100976 Mutual Funds in Developing Markets: Addressing Challenges to Growth MUTUAL FUNDS in developing markets: addressing challenges to growth I © 2015 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is subject to copyright. Because the World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. All queries on rights and licenses should be addressed to the Publishing and Knowledge Division, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. Mutual Funds in Developing Markets: Addressing Challenges to Growth Table of Contents Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii Acronyms and Abbreviations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix Executive summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Chapter 1. Overview of Mutual Fund Sector Characteristics in Select Developing Countries . . . . . . . . . . . . . . . . . . . . . 5 Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Definition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Role of Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Asset Accumulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Financial Intermediation and Mutual Fund Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Ownership of Mutual Funds: Institutional and Retail Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Distribution of Mutual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Mutual Fund Charges. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Interdependency with Banks, Pension Funds, and Insurance Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 In Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Chapter 2. Legislation, Regulation, and Taxation of Mutual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Legal and Regulatory Apparatus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Key Aspects of the Legal/Regulatory Framework. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Other Laws That Affect Mutual Fund Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Taxation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 In Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Chapter 3. Market Drivers and Impediments to Mutual Fund Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Market Structure and Infrastructure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 In Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Appendices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Appendix 1: Mutual Fund Study Case Studies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Brazil. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Kenya . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Morocco . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Peru . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Turkey. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Appendix 2: Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 MUTUAL FUNDS in developing markets: addressing challenges to growth v List of Boxes Box 1.1 History of Investment Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Box 1.2 Key Mutual Fund Markets Worldwide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Box 1.3 Captive and Third-Party Distribution Channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Box 1.4 Fund Charges and Share Classes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Box 2.1 History of Mutual Fund Legislation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Box 2.2 IOSCO Principles on Collective Investment Schemes (CIS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Box 2.3 Regulating by “Function” or “Institution” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Box 2.4 Variants on Mutual Funds Formed as Open-Ended Investment Companies . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Box 2.5 Variants on Mutual Funds Formed as Unit Trusts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Box 2.6 Variants on Mutual Funds Formed as Contractual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Box 2.7 Closed-Ended Funds and U.K. Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Box 2.8 Mutual Funds Formed as Investment Companies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Box 2.9 Mutual Funds and Retirement Savings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Box 2.10 Brazil and Peru Taxation Regime for Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Box 3.1 Distinction between Retail and Institutional Demand. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Box 3.2 Brazilian Fund Market Response to Investor Fear of Inflation and Interest Rate Volatility. . . . . . . . . . . . . 58 Box 3.3 Money Market Funds and the Risks of Constant Value MMFs in Volatile Interest Rate Environments . . . . 59 Box 3.4 Achieving Investment Diversification in Ugandan Equity Mutual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Box 3.5 Nontraditional Distribution Channels for Mutual Funds in India. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 Box 3.6 Market Infrastructure Supporting Mutual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 List of Figures Figure 1.1 Global Mutual Fund Assets under Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Figure 1.2 2013 Largest Mutual Fund Assets under Management by Country/Region. . . . . . . . . . . . . . . . . . . . . . . . . . 8 Figure 1.3 Total Mutual Funds Assets under Management: High-Income MF sectors versus Middle-Income MF Sectors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Figure 1.4 2012 Mutual Fund Assets and Compound Annual Growth Rate, 2002–2012. . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Figure 1.5 Annual Net Sales, 2001–2012, $ millions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Figure 1.6 ICI Data for Mutual Fund Sector Asset Exposure: High-Income versus Middle-Income Countries. . . . . . 