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Overview of Mutual Funds andFinancial Sector Development
Mike Lubrano, IFC
NBFI Video Conference28 February - 1 March 2001
Washington DC
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Introduction and overview
• The role of investment funds• How they work; structures• The scale of the funds market• How they developed internationally
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What is an investment fund?• Entity publicly offering shares or
units• Invests the money attracted mainly in
publicly offered securities• Manages money as a single pooled
portfolio• Investors have no control over
portfolio decisions
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What Investment Funds are Not
• Risk taking intermediaries• Banks / Quasi-banks• Captive Finance Subsidiaries• Instant Liquidity Generators• Alter Egos
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What funds do: intermediate
Savers: individuals, companies, governments
Intermediaries: banks; insurance, pension and investment funds
Brokers, dealers
Markets
Primary dealers, investment banks
Borrowers: governments, companies, individuals
moneybondssharesloans
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What funds do for investors
• Diversify risk• Reduce costs• Offer professional management• Protect investors: highly transparent• Increase savings choice
– Can be base for personal pensions• More flexible than contractual savings• Lower cost than contractual savings
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What funds do for economies
• Mobilize savings• Widen and deepen capital markets• Balance foreign capital flows• Provide longer term financing• Pressure for risk reduction, improved
performance• Create demand for
– innovation, new products (derivatives)– better infrastructure– better disclosure– corporate governance
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How Funds Work
Investor Fund Issuers
Gains from sales of Assets
Distributions Dividends;Interest
MoneyMoney
FundShares
Securities
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Key Players and Their Roles• Sponsor - creates fund• Portfolio manager – chooses assets• Administration – operates fund• Custody – safekeeps assets• Marketing – sells the fund to investors• Oversight – checks the fund operates
legally and in the interests of investors
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One Common Approach
Fund
Management Company
Auditor
Regulator
Custodian
safekeeps assets
operates regulates
audits
regulates
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Legal Structures of Funds
CustodianManagementCompany
UnitsContractual
TrusteeTrusteeUnitsTrust
CustodianDirectorsSharesCompany
Safekeepingof assets
Responsibleto Investors
IssueStructure
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Types of FundsType Capital Issuance Trading
Open end Variable Continuous At NAV viamanagementcompany
Closed end Fixed One off At marketprice onexchange
Interval Variable One off /periodic
On exchange /periodicredemptions
Open end/Exchangetraded
Variable Continuous On exchange /alsoredeemable
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Open versus closed
Issue A15.0%
Issue B15.0%
Issue C15.0%
Issue D10.0%
Issue E10.0%
Issue F10.0%
Issue G10.0%
Issue H10.0%
Cash5.0%
Issue A15.0%
Issue B15.0%
Issue C15.0%
Issue E10.0%
Issue F10.0%
Issue G10.0%
|ssue H10.0%
Issue I10.0%
Cash5.0%
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Open end funds need liquidmarkets
• Constantly buy and sell assets to meetpurchases and sales of fund shares orunits
• Must be able to value assets correctly toset a correct price on shares or units
• Can present problem in emerging markets• Closed ended funds suit illiquid markets
better
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Significance of open ended funds(Source: BIS 1998)
618415As % ofmarketcap
1634946As % ofGDP
UKFranceJapanUSAs atend1996
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Size of open end fund markets:End 1998 (source: ICI, Cadogan)
7,3825,766US1,680297UK
13,442202Korea4,344359Japan
721.4Hungary6,335621France1053.4Chile
Number offunds
Value of funds- $ billion
Country
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% ownership of mutual funds byincome groups in the US
(source: ICI)
0
10
20
30
40
50
60
70
80
90
< $25,000$25,000 - 34,999$35,000 - $49,999$50,000 - $74,999$75,000 - $99,999>$100,000
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How funds developedinternationally
Spontaneously• First fund enabled
the investor ofmodest means toaccess adiversifiedportfolio: 1868 inthe UK
Artificially• Created to serve
specific need – eg– Assist privatisation– Bypass poor
banking system– Kick start stock
markets– Retail government
bonds
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FeaturesSpontaneous• More sustainable
since develop oncemarkets andexpertise exist
• Market unregulatedat start
Artificial• Less sustainable
unless consistenteffort made: often pre-date markets soexpertise lacking andoperation hindered
• Market often poorlyregulated at start
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Outcomes – not dissimilarSpontaneous• Scandals occur so
regulation isintroduced
• New scandals occur• Regulation and
markets are improved• Examples: US
Investment CompaniesAct 1940, UK FinancialServices Act 1986
Artificial• Scandals occur eg
Czech PrivatisationFunds, Korea, Mexico
• Regulation andmarkets are improved
• Or market fails todevelop
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Candidates for Regulation
• Funds (securities regulator)• Fund management company (securities
regulator)• Custodian or trustee (securities
regulator and banking regulator – oftenbanks)
• Fund salespeople (securities regulator)• Auditor (professional ethics – additional
standards may be needed)
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Measures & ObjectivesRegulatory Measure Anti-
competitiveBehavior
MarketMisconduct
AsymmetricInformation
SystemicInstability
Competition RegulationAntitrust/competition policy ✓✓✓✓
Market Conduct RegulationDisclosure standards (assets;fees) ✓✓✓✓
Comparable presentation of results ✓✓✓✓
Marketing/advertising rules (KYC rules) ✓✓✓✓ ✓ ✓✓✓
Valuation (NAV at MTM) ✓✓✓✓ ??(Korea)Limits on permitted activities ✓✓✓✓
(conflict of interest; self-dealing)Limit basis for calculating fees ✓✓✓✓ ??(Korea)Prudential RegulationLicensing; fit and proper ✓✓✓✓ ✓ ✓✓✓ ??(Korea)Legal separation; segreg. of assets ✓✓✓✓ ✓ ✓✓✓ ??(Korea)[Minimum capital requirements] ✓✓✓✓ ✓ ✓✓✓ ??(Korea)Legal investment ✓✓✓✓ ??(Korea)Liquidity requirements ✓✓✓✓ ??(Korea)Leverage limitations ✓✓✓✓ ??(Korea)Diversification -concentration limits ✓✓✓✓ ??(Korea)Private oversight (custodians, audit) ✓✓✓✓ ??(Korea)Redundant RegulationsFee Caps ??[Minimum Capital Requirement] ??(Korea)
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To make funds work, you need:• Sufficient demand (savings)• Adequate supply of quality assets• Appropriate legal framework• Competent regulatory body with
sufficient resources• Capacity to effectively enforce law• Distribution channels
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.. And ..• Competent fund operators with
sufficient capital• Operational infrastructure
(exchanges, custody, brokerage,etc)
• Reliable money transmission• Appropriate accounting standards• Neutral or beneficial tax• Efficient disclosure mechanisms
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If you don’t have some or all of these…• Does the political will exist to create
them?It should, because:• Funds mobilize savings, deepening
markets• Savings finance corporate and
government borrowing• Domestic savings reduce impact of
foreign flows• Use for private pension provisionNeed political stability: long haul
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Where to start?
• Training all those relevant to tasks• Create strategy with tasks - clear
leadership and accountability• Create legal, regulatory framework, fiscal
and accounting framework• Create regulatory body• Brief potential fund managers, custodians,
etc. on opportunities