THE EVALUATION OF MUTUAL FUND PERFORMANCE IN PAKISTAN

By

ANEES KHAN

FAISAL USMAN

BACHELOR OF BUSINESS ADMINISTRATION

(FINANCE)

Department of Accounting & Finance

Faculty of Management Sciences

International Islamic University Islamabad

THE EVALUATION OF MUTUAL FUNDS PERFORMANCE IN PAKISTAN

INTRODUCTION

Generally there are two ways of investment. One is direct investment and the second is indirect investment. The direct investment is one in which the individuals itself invest and the indirect is one in which the individuals gives his/her money to some institutions. Now direct investment is suitable for the person who has the knowledge, information and expertise of investing the money. But those investors who want to invest his/her money and want some return for their investment but they lack the information and don’t have the expertise to invest. So for those investors the mutual fund companies are the appropriate option. Mutual fund is a pool of money created by the individual investors and gives it to the professionals. Then the professionals manage these funds and create a portfolio of assets and they define their objective whether to invest in equity market or in debt market. Currently in Pakistan 25 asset management companies are offering different kinds of funds. The mutual fund association of Pakistan (MUFAP) is the body that ensures the transparency and high ethical conduct and is responsible for the growth of the mutual fund industry. In Pakistan the first open end mutual fund was introduced in 1962 by the government. In 1966 the government established the investment corporation of Pakistan (ICP) which offers a series of closed end mutual funds. In the late 90’s there was a growing trend of launching many private mutual funds. In the period of 2001 to 2007 there was a tremendous increase in the returns but in 2008 due to financial crises the net asset value decreased from Rs 390 billion to Rs 187 billion in 2009.The mutual fund performance in 2008 to 2009 is in very worse condition due to financial crises but after that the mutual fund industry again stand on his feet and the fund size increases day by day due to the interest of people and high returns offered by these mutual funds. The first eight month (jul-feb, 12), the mutual fund industry has shown 44% increase and the fund size increase to Rs 250 billion in the month of June. In February 2012 the fund size grow to Rs 360 billion from Rs 340 billion from the previous month. Thus the mutual fund industry has the potential to grow further and provide best opportunities for the investors and also very helpful for the whole economy of Pakistan.

MUTUAL FUND INDUSTRY SIZE

Open end mutual fund Rs 338 billions

Close end mutual fund Rs 22 billions

TOTAL NUMBER OF FUNDS

Open end mutual fund 34

Close end mutual fund 22

MUTUAL FUND

TYPES OF MUTUAL FUNDS

By structure the mutual funds are classified as open ended fund and closed ended fund.

Open-ended Funds

Open end funds are offer to public and there is no limit of authorize capital and the shares are purchased and sold by the company outlet. If you want to sell these shares than the daily prices will be calculated by Net asset value (NAV) and if you want to

INVESTORS

FUND MANAGER

SECURITIES

RETURNS

buy back these shares then you will buy it on the price as calculated through NAV. The net asset value is calculated by subtracting the Fund liabilities from the total assets.

Net Asset Value = Total Assets – Liabilities / no of shares outstanding

Close-ended Funds

Close end funds offer shares through IPO (initial public Offering).This fund operates like public limited company and the shares are traded in the secondary market. When you want to divest then you go to the stock exchange. One difference from the open end fund is that in close end fund there is limit of authorize capital approved by the ACCP.Here the prices of the fund are determined by market forces (supply and demand).

Types of Mutual Funds (By Objective)

By objective the mutual fund is of various types,

Money Market Fund Income Fund Islamic Fund Asset Allocation Fund Growth fund

Money Market Funds

These funds are invested in short term securities issued by the government or by the corporations such as T-bills and commercial paper, whose life is less than one year and these are the most liquid instruments.

Income Funds

The main objective of this fund is high income depending on the risk means if the funds are invested in risky securities issued by the corporation than the return will be high but if it is invested in non- risky securities issued by government than the return will be low.

Islamic Funds

As the name suggests these funds are to be invested in the securities which are according to the shariah, these funds are not invested in the securities which bear the interest.

Asset Allocation Funds

These funds are invested in various securities in order to diversify or minimize the risk. Such type of portfolio is created in which the risk is minimum. These funds are suitable for the investors who don’t want to take maximum risk.

Growth Funds

The main purpose of these funds is to increase your principle amount and it is a long term investment may be from 3 years to 5 years.

ADVANTAGES OF MUTUAL FUNDS

Diversification:

The most important advantage of mutual fund is diversification means to minimize the risk. Mutual funds have this quality of diversification because the fund is invested in a variety of assets.

