects of inflation and tax, and most people do not have the necessary expertise and time required to make appropriate decisions for analysing risky investments, many people tend to rely on professional fund managers of mutual funds.

Bearing in mind the huge gap in financial literacy in a country like Bangladesh, people should be even more reliant on mutual funds. Therefore, one would assume mutual funds have a huge potential to exponentially grow as a viable and attractive alternative for investors. Sadly, the reality is in stark contrast to that expectation in recent times. In fact, currently most, if not all, mutual funds are being traded at the DSE (Dhaka Stock Exchange) at only 50 per cent-60 per cent of Net Asset Value (NAV). Of course, at first glance, it does look like these mutual funds are massively undervalued. Is the mutual funds industry is going through irrational despair? We all are sure about investors being despair on mutual funds but a lot of things need to be explored before we can conclude whether the investors are "irrational" or not.

The first mutual fund (1STICB) was started in Bangladesh back in 1980. Since then, 40 more funds have been listed in DSE. These close-end mutual funds raised money from the investors with a set maturity. The total NAV (BDT 51.27 billion) of mutual fund industry consists of only 2.1 per cent of total equity market capitalisation of DSE.

As mentioned above, with the help of professional fund managers, investors generally expect higher risk-adjusted return compared to relatively safer options such as bank fixed deposits. Therefore, let us first explore whether the return from investment in mutual funds actually outperformed the fixed bank deposits and other alternatives.

The aftermath of market crash in 2010 has inevitably hit the mutual funds quite hard. Even then in the last five years, the cumulative average growth rate (CAGR) return of top 10 mutual funds was 13.1 per cent. Despite the market crash, mutual funds have outperformed fixed deposits in banks and slightly underperformed the Sanchayapatra yield rate on return perspective. However, if we look at the return during the last seven years, the top 10 mutual funds have significantly outperformed CAGR as the reported NAV grew at 27.5 per cent.

It is evident that the reported return of mutual funds significantly outperformed other alternatives. Now let us delve more into the fact that despite this impressive performance why the mutual funds industry is still struggling to gain traction to the investors.

Investors put their hard-earned money into mutual funds and trust the fund managers to do thorough analysis and appropriate due diligence while investing that money. The key word here is trust. If there is even a perception of that trust being breached, it is only downhill from there.

Imagine a situation where you have put your money in a particular bank and certain developments in that bank makes a lion's share of depositors doubtful whether they will get their deposits back. In such situations, you will be seeing a long queue of depositors in front of the bank to withdraw money as early as possible.

In the case of close-end mutual funds, investors will just sell their holdings with complete disregard of the reported NAV. As there is a widely circulated report of some mutual funds taking illegal and unethical means to invest the funds, investors simply stopped believing the reported NAV for almost all the funds. This industry-wide perception can continue to persist as the total portfolio of the mutual funds is only disclosed annually. A full disclosure of the full portfolio holdings at least on a quarterly basis may have helped to stem the panic of the investors. In the status quo, the information asymmetry is just too high for investors to feel comfortable in investing in mutual funds.

An even more alarming case developing in the mutual funds industry is the possibility of extension of maturity of the close-end mutual funds. If this indeed goes ahead, there will be long-term and catastrophic implications for the whole mutual fund industry. As a minority investor, the situation can get quite messy if you put your savings into a mutual fund for 10 years, only to find out after 10 years that you will get your money back after five more years and, of course, there's no guarantee that the firm will not ask for further extensions and going on like this till perpetuity. And if you sell the shares in current market, you will have to do that at 40-50 per cent discount to the reported fair value of your investment.

The possible motivation for extension of maturity from the fund manager's perspective is the fact that if the fund is liquidated, the particular firm will lose the management fees associated with the fund. This rationale has hardly any merit. First of all, it cannot possibly be a headache of the general investors. If the fund's performance is satisfactory, it can always issue another fund. Given the firm's reputation and previous performance history, investors may go for subscription. This is pretty routine for close-end mutual funds throughout the world. Therefore, if anyone doesn't follow these well-established norms, it is safe to assume foul play and it would not be quite irrational to believe that the reported NAV may well be a lot higher than it actually is.

Another argument for the supporters of extension is if a mutual fund is liquidated, this will negatively affect the prices the fund will get for its holdings because of the liquidity issue. This should not have been the case as the fund managers should have a sound planning for liquidation. In any case, a fund can always take the route of converting to open-end mutual fund. Some might argue that given the massive undervaluation of prices compared to NAV, investors will flock together to liquidate their holdings and take arbitrage profit even if it is converted to open-end. Well, if the fund unequivocally declares that it will not be further extended beyond its maturity, the prices are more likely to quickly adjust and get a lot closer to the reported NAV. Therefore, the incentive for liquidation from investors' point of view may not be as high as generally feared.

The biggest differentiating factor between mutual funds is the reputation of the firm. It is a long game and it takes decades to build that reputation. Acute short-termism, therefore, should not cloud the judgment of the mutual funds. It should be a no-brainer for regulatory authorities not to permit the extension of the maturity of the mutual funds.

This may well be the make-or-break for mutual funds industry. We are, in all likelihood, at a crossroads. If the mutual funds get to extend the maturity at will completely disregarding the interest of minority investors, the status quo will persist for foreseeable future. The information asymmetry will never let us conclude whether these funds are undervalued or overvalued. The relevant question then should be: "Why will you still want to invest in mutual funds?"

Abdullah-Al-Rezwan (Fuad) and Nahiyan Nasir can be contacted respectively at fuad.ibal8@cimail.com and nasir.nahiyan@gmail.com