11 Figure 1.7 2012 Mutual Fund Asset Exposure Broken Down by Asset Class. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Figure 1.8 Distribution Channels for Mutual Funds in Selected European Countries, 2011. . . . . . . . . . . . . . . . . . . . . 13 Figure 3.1 Net Acquisition of Deposits and Currency and Net Retail Sales of Mutual Funds by U.K. Households versus Bank of England Base Rate, 2004–2013. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Figure 3.2 Global Net Sales of Equity Funds versus Annual Return on Equities, 2002–2013 . . . . . . . . . . . . . . . . . . . 60 Figure 3.3 Total Expense Ratios in Select Emerging and Developed Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Figure 3.4 2012 Mutual Fund Assets/GDP versus Stock Market Capitalization/GD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Figure 3.5 Bank Domination of Mutual Fund Operators by Number of Operators. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 vi MUTUAL FUNDS in developing markets: addressing challenges to growth List of Tables Table 1.1 Main Distribution Channels for Mutual Funds by Country, Year End 2012. . . . . . . . . . . . . . . . . . . . . . . . . . 14 Table 1.2 Typical Fund Charge Rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Table 2.1 Components of the Legal and Regulatory Apparatus for Mutual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Table 2.2 Legislation Enabling Mutual Funds in Selected Emerging Markets.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Table 2.3 Variations in Primary Legislation Enabling Mutual Funds as at Year End 2012 . . . . . . . . . . . . . . . . . . . . . 25 Table 2.4 Mutual Fund Regulators in Selected Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Table 2.5 Ability of the Regulator to Issue Regulations in Case Study Markets as at Year End 2012. . . . . . . . . . . 27 Table 2.6 SROs and Trade Associations in Selected Markets at Year End 2013. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Table 2.7 Legal Structures of Mutual Funds Envisaged in Selected Emerging Markets Countries as at Year End 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Table 2.8 Key Roles and Responsibilities of Different Parties to Mutual Funds Worldwide, by Legal Structure. 34 Table 2.9 Presence of Structural Variations in Case Study Markets as at Year End 2012. . . . . . . . . . . . . . . . . . . . . 35 Table 2.10 Required Licensed Status for Entities Responsible for Mutual Fund Operation for Selected Countries. . 36 Table 2.11 Custody Arrangements for Different Legal Structures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Table 2.12 Charges Limited by Regulation and General Level of Charges in Case Study Countries as at Year End 2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Table 2.13 Ability to Offer Foreign Mutual Funds to the Domestic Public Subject to Registration with the Regulator as at Year End 2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Table 2.14 Levels at Which Tax May Have an Impact on Funds and Their Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Table 2.15 Description of Taxation Systems of Funds in Selected Countries as at Year End 2012 . . . . . . . . . . . . . . 48 Table 3.1 Selected Emerging Markets Categorized by Gross National Income per Capita: Value of Mutual Funds as a Percentage of GDP, Year End 2011. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 MUTUAL FUNDS in developing markets: addressing challenges to growth vii Acknowledgments This report is a joint product of the World Bank and IOSCO. The This study draws input from country case studies previously report was prepared by Shanthi Divakaran (Team Leader and Senior prepared by Sally Buxton (Turkey and Kenya), Mark St Giles (Peru Financial Sector Specialist, Finance & Markets Global Practice, and Brazil) and Yann Christin (Expert Consultant, case study on World Bank), Sally Buxton (Expert Consultant, Cadogan Financial Morocco), which benefited from the support and guidance of the Ltd.) and Mark St Giles (Expert Consultant, Cadogan Financial Ltd.) following colleagues: Isfandyar Zaman Khan (Program Leader, with research assistance from Sevara Atamuratova (Research World Bank) and Alper Oguz (Senior Financial Sector Specialist) Analyst, Finance & Markets Global Practice, World Bank). The report on Turkey; Evans Osano (Senior Securities Markets Specialist) was prepared under the overall guidance and support of Michel Noel on Kenya; Clemente del Valle (former World Bank Lead Financial (Head, Investment Funds, Finance & Markets Global Practice, World Sector Specialist) on Peru; Anderson Caputo Silva (Lead Securities Bank) and Alison Harwood (Manager, Finance & Markets Global Markets Specialist) and Heinz Rudolph (Lead Pension Specialist) on Practice, World Bank). The IOSCO team, under the leadership of Brazil; Gabriel Sensenbrenner (Lead Financial Sector Specialist) on Isabel Pastor (Senior Advisor, IOSCO), and consisting of Alp Eroglu Morocco. Data compilation and analysis from IOSCO survey and (Senior Advisor, Growth and Emerging Markets Committee), Tony summaries of the case studies (in annex) were prepared by Sevara Iloka (Advisor, Growth and Emerging Markets Committee), Youngki Atamuratova (with guidance from Sally Buxton and Mark St. Giles). Kim (former Advisor, Growth and Emerging Markets Committee), The team is thankful to Chris Plantier, Senior Economist at the and Nobambo Mlandu (former Advisor, Growth and Emerging Investment Company Institute (ICI), for permission to use charts Markets Committee) led the preparation of the WB-IOSCO survey from his research on “Globalisation and the Global Growth of Long- of mutual fund sectors in emerging markets that was a critical input Term Mutual Funds” which is referenced in this report. into this report; and