An Introduction to Mutual Funds

Presented byUmair Javed Imam

AVAIS HYDER LIAQUAT NOUMAN CHARTERED ACCOUNTANTS

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What Is a Mutual Fund?

A mutual fund is a company that invests in a diversifiedportfolio of securities. People who buy shares ofa mutual fund are its owners or shareholders. Theirinvestments provide the money for a mutual fund tobuy securities such as stocks and bonds. A mutual fundcan make money from its securities in two ways: asecurity can pay dividends or interest to the fund, or asecurity can rise in value. A fund can also lose moneyand drop in value.

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New to Mutual Funds

• Pooled vehicle• Professional Management• Investment Plans• Legal Framework• Investors• Trustees• Asset Management Company• Registrar• Custodian

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POOLED VEHICLE

• A Mutual Fund is a vehicle to pool money from investors, with a promise that the money would be invested in a particular manner, by professional managers who are expected to honor the promise.

• In Pakistan the Mutual Funds are governed by the regulations of Securities and Exchange Commission of Pakistan (SECP).

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PROFESSIONAL MANAGEMENT

• The idea behind a mutual Fund is that individual investors generally lack the time, the inclination or the skills to manage their own investments. Thus, mutual funds hire professional managers to manage the investments for the benefit of their investors in return for a management fee.

• The organization that manages the investment is the Asset Management Company (AMC). Employees of the AMC who perform this role of the managing investments are the fund managers

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INVESTMENT PLANS (SCHEMES)

• Investors have their individual preferences on how they would like their money invested and how much risk they are willing to take.

• An individual investor could choose to hire a professional manager to manage his/her money as per his/her investment and risk preferences. Such personal treatment, often referred to as Portfolio Management Schemes (PMS).

• It is possible to balance the time and cost required to manage investments by grouping investors together based on their preferences. In this manner, the focus of the investment activity can be shifted from a single investor (in case of PMS) to a group of investors having similar expectations (in case of mutual fund).

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LEGAL FRAMEWORK

• Across the world, the mutual fund sector is viewed as a critical mechanism to channel investor funds into the capital market. Since these investors are often not so well qualified to invest, the mutual fund business is highly regulated.

• Regulations vary from country to country. But broadly, they provide for:

• Checks and balances in the legal structure; • Pre-qualifications to start a mutual fund; • Permissible schemes and investments; • Control over marketing process; • Level of operational flexibility to the professional investors;

and • Valuation of securities, etc.

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INVESTMENT GURU

Warren Edward Buffet (born August 30, 1930, in Omaha, Nebraska) is an American investor, businessman and philanthropist. He is regarded as one of the world's greatest stock market investors, and is the largest shareholder and CEO of Berkshire Hathaway. With an estimated net worth of around US$62 billion, he was ranked by Forbes as the richest person in the world as of February 11, 2008.

Who are the Parties Involved?

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Investors

• Mutual Fund is a solution for investors who lack the time, the inclination or the skills to actively manage their investment risk in individual securities. They can delegate this role to the mutual fund, while retaining the right and the obligation to monitor their investments in the scheme

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Trustees

• Trustees are the people within a mutual fund organization who are responsible for ensuring that investors interests in a scheme are properly taken care of.

• In return for their services, they are paid trustee fees, which are normally charged to the scheme.

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Asset Management Company (AMC)

• AMCs manage the investment portfolios of funds. An AMC's income comes from the management fees it charges the fund it manages.

• In order to earn the management fee, an AMC has naturally to employ people and bear all the establishment costs that are related to its activity, such as for premises, furniture, computers and other assets, software development communication costs, etc. These are to be met out of the management fee earned. Expenses such as on trustee fees, marketing, etc. can be directly borne by the mutual fund.

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Registrar

• An investor's holding in mutual fund schemes is typically tracked by the scheme's registrar and transfer agent (R&T). Some AMCs prefer to handle this role in-house, i.e. on their own instead of appointing an R&T. The registrar or the AMC as the case may be maintains an account of the investor's investments in and disinvestment from the schemes. Requests to invest more money into a scheme, or to redeem money against existing investments in a scheme are processed by the R&T.mutual fund scheme.

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Custodian / Depository

• The custodian maintains custody of the securities in which the schemes invests-as distinct from the registrar who tracks the investment by investors in the scheme.This ensures an ongoing independent record of the investments of the scheme.

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INVESTMENT GURU

• George Soros (born August 12, 1930, in Budapest, Hungary, is a Hungarian-born American financial speculator, stock investor, philanthropist, and political activist

• Soros is famously known for "breaking the Bank of England on Black Wednesday in 1992. With an estimated current net worth of around $8.5 billion, he is ranked by Forbes as the 80th-richest person in the world.

