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Mutual Funds in Pakistan

“Mutual fund is a pool of money invested

according to a common investment objective
by an asset management company (AMC) on
behalf of the fund’s investors”. A mutual fund
can generate profits from three different
sources, which are: Dividend, Capital Gains
and Appreciation of Share Price. The figure
shows a mutual fund is deals with the following
entities; trustee, auditor, SECP, AMC and
investor. A mutual fund provides liquidity,
portfolio management expertise, risk
diversification, and stability to stock market1
and it also mobilises savings by attracting
funds from small investors.


Mutual funds in Pakistan are registered and legally established in the form of a
Trust, under the Trust Act of 1882. The mutual fund industry is regulated by, the
Securities and Exchange Commission of Pakistan (SECP) which licenses each Asset
Management Company in strict compliance with the NBFC Rules, 2003 and requires
all AMC’s to obtain an independent rating2.

Mutual Funds were introduced in Pakistan in 1962, with the public offering of
National Investment (Unit) Trust (NIT), followed by the establishment of the
Investment Corporation of Pakistan (ICP) in 1966.

Rate of Return

“A return is a measurement of how much an investment has increased or decreased

in value over any given time period”. The return of a mutual fund is calculated by
using the following formula;

(Final NAV + Distributions - Original NAV) / (Original NAV) X 100

Returns basically show how your investment has increased or decreased in value.
Compounding earns returns on your returns and Transaction costs reduce returns.

Rules Govern Mutual Funds in Pakistan



There are two rules govern mutual funds in Pakistan, which are:

1. Investment Companies and Investment Advisors' Rules, 1971. (Govern closed-

end mutual funds)
2. Asset Management Companies Rules, 1995. (Govern open-ended mutual funds)

Types of Mutual Funds

Mutual funds can be characterized as ‘Open’ or ‘Closed’ End3.

1. Open-End Funds

Open-End funds continually issue new units and redeem outstanding units upon
investor request. The unit holders buy units of the fund or may redeem them at the
published Net Asset Value (NAV). Typically, these funds have a perpetual lifespan.
The asset management company launches the fund and continues to remain the
counter party in the sale and purchase transactions with the unit holder.

In Pakistan there exists 34 open ended mutual funds (as of 2006) including National
Investment (Unit) Trust (NIT) in the public sector and Atlas Income Fund, Crosby
Dragon Fund and Faysal Balanced Growth Fund.

2. Closed-End Funds:

In Closed-End funds, a fixed number of share certificates are issued by the fund; the
shares trade in the secondary markets (stock markets). Market price of the share
certificates is determined by their demand and supply and they do not necessarily
trade at NAV. Though many of these funds have a perpetual lifespan, others have a
finite lifespan. The asset management company launches the fund and no longer
remains the counter party in the sales and purchase transactions with the unit

In Pakistan there exist 22 close ended mutual funds (as of 2006) including Al-
Meezan Mutual Fund, Asian Stocks Fund and ABAMCO Composite Fund.
To summarize both types of funds, a concise description of them are listed below4.

Open-end fund Close-end fund

• Issues redeemable units • Issues irredeemable shares



• Not necessarily listed • Listed

• Does not conduct general • Conducts AGMs

meetings of unit holders
• Bestow voting rights to
• No voting rights of unit holders shareholders

• May issue as many units and • Has fixed pool of money and
redeem them at NAV does not continuously offer
shares, however may increase
• Each time, units are directly
its capital under the Companies
acquired from or sold to the
company through their authorized
offices • Shares are acquired from the
company on initial public offer
• License of investment advisory is
and from existing shareholders
• Units are traded at NAV
• License of asset management
services is required

• Shares are trades at market

price rather NAV reported by the
fund manager

Performance evaluation of Mutual Funds

We have two major requirements of a portfolio management. One is the ability to
derive above average returns for a given risk class (large risk-adjusted returns); and
second is the ability to completely diversify the portfolio to eliminate all
unsystematic risk. Mainly on these two basis a proformane of mutual fund is
measured. The folowing are some of the ways used to measure the efficiency and
performance of mutual funds.

Jensen Alpha

Jensen alpha is used to measure the excess returns on a portfolio, which helps in its
pricing. It is developed by Michael Jensen in the 1970's5. To calculate alpha the
market return, the risk-free rate of return, and the beta of the portfolio is used as
inputs. The following formula is used to calculate Jensen alpha.
Jensen's alpha = Portfolio Return - (Risk Free Rate + Portfolio Beta
(Market Return - Risk Free Rate))

Sharpe Ratio


The Sharpe ratio is developed by William Sharpe in 1966. This measure is used to
evaluate how well the investment return is compensating the investor for the risk
taken. It is calculated as,

Where E[R-Rf] is expected value of the excess of the asset return over the
benchmark return and σ is the standard deviation of the excess return6. The
Sharpe ratio tells us whether a portfolio's returns are due to smart investment
decisions or a result of excess risk. This measurement is very useful because
although one portfolio or fund can reap higher returns than its peers, it is only a
good investment if those higher returns do not come with too much additional risk.
When comparing two portfolios each with the expected return E[R] against the
same benchmark with return Rf, the portfolio with the higher Sharpe ratio gives
more return for the same risk.

