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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