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Types Of Mutual Funds

• Open End Fund

• Close End Fund

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Open-end Fund

• These are mutual funds which continually create new units or redeem issued units on demand. They are also called unit trusts, because they are registered as trusts. The unit holders buy the units of the fund or may redeem them on a continuous basis at the prevailing NAV.

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Closed-end Fund

• Closed-end funds can be floated under a company structure as well as a trust structure. In case of trust structure, a fixed number of certificates are issued (shares in the case of a company structure) during an initial public offering (IPO). These certificates/shares are listed on a stock exchange for secondary trading .

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Net Asset Value

• A fund's NAV is equal to the market value of its underlying assets, which include stocks, bonds and other securities and assets which are held in the portfolio, minus liabilities, divided by the number of units or shares outstanding.

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ASSET VALUE

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INVESTMENT GURU• Dr. Joseph Mark Mobius (born

August 17, 1936) is a global investor and emerging markets fund manager, and is considered to be one of the leaders in the industry as he has been involved in these markets for over 40 years

• Dr J Mark Mobius, to give him his official title, is a fund manager. He works for Templeton Worldwide, the American mutual fund business and right now has about $10-billion of other people's money to look after. In fact, some of it is his own; he will not say how much it is, probably a few million dollars

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Mutual Fund Categories

• Equity Funds• Income Funds• Balanced Funds

• Islamic fund• Index Funds• Sector Funds

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Equity Funds

• Equity Funds invest primarily in the stocks of various types of companies. The types of stocks in which an equity fund will invest will depend upon the fund's investment objectives, policies, and strategies.

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Income Funds

• Income Funds: Income funds aim towards providing a regular stream of income to the investor. To accomplish this goal they invest in medium to long term instruments such as Term Finance Certificates (TFC), government securities, and a combination of short term CFS (Continuous Funding System) and high yielding deposits.

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Balanced Funds

• The strategy of balanced funds is to combine securities from different asset classes in varying proportions to help manage moderate risk and consistent return. These funds generally tend to invest up to 65% in equity securities and the remaining in fixed income instruments.

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Islamic Funds

• In case of Islamic Funds, the investment made in different instruments is to be in line with the Islamic Shairah Rules. The Fund is generally to be governed by an Islamic Shariah Board. And then there is a purification process that needs to be followed, as some of the money lying in reserve may gain interest, which is not desirable in case of Islamic investments.

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Index Funds

• The intent of an index fund is basically to track the performance of the stock market. If the overall market advances, a good index fund follows the rise. When the market declines, so will the index fund. Index funds' portfolios consist of securities listed on the popular stock market indices.

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Sector Funds

• As was noted earlier, most mutual funds have fairly broad-based, diversified portfolios. In the case of sector funds, however, the portfolios consist of investment from only one sector of the economy. Sector funds concentrate in one specific market segment; for example, energy, transportation, precious metals, health sciences, utilities, leisure industries, etc. In other words, they are very narrowly based.

How Mutual Funds Generate Their Income

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Depending on the investment policy of the mutual funds, the

main sources of income are • Dividends from equity investments.• Return from term finance certificate or corporate paper.• Profit from Government securities.• Return on deposits/ COIs with banks/ financial

institutions.• Profit from money market transactions.

• Profit from PLS accounts with banks.

• Capital gains or losses on sale of equity securities, term finance certificates and Government securities.

• Any appreciation in the value of investment, but not realized, is not taken as income, but recognized for calculating the NAV.

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Mutual Funds in PakistanMajor Players

Asset Management Companies• JS• UBL • PICIC • Almeezan • AKD • Arif Habib • Atlas • NAMCO• HBL• BMA• Askari• IGI• AMZ• Dawood

How Mutual Funds have evolved in Pakistan?

Investment Corporation of Pakistan and National Investment Trust were pioneers in establishing close-end and open-end mutual funds.

Presently open-ended mutual funds stand at Rs. 325 b [Feb-2008]. The market cap of close end mutual funds was Rs. 36.24 b [11-4-08].

Out of Rs. 325 b open end funds, Rs. 124 b [38%] were in equity funds, and Rs. 127 b [39%] were in income fund.

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What are the potential advantages of investing in

mutual funds?

Diversification: Investing in a number of differentsecurities helps reduce the risk of investing. Whenyou buy a mutual fund, you are buying an interest ina portfolio of dozens of different securities, giving youinstant diversification, at least within the typeof securities held in the fund.

There are many reasons why people invest in mutual funds:

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There are many reasons why people invest in mutual funds:

Professional Management: Mutual funds are managedby professionals who are experienced in investingmoney and who have the skills and resources toresearch many different investment opportunities.

Performance Monitoring: The value of most mutualfunds is reported daily in the financial press andon many internet sites, allowing you to continuallymonitor the performance of your investment.