Liquidity:

The second quality of mutual fund is its liquidity, because at any time you can sell your shares at a net asset value (open ended) and get your money back.

Professional Management:

This is also one of the important advantages of mutual funds. Mutual funds have their own experts who are professional and can manage your portfolio in a best way.

Low Investment:

Mutual fund is very helpful for those investors who have low amount for investment. The mutual funds provide opportunities for those investors and they can invest a minimum amount in these funds.

Low Transaction Cost:

The transaction cost is low because the mutual fund collectively invests a large amount of funds in the securities. If individual investors buy and sell the shares than the transaction cost is high.

A BRIEF HISTORY OF MUTUAL FUNDS

The history of mutual fund industry is uncertain because some historian believes that the close end mutual fund concept was started in Netherlands in 1822 by King William, while other believe that it was started by the Dutch merchant Adriaan Van Ketwich who started his first investment trust in 1774.he certainly gives the idea of diversification for the investors who like minimum risk. He gives the name to his Ketwich's fund, Eendragt Maakt Magt which gives a slogan of “unity creates strength” he gives these lines in a context that when different investors pool the money at one place and invest in different kinds of securities than it reduces the risk as he gives the idea of diversification. The modern mutual fund was introduced in Massachusetts in 1924.with the passage of time the number of mutual fund was increasing day by day due to higher interest of investor to invest in these funds and currently there are more than ten thousand mutual funds in the U.S market alone.

LITERATURE REVIEW

A lot of work has been done on the performance of mutual funds in the developed countries. But in Pakistan the research work on this sector is not significant. (Amir Shah and Tahir Hijazi, 2005) conducted a research on the performance evaluation of mutual funds and he concluded that the mutual fund overall outperform the market and have the ability to add value.

(Roger Otten and Dennis Bams, 2002) conducted the research on the European mutual funds and he concluded that small cap funds have the ability to add value due to positive alphas.

(George P. Artikis, 2003) evaluate the performance of balanced mutual fund and he finds that the return of these funds is lower than the General Index of the ASE.

(Athanasios G. Noulas, John A.Papanastasiou, John Lizaridis, 2005) presented the article on the Greek mutual fund performance of equity funds and he determine that there is a positive relationship between risk and return and the betas calculated for these funds is less that than one.

(Kanchan Chainani, Rounak Jhawar, Sagar Bavishi, 2009) conducted a study on Indian mutual fund performance and found that the fund returns are highly correlated to the market. If the stock market perform efficiently than the fund returns will also higher and Vic versa.

(William J. Bartin, Laurie Prather, 2008) present the paper on the fund performance of mutual fund and this paper shows the increasing growth of the FOFs and suggest that the

FOFs performance is good than the traditional funds means that they invest in funds of mutual fund instead in individual securities.

(Rongly Yuan, Jason Zezhong Xiao, Hong Zou, 2007) conducted a study on mutual fund ownership and firm performance and he found that there is a positive effect of mutual fund on firm performance.

HYPOYHESIS

H^sub 0^: The mutual funds outperform the market in Pakistan.

H^sub 1^: The mutual funds underperform the market in Pakistan

SAMPLE

We have selected five close end mutual funds listed in Karachi stock exchange for our project and use the data from 2005 to 2008 and we selected this limited data because the most some funds are introduced in 2004 and their annual reports are not issued. The data has been taken from the annual reports, Asset Management companies, mutual fund association of Pakistan (MUFAP) and SECP.

METHODOLOGY

There are four methods used for the performance evaluation of mutual funds. From these measures you can check the performance.

Sharp Measure Trey nor Measure Jenson Differential Measure Fama and French factor model

RETURNS OF FUND

SHARP MEASURE

In 1960, William Sharp extended the Markowitz Portfolio theory. The Markowitz takes riskier portfolio and has some risk but William sharp also included risk free security and introduces another theory of Capital Market theory. According to this theory when the risk free securities are added to the riskier than the risk and return position will

change and he introduces the capital market line to be the efficient frontier line. Sharp ratio measure the required rate of return for the riskier securities. Higher the value of this ratio higher will be the performance.

SHARP RATIO = Rp−RfS .Dp

Where

Rp = the average return of portfolio

RF = Risk free return

S.Dp = standard deviation of portfolio

This above table gives the return against risk. We calculated the ratio of taking five close end mutual funds listed in Karachi stock exchange by taking data from 2005-2008 .The sharp ratio indicates that these funds perform better than the market because the sharp ratio of market is (0.56) which is less than the ratio of these funds. All the funds have positive returns it means that it is well diversified by the fund manager.