provided both important input and reviews of this document. The team is also thankful to the members of the Rogelio Marchetti (former World Bank Senior Financial Sector Growth and Emerging Markets Steering Committee and Mr. Werner Specialist) and Clemente del Valle (former World Bank Lead Bijkerk (Head of the Research Department, IOSCO) for their useful Financial Sector Specialist) played an important role in helping comments/feedback to the draft report that was circulated. to kick start this study and provided early input into this work. Nikoloz Anasashvili (Research Analyst) provided additional The team is thankful to the peer reviewers for their excellent research assistance. Marilyn Benjamin (Program Assistant) and comments on this study. Comments were received from the Thelma Ayamel (Program Assistant) provided valuable contract following official reviewers: John Pollner (Lead Financial Officer, and logistical support. Honglin Li provided very helpful knowledge World Bank), Leora Klapper (Lead Economist, World Bank), Xavier management assistance, and Corporate Visions designed the Jordan (Chief Investment Officer, IFC Capital Markets –FIG) and layout of this report with Aichin Lim Jones. Anderson Caputo Silva (Lead Securities Market Specialist, World Bank). Valuable comments were also received from Ana Fiorella Caravajal (Lead Securities Market Specialist, World Bank) and Alexander Berg (Senior Financial Sector Specialist, World Bank). viii MUTUAL FUNDS in developing markets: addressing challenges to growth Acronyms and Abbreviations ACD Authorised Corporate Director ANBIMA Associação Brasileira das Entidades dos Mercados Financeiro e de Capitais (Brazil) AUM Assets Under Management CIS Collective Investment Scheme EEA European Economic Area ETF Exchange-Traded Fund EU European Union GAAP Generally Accepted Accounting Principles GDP Gross Domestic Product ICI Investment Company Institute IFRS International Financial Reporting Standards IOSCO International Organization of Securities Commissions IRA Individual Retirement Account MMF Money Market Fund NAV Net Asset Value OECD Organisation for Economic Co-operation and Development SEBI Securities and Exchange Board of India SEC Securities and Exchange Commission (U.S.) SRO Self-Regulatory Organization UCITS Undertakings for Collective Investment in Transferable Securities MUTUAL FUNDS in developing markets: addressing challenges to growth ix Executive Summary Background An estimated 76,200 mutual funds worldwide currently control about $30 trillion1 in assets under management, representing just over 20 percent of total global assets under management on behalf of investors worldwide.2 Mutual funds have typically come about as an outcome of developed financial markets, not a cause of it. Unsurprisingly, therefore, developed markets control roughly over 90 percent of mutual fund assets.3 Yet many developing countries are currently seeking to foster a domestic mutual fund sector, because mutual funds provide cost-effective, professionally managed diversification of risk to investors, while supporting economic growth. Mutual funds are a major intermediary between savers and they are not standardized in terms of legal structure, investment borrowers, gathering savings out of bank deposits and investing focus, or management style; nor are they always consistently these savings into money market instruments, bonds, and categorized in available data. Policy makers and regulators equities issued by governments and corporates. Mutual funds must understand the mutual fund sector to realistically assess are essentially designed to diversify risk for smaller savers who do the sector’s ability to function, and to effectively facilitate and not have enough money to achieve this diversification themselves; supervise these funds. thus, mutual funds tend to be a middle class savings vehicle. However, these funds are also a valuable investment vehicle for This study provides policy makers in developing countries who institutional investors and corporates who likewise benefit from seek to foster the domestic mutual fund sector with a handbook this cost-effective professional management of diversification of to understand the sector; it presents a range of legal/regulatory risk. Mutual funds therefore play a significant role in investing for and market-related factors that drive or impede mutual funds. retirement as well as serving as an underlying investment vehicle for The objective of this report is to lay out salient features that help insurance companies. Likewise, corporates find the cost-effective develop the mutual fund industry in developing countries and unlock diversification of risk offered by money market funds (which invest some of the key drivers and impediments that typically assist or predominantly in short-term debt instruments) attractive for stunt their growth. Few reports so far have drawn on cross-country treasury management. studies to examine developing country mutual fund sectors. This study explores the nature of mutual fund sectors in different Mutual fund markets sometimes develop organically. However, in developing countries and presents, through illustrative examples, many emerging markets, and sometimes developed markets, mutual the heterogeneity in characteristics that arise for mutual fund funds are often “synthetically” developed by first establishing the sectors developed in different geographic and economic contexts.6 legal and regulatory framework, based on international standards, for such funds to exist. In the United Kingdom, the United States, The study focuses primarily on publicly offered, domestic mutual and Zimbabwe, funds developed first and fund-specific law and funds (legally domiciled in the host country in which they are regulation came later. In other cases, such as Kenya, Morocco, primarily distributed). The study draws from five country case or Spain,4 fund law and regulation were set up before funds were studies of mutual fund sectors conducted by the World Bank in actually created. 