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There are many reasons why people invest in mutual funds:

• Liquidity: Units or shares of mutual funds can beredeemed at any time in open end fund.

• Flexibility: Many mutual fund companies administerseveral different mutual funds (e.g., money market,fixed-income, growth, balanced and internationalfunds) and allow you to switch between funds withintheir ‘fund family’ at little or no charge. This can enableyou to change the balance of your portfolio as yourpersonal needs or market conditions change.

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What are some of the potential disadvantages?

When you invest in a mutual fund you place your moneyin the hands of a professional manager. The return onyour investment will depend heavily on that manager’s skilland judgement. Even the best portfolio advisers are wrongsometimes, and studies have shown that few portfolioadvisers are able to consistently out-perform the market.Check the fund manager’s track record over a period oftime when choosing a fund.

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What are some of the potential disadvantages?

As a mutual fund investor, you will also be paying, throughmanagement expenses and commissions, for managementservices and for various administrative and sales costs.Those fees and commissions reduce the return on yourinvestment and are charged, in almost all cases, whetherthe fund performs well or not. Sales commissions andredemption fees can have a very significant impact on yourreturn if you decide to redeem your mutual fund investmentin the short-term.

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FRONT END LOAD/BACK END LOAD

Sales Charges (Loads) are the commissions that you may

have to pay when you buy or redeem units of a fund. Sales

charges may be applied when you buy units of the fund

(a front-end load), when you redeem your units (a back-end

load), or there may be no sales charges at all (no-load).

Where front-end loads are charged, the rate can vary from

dealer to dealer and may be negotiable.

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RISK INVOLVED

The funds management apart from following the rules laid down by the SECP has also internally spelled out elaborate

risk management procedures to manage the risk based on the guidelines divided among the following three major

components:

Identifying Investment Risk

Risk Measurement

Risk Management

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Identifying Investment Risk

• In order to properly and efficiently manage risks, the first step taken by Mutual Funds Risk Management team is identifying the risks associated with Investments. There are a number of risk types that the Mutual Funds recognize in making investments. These are; Market Risk of volatile market values, Credit Risk of changing credit qualities, Spread Risks relate to uncertain cost of credit, Liquidity Risk and Operational risk that are of potential loss due to process failure.

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Risk Measurement

Once the risks are identified, measuring the risk level isanother stage of risk management. The risk measurementmethods used by Mutual Funds are:

• Positions: all investments must be recorded and reported• Valuations: independent valuations by mark-to-market or mark-to-

model for unlisted holdings• Sensitivities: detailed sensitivity of value to changes in market factors

– interest rates, credit spreads, prices, volatilities, currencies• Stress Tests: potential impact of extreme market moves• Back-testing: comparing realized returns with expected returns to

validate the process• Attribution: attribution of risks to the investment process such as

strategy/tactics/execution, market/style/selection, currency/price/interest/spread

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Risk Management

• The final step of managing risk involves comparing the risk measured to the risk profile of the respective investments. Risk management is asking all of the questions and believing none of the answers and it is an on-going process that takes time.

• These functions are executed using analytical tools such as Bloomberg and Mat Lab.

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SAMPLE CASE STUDY OF

XYZ COMPANY

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ORGANIZATIONAL PLAN

OF XYZ COMPANY

Treasury DepartmentSettlement DepartmentAccounts DepartmentMarketing Department

Human Resource DepartmentInformation Technology Department

Research and DevelopmentAdministration Department

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• Treasury Department

• The treasury department is responsible for the optimal allocation of the funds held by the xyz ltd. It works in close coordination with the accounting and settlement departments in order to manage the cash flows, documentation and clearing of transactions with external parties such as brokers, trustees and counter parties.

• The primary function of the department is to carry out the allocation of assets in funds.

• Settlement Department

• The settlement department is responsible to clearing all transactions with all parties. In verifies the entries made in the system for its trades made by the treasury and in responsible for the related paperwork and communication with outside parties as well as with the trustees regarding deliveries and payments.

• The settlement head maintains information on redemptions, investments, placements and settlement of transactions.

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• Accounts Department

• The accounts department is responsible for recording the funds’ related transactions that take place as well as maintaining the accounting records on a daily basis. It also handles the cash placements in various banks in order to handle it in efficient manner. The decision regarding the cash placements is backed by the investment committee.

• Marketing Department

• Marketing is one of the most important instruments of business plan. Without marketing, people will not be able to find what business is about and all services. Marketing is most important activity in a business because it has a direct effect on profitability and sales. There are different methods when it comes to marketing. This includes direct marketing, relationship marketing, advertising, public relations, and positioning.