TREYNOR MEASURE

There are two types of risk, one is called systematic and the other is called unsystematic risk. The systematic risk is one which is related to the system and which

cannot be diversified or controlled and it measured through (Beta), while the unsystematic risk is related to the company and it is diversifiable and controlled.Treynor take only systematic risk and assume that the unsystematic risk is controlled by the company. Higher this ratio higher will be the performance.

MUTUAL FUNDS (CLOSE END) SHARP RATIO S.D

ATLAS FOF 0.125217 11.5FIRST CAPITAL M.F 0.493985 13.3MEEZAN BALANCED FUND 0.379508 12.2PICIC GROWTH FUND 0.71068 10.3PICIC INVESTMENT FUND 0.6839 10.6

TREYNOR RATIO = Rp−Rfβ

Where

Rp = the average return of portfolio

RF = average risk free return

β= measure of systematic risk

BETA = COV (Ra−Rp)VAR(Rp)

The above figure shows that the beta of all the funds is lesser than the market because the beta of market is one while the funds beta is less than one. This indicates that the fund takes minimum risk and gives higher returns than the market. The ranking of sharp and trey nor ratio is different because the funds are not diversified in a same manner.

JENSON DIFFERENTIAL MEASURE

In 1969, Jenson calculated alpha (α) in the CAPM model which is the difference between the portfolio return and the predicted return of CAPM.it shows whether your portfolio is outperforming or underperforming. If the value of alpha is positive it means your portfolio is outperforming and if negative than underperforming.

Rp−Rf=α+(Rm−Rf )β

Where

MUTUAL FUND (CLOSE END) TREYNOR RATIO BETA ATLAS FOF 0.026667 0.55FIRST CAPITAL M.F 0.091111 0.72MEEZAN BALANCED FUND 0.073492 0.63PICIC GROWTH FUND 0.08044 0.91PICIC INVESTMENT FUND 0.066514 1.09

Rp = the average return of portfolio

RF = average risk free return

α & β= parameters of the model

Rm = market return

The Jensen differential ratio indicates whether the portfolio is outperforming or not. The above table shows that only one fund that is ATLAS FOF which is underperforming because its alpha is negative, while the other funds outperform the market because their alphas are

positive.

FAMA AND FRENCH FACTOR MODEL

We are not using this model because for this model we need book to market ratio from 2005-2009 which is not available.

RELATIVE PERFORMANCE

The relative performance is another method of comparing the performance of mutual fund in its category for different time periods. In this paper we selected Islamic Balanced Fund, Equity Fund and Fund of Fund. So we only compare the performance of equity funds because in this category the funds are more, in the case of fund of fund and Islamic balanced fund, there is no other peers in this category listed in KSE, therefore we cannot compare the relative performance of these funds. We first compare the funds managed by the PICIC Asset Management Company Limited and then the others which are managed by Safeway Mutual fund, First Capital Investment Limited and AkD Investment Management ltd. We have invested Rs1 because the value of this Rs1 is used as a measure of the relative performance in order to standardize the returns of these investments that have different trading prices. On Y-axis in the graph we have taken the value of Rs1 and on X-axis we have taken the months 2005-2008.

JENSON DIFFERENTIAL RATIO  ALPHA ATLAS FOF -1.43FIRST CAPITAL M.F 2.73MEEZAN BALANCED FUND 1.28PICIC GROWTH FUND 2.47PICIC INVESTMENT FUND 1.42

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 460

0.2

0.4

0.6

0.8

1

1.2

1.4

PICIC INVESTMENT VERSUS PICIC GROWTH FUND

Value in PICIC I.F value in PICIC G.F

The graph shows that the overall performance of these two funds are similar but there were deviation in the start of 2005 and this graph shows that the funds invested in these funds are managed well because these are managed by the same investment management company and their performance is also the same trend from 2006 to 2008 except in the start of 2005 there is some difference in the performance of these two.

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 460

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

Golden Arrow Selected Fund, First Capital M.F and Safeway M.F

Value in G.A.S.S.F Value in S.M.F Value in First C.F

This graph shows the performance of different equity funds managed by different investment management companies. The Golden Arrow selected stock fund and the First Capital mutual fund performance is in the same manner and they perform same and their performance is higher than the golden Arrow Selected Stock Fund.