2012—Brazil, Kenya, Morocco, Peru, and Turkey—and on various other examples. The details of these studies are provided in the The varying scale of domestic mutual fund markets around the chapters that follow, using data and insights from the time of world—in both developing and mature markets—is a function of the respective case studies, with updated data where possible. many different interacting factors. The diversity of fund sectors The study also draws on a 2013 global survey conducted by the also reflects the diversity of environments in which they operate.5 International Organization of Securities Commissions (IOSCO) Moreover, mutual funds themselves defy clear comparison because on mutual fund markets in developing countries. Throughout the Executive Summary | 1 report these case studies are referenced to depict the heterogeneity to a limited number of investors, using the same legal framework as well as similarities in trends of mutual fund sectors globally. The set up for funds sold to retail investors.11 reader must note that these examples are not meant to reflect best or worst practice, but rather are used for illustrative purposes. Development of Mutual Fund Sectors For policymakers seeking to initiate or expand a mutual fund Introduction to Mutual Funds sector, the first step is to identify the current level of development A mutual fund is a form of open-ended collective investment and success of the mutual fund sector. scheme,7 or investment fund. It is a pool of savings collected from multiple investors who buy units representing proportionate If there is no mutual fund sector in the economy, and the country ownership of the fund. The resulting pool of funds, or the fund’s seeks to initiate such funds, policymakers should first consider capital, is collectively managed by a professional management the nature and scale of the capital markets. They should assess, company, in line with the investment objective outlined in the fund’s for instance if capital markets are expanding and offering potential prospectus. Mutual funds are typically understood to mean open- for mutual funds to expand; and if there is sufficient liquidity in the ended funds; that is, funds that are obliged to buy back their shares market to allow mutual funds to easily operate. Because mutual or units from holders on a regular (usually read as “daily”) basis. funds must be able to invest new money flowing into them and be This form of collective investment scheme is closely regulated able to raise money by selling assets when investors wish to exit the because it is legally eligible to gather savings from the public and is fund, they cannot operate in narrow and illiquid capital markets. If required, in turn, to invest those savings in a diversified portfolio of the stock market, for instance, lists 30 or fewer securities and most transferable/tradable securities. or all of these are rarely traded,12 then it is unlikely that mutual funds could function effectively. In such cases, before developing Mutual funds typically consist of four main types of funds, mutual funds, policy makers could first seek to improve the level of defined by their asset exposure: (1) funds that invest predominantly issuance and market turnover in the capital markets. They could in equity securities, (2) funds that invest predominantly in debt also prioritize improving the environment for closed-ended funds securities, (3) funds that invest in a hybrid of both equity and debt —such as venture capital and private equity funds—that do not securities, and (4) funds that invest in short-term debt instruments need liquid assets to function, since these funds can also help add (money market funds).8 to issuance listed on exchanges. These funds are set up through one of three common legal If, on the other hand, the country has a mutual fund sector, structures: trust, corporate, or contractual-type funds. The policymakers must understand the current health and level of country’s legal tradition, whether civil code or common law, will development of this sector. They must assess how the mutual influence the type of legal structure enabled for mutual funds. The fund market has developed relative to the economy;13 whether legal structure typically embeds governance requirements to deal the market is perceived to offer good potential for development;14 with some of the principal-agency risks inherent in the mutual fund how effective the sector has been in mobilizing savings;15 and the model.9 The legal structure also determines the arrangements for relative success of mutual funds with respect to other savings operating the fund, safeguarding its assets, and ensuring third-party vehicles. If the mutual fund sector is thought not to be growing supervision. Despite the prevalence of different legal structures, the sufficiently, the next step is to identify the reasons for inadequate operational characteristics of mutual fund structures are becoming growth. Typically (but not always) these reasons will fall into one or increasingly similar, as regulatory frameworks cohere around the more of the following categories which are further explored in the IOSCO principles on collective investment schemes (outlined in chapters of this study: Chapter 2) and, increasingly, regional standards. •• Quality of law and regulation and supervision. While a good Demand for mutual funds derives from institutional investors quality legal and regulatory framework in itself will not create (including corporates) and retail investors. In some countries, a successful