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Research and Development

• Risk department provides research-based information to the high net worth individual and institutional clients with pertinent facts to assist them in buying or selling securities. Research department of the company is meticulously judging the effects of subtle market as well as analysis past and present company and industry record. Research Department also evaluates marketing as well as operational strategies of the companies in order to give authentic information to the clients. Resources which personnel of research department use include reference manuals, statistical reports, corporate financial statements, and business and government publications.

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STANDARD OPERATING PROCEDURES (SOP)

OFXYZ COMPANY

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SOP OF XYZ COMPANY

• INTRODUCTION, PURPOSE AND SCOPE

OBJECTIVE • The principal objective of the Manual is to provide personnel

with a standard document to serve as a guideline in carrying out their responsibilities. Compliance with the Manual is mandatory to ensure a sound accounting and internal control environment and to facilitate generation of necessary information in an effective and efficient manner. Accordingly, the policies and procedures detailed in this Manual must be complied with by all the concerned employees of the company.

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SOP OF XYZ COMPANY

• SCOPE• The Manual applies to all personnel involved in the

operations of the company. It will play a key role in communicating and maintaining the company’s operating and financial policies and procedures and internal control system.

• Further, powers and responsibilities exercisable by employees of the company shall be governed by the ‘signature mandate’ of the company as issued and amended from time to time.

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SOP OF XYZ COMPANYRECEIPTS AND PAYMENTS

No Dealing in Cash Except for Certain Transactions• The Company will not deal in cash for either payments or receipts, except for

petty cash transactions.

Receipts• Receipts of the management company include, but are not limited to, the

following:

» Management Fee» Front end / Back end load» Dividend and Mark-up / Profit » Disposal of Investments & Trading Gains» Carry Over Transactions» Profit / Mark-up on Bank Account and Debt Instruments» Disposal of Fixed Assets» Arrangement Fee, Participation Fee, etc.

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SOP OF XYZ COMPANY

TRANSACTIONS WITH BROKERSObjective

I. All transactions of equity and money market of XYZ and Mutual Funds shall only be made through authorized brokers.

II. Responsibility

Brokerage shall be paid to brokers at agreed rates. In case, brokerage is to be paid at a rate other than agreed rate, the same has to be approved by at least two of CIO, CEO, and one Director.

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SOP OF XYZ COMPANY

• BANK RECONCILIATION• Time Line

• I. Any cheque deposited that has not been cleared for more than two working days shall be reported to the CFO immediately.

• II. Any stale cheque (cheque that has not been presented within 6 months of the date of issue) shall be reversed with the reinstatement of related liability.

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SOP OF XYZ COMPANY

RISK MANAGEMENT

Introduction• I. The Fund Management division manages mutual funds that

may be investing in equities, fixed income and derivatives. As well as managing the risk of stock market and interest rate movements, the department is involved in monitoring the credit risk of bond issuers, depositary institutions, and brokers.

• General • The Fund Management staff must be well versed with relevant

Laws and Regulations• II. The Fund Management staff must comply with all the

procedures as laid down in Sections of the SOPs.

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SOP OF XYZ COMPANY

• MIS AND FINANCIAL REPORTING• Objective• I. To declare NAV for investment and redemption requests,

sending to newspapers, stock exchange(s) and SECP, and Board of Directors.

• II. As per Rule 80(4) of the NBFC Rules and with compliance of the Offering Document of the respective fund there must be at least four regular dealing days per week.

• The said report shall be prepared by Associate Operations, reviewed and approved by CFO and CEO.

• III. After the NAV bunch has been reviewed and approved by CFO, CFO shall authorize NAV to be sent to newspapers, stock exchange(s) and SECP through fax or e-mail.

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SOP OF XYZ COMPANY

Net Assets Value (NAV)

• Procedure for calculation of NAV• NAV means the excess of assets over liabilities.• NAV shall be calculated in accordance with the

principles mentioned in clause (xxxiv) of Rule 2 of the NBFC Rules, 2003 except for the valuation of debt instruments that shall be valued on the basis of discounted cash flow method as allowed under the International Accounting Standards and approved by the Board of Directors through resolution dated April 27, 2005.

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SOP OF XYZ COMPANY

• Borrowings• Objective• To set out the procedures for undertaking borrowings on

behalf of the Fund. • Responsibility• Borrowings shall be made with the prior approval of the

Board of Directors.• Purpose for which borrowings can be made• The Management Company may cause the Fund (Trustee) to

borrow amounts not exceeding fifteen percent of the total Net Asset Value of the Fund (or such limits prescribed by the Rules).

• Borrowing shall be carried out only to meet redemption requests and shall be repayable within a period of ninety days.

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An Introduction to Mutual Funds

THE END

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AVAIS HYDER LIAQUAT NOUMAN CHARTERED ACCOUNTANTS