Sortino Ratio

A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of
upward price movements on standard deviation to measure only return against
downward price volatility7.

Treynor ratio

The Treynor ratio is a measurement of the returns earned in excess of that which
could have been earned on an investment that has no diversifiable risk (e.g.,
Treasury Bills or a completely diversified portfolio), per each unit of market risk

The Treynor ratio (sometimes called reward-to-volatility ratio) relates excess

return over the risk-free rate to the additional risk taken; however, systematic risk is
used instead of total risk. The higher the Treynor ratio, the better the performance
of the portfolio under analysis.





Treynor ratio,

portfolio i's return,

risk free rate

portfolio i's beta

Like the Sharpe ratio, the Treynor ratio (T) does not quantify the value added, if
any, of active portfolio management. It is a ranking criterion only. A ranking of
portfolios based on the Treynor Ratio is only useful if the portfolios under
consideration are sub-portfolios of a broader, fully diversified portfolio. If this is not
the case, portfolios with identical systematic risk, but different total risk, will be
rated the same. But the portfolio with a higher total risk is less diversified and
therefore has a higher unsystematic risk which is not priced in the market9.

Information Measure

It is a system of measurement of information based on the probabilities of the

events that convey information. The Information ratio is a measure of the risk-
adjusted return of a financial security (or asset or portfolio). It is defined as
expected active return divided by tracking error, where active return is the
difference between the return of the security and the return of a selected
benchmark index, and tracking error is the standard deviation of the active return;
i.e., the information ratio IR is:

where R is the portfolio return, Rb is the benchmark return, α = E[R − Rb] is the
expected value of the active return, and ω = σ is the standard deviation of the
active return, which is an alternate definition of the aforementioned tracking error10.

The information ratio is often used to gauge the skill of managers of mutual funds,
hedge funds, etc. In this case, it measures the expected active return of the
manager's portfolio divided by the amount of risk that the manager takes relative to



the benchmark11. The higher the information ratio, the higher the active return of
the portfolio, given the amount of risk taken, and the better the manager. Top-
quartile investment managers typically achieve information ratios of about one-half.

Arbitrage pricing theory (APT)

This theory was initiated by Stephen Ross in 1976. It gives an idea of how to price
assets. APT depicts the expected return of a financial asset as a function of various
macro-economic or market factors. The sensitivity to changes in each factor is
represented by a factor-specific beta coefficient12. The evaluated expected return
based on the factors than used to price an investment. If the price diverges,
arbitrage should bring it back into line. APT model describes by the following linear

Where E(rj) is the risky asset's

expected return, RPk is the risk premium of the factor, rf is the risk-free rate, Fk is
the macroeconomic factor and bjk is the sensitivity of the asset to factor k.

Modern portfolio theory MPT

MPT indicate the ways which investors use in diversification to optimize their
portfolios. MPT also tells the approach to price a risky investment. The basic
concepts of this theory is based on Markowitz diversification, the efficient frontier,
capital asset pricing model, the alpha and beta coefficients, and the securities
market line. In MPT a portfolio is considered as a weighted combination of assets,
and portfolio return is the weighted combination of the assets returns. In addition
portfolio return is a random variable with expected value and a risk factor which is
denoted by standard deviation13.

Market timing ability in Mutual Funds

A strategy of moving in and out of a given market in order to take advantage of the
market’s positive and negative trends. As a strategy, market timing is the opposite
of “buy and hold” investing and seeks to benefit from the bullish trends without
suffering from the bearish trends. Market timers aim to buy “low” and sell “high” by
following a consistent, or mechanical, strategy. Studies have found that most
average investors are “inadvertent market timers” because they react emotionally
to market fluctuations and end up buying “high” and selling “low”, the reverse of an




effective market timing strategy. This is why many advisors say that market timing
is a bad idea. Without an effective, mechanical timing strategy, it is indeed difficult
to successfully time a market on a consistent basis that results in long term

Treynor and Mazuy Model

Treynor and Mazuy (1966), putting a quadratic term of the excess market return
into equation, provide us with a better framework for the adjustments of the
portfolio’s beta to test a fund manager’s timing ability. It can be viewed as the
extension of the Capital Asset Pricing model (CAPM). If the fund manager can
forecast market trend, he will change the proportion of the market portfolio in
advance. The fund manager with timing ability will be able to adjust the risk
exposure from the market15. To take a simple example, if a fund manager expects a
coming up (down) market, he will hold a larger (smaller) proportion of the market
portfolio. Therefore, the portfolio return can be viewed as a convex function of the
market return. The equation can be given below:

R p ,t = α p + β 1 Rm,t + β 2 Rm2 ,t + ε p ,t

where, the coefficient is used to measure the timing ability. When is

β2 β2
significantly larger than zero, it represents that, in a up (down) market, the
increasing (decreasing) proportion in the risk premium of the mutual fund is larger
than that in the market portfolio. This model was formulated empirically by Treynor
and Mazuy (1966). It was then theoretically validated by Jensen (1972), and
Bhattacharya and Pfleiderer (1983)16.


15 Treynor, J. L., and K. K. Mazuy, “Can Mutual Funds Outguess the Market?” Harvard
Business Review 44, 131-136 (1966).