mutual fund market,16 the market needs adequate such as Peru, the mutual fund sector is virtually 100 percent retail regulation and supervision to create investor confidence. On owned. In other cases, such as Morocco, institutional investors the other hand, excessively complex regulation may well be a own more than 90 percent of assets under management in mutual deterrent: Most highly developed markets started without any funds. Although in many countries funds can be licensed and taxed regulation and had to create frameworks to tackle problems as mutual funds only if they meet the diversity of ownership test, as they arose, continually adapting them over time. Law and in other countries it is possible for a fund to be created and sold regulation governing pension funds and other institutional exclusively to a single institutional client under the same legislative investors may also limit their investment into mutual funds; and regulatory requirements as funds that are offered to the public.10 this, in turn, may affect the mutual fund sector’s success. This is the case in Brazil, for instance, where Article 71 of Instrução 409 permits a fund to be created exclusively for a single client. •• Level of savings. If there is an insufficiently large middle class Similarly, in Morocco, the mutual fund industry is characterized with surplus savings that are willing to risk and deploy these by a large number of “dedicated” funds; that is, a relatively large savings for the long term in mutual funds, demand for mutual proportion of funds are set up as investment structures dedicated funds will quite simply be inadequate. In this case it can be useful to facilitate institutional investors such as pension 2 | MUTUAL FUNDS in developing markets: addressing challenges to growth funds to invest in mutual funds, while greater retail demand for channels for mutual funds can also restrict independent fund mutual funds develops. operators from entering the market. •• Financial literacy and awareness of financial products. If •• Flexibility in marketing mutual funds. If the legal and financial literacy and awareness is low, there may be decreased regulatory framework does not enable innovative fund retail interest in mutual funds. Awareness and education structures—such as master-feeders; umbrella funds; and programs to develop retail demand is a long-term and expensive multi share or unit classes—mutual fund operators may not exercise, which a nascent sector may not be able to undertake, have adequate flexibility to market mutual funds, which may so government or regulatory support may be needed. Developing impede the sector from accumulating assets. a financial advisory sector may also develop retail demand for mutual funds, since many people prefer to get face-to-face If mutual funds are sufficiently attractive to investors, then financial guidance.17 operators will come forward to create, offer and manage these funds, and distributors will be ready to distribute them. In •• Tax treatment of mutual funds. If mutual funds have less general, a mutual fund market (or a sector of that market) may favorable tax status than other types of savings vehicles rapidly expand if the operators of mutual funds find a particular (such as bank deposits or insurance products), then they are advantage that can be exploited. The nature of the advantage may unlikely to attract savings from individuals or investments from vary from country to country: In one country a money market fund institutional investors. may be able to offer higher returns to investors because income paid out by the fund is not subject to withholding tax, whereas interest •• Competition from other savings media, in particular paid on a bank deposit is; in another, a mutual fund may offer an mandatory pension fund savings and bank deposits. Where institutional investor a way to conveniently and cost effectively pension saving is mandatory, this may affect mutual funds achieve instant exposure to a domestic or foreign market. either positively or negatively. If pension funds can invest in mutual funds, then mutual fund growth may be affected Given the heterogeneity of contexts within which mutual funds positively; if they cannot, and particularly if required levels of operate, it is not possible to identify a single path that can mandatory pension saving are high, this will tend to crowd out ensure a mutual fund sector’s success and make certain that other savings, including mutual funds. If saving into pension the sector contributes effectively to the economy of a country. funds is voluntary and such funds are more tax efficient than On the contrary, many factors intersect to influence outcomes, as mutual funds and cannot or do not invest in mutual funds, this outlined in the chapters of this report. is likely to reduce the potential for mutual fund sector growth. Similarly, if interest rates on bank deposits are high, investors may find little incentive to risk capital in mutual funds investing Endnotes in shares or bonds, particularly if deposits are more tax efficient 1. Source: Investment Company Institute 2014. than investing in mutual funds. 2. UK Fund Management 2014, The Financial Markets Series, •• Competition from foreign domiciled funds. If funds domiciled TheCityUK, September 2014. in foreign jurisdictions can be publicly offered, and these funds 3. ICI Statistics on global mutual fund markets. offer wider global investment coverage, better tax treatment or 4. In Spain, a mutual fund sector came into being after the tax avoidance, or greater credibility than domestically domiciled country passed a mutual fund law, following the European funds, then local funds will find it harder to compete. Union’s Directive on Undertakings for Collective Investment in Transferable Securities (