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 460

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

Over all Performance of Equity M.F

Value in PICIC I.F value in PICIC G.F Value in G.A.S.S.FValue in S.M.F Value in First C.F

Now we are going to explain the overall relative performance of the equity funds. The above graph shows that all the funds perform better and they have the ability to add value. In the mid of 2007 the performance of Safeway mutual fund and first capital mutual fund is higher than the others. Thus the equity funds performance is good and all the funds perform better in this category.

CONCLUSION

This project gives a brief introduction of Pakistani mutual funds and analyzes the performance of mutual funds against the risk by using different models of evaluation. Survivorship bias data is used of balanced fund, fund of fund and equity fund. The mutual fund industry has the potential to add value because this industry is growing day by day and the public take keen interest to invest in the mutual funds. The performance of these mutual funds as we calculated by using different models shows that they outperform the market by overall, only one fund have negative alpha and the reason is diversification means that this fund is not well diversified. The returns of these funds are also positive and they outperform the market, their Betas are also less than one. This shows that by taking low risk and gives more return. The mutual fund industry in foreign countries is of very large size and capital as compared to Pakistan. Pakistani mutual funds need some improvement in rules and regulation provided by SECP.Currently the economic structure of our country is not so good, but the mutual fund also in these situations provide better returns as compared to market. In short the mutual fund industry outperforms the market.

REFERENCES

William J. Bertin, Laurie Prather. “Management Structure and the Performance of funds of mutual funds”. Journal of Business Research 62 (2009) 1364-1369.

Naim Sipra (2006). “Mutual Fund Performance in Pakistan”, 1995-2004 (CMER WORKING PAPER No. 06-45.

Ming-Ming Lai, Siok-Hwa Lau. “Evaluating Mutual Performance in an emerging Asian Economy: the Malaysian Experience” (Journal of Asian Economics 21 (2010) 378-390).

Talat Afza and Ali Rauf. “Performance Evaluation of Pakistani Mutual Funds” (Pakistan Economic and Social Review volume 47, No.2 (Winter 2009), pp. 199-214).

Roger Otten, Dennis Bams. “European Mutual Fund Performance” (European Financial Management, Vol. 8, No. 1, 2002, 75-101.

Muhammad Amir, Arslan Qayyum, Adeel Nasir, Shabir Hussain, and Sehrish Butt “Close Ended Mutual Fund and Stock Market Growth: A study of KSE Pakistan” (European Journal of Social Sciences – Volume 24, Number 1 (2011).

Roger Otten, Dennis Bams. “How to measure mutual fund Performance: economic versus statistical relevance (Accounting and Finance 44 (2004) 203-222).

Athanasios G. Noulas, John A. Papanastasiou, John Lazaridis.”Performance of mutual funds”(Managerial finance, Vol. 31 Iss: 2 pp. 101- 112).

S.M Aamir Shah and Syed Tahir Hijazi.” Performance evaluation of mutual funds in pakistan (The Pakistan Development Review 44: 4 part II(winter 2005) pp. 863-876.

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MUTUAL FUNDS 2005 2006 2007 2008

ATLAS FOF

NET ASSET VALUE PER CERTIFICATE 10.5317 11.9745 12.31 11.2799

RETURN PER CERTIFICATE 0.53166 1.94432 1.83551 0.56995

RETURN OF FUND 0.05048 0.16237 0.14911 0.05053

FIRST CAPITAL M.F

NET ASSET VALUE PER CERTIFICATE 9.50743 11.7362 12.676 11.2535

RETURN PER CERTIFICATE 1.60631 3.21796 3.81333 -1.4225

RETURN OF FUND 0.16895 0.27419 0.30083 -0.1264

MEEZAN BALANCED FUND

NET ASSET VALUE PER CERTIFICATE ------ 12.61 13.3181 11.864

RETURN PER CERTIFICATE ------ 2.38807 2.70802 0.14598

RETURN OF FUND ------ 0.18938 0.20333 0.0123

PICIC GROWTH FUND

NET ASSET VALUE PER CERTIFICATE 57.4416 41.9716 47.58 39.804

RETURN PER CERTIFICATE 17.004 11.4276 6.311 -2.1128

RETURN OF FUND 0.29602 0.27227 0.13264 -0.0531

PICIC INVESTMENT FUND

NET ASSET VALUE PER CERTIFICATE 20.7047 19.3241 22.0815 17.8293

RETURN PER CERTIFICATE 4.28614 6.07848 3.82528 -0.8855

RETURN OF FUND 0.20701 0.31455 0.17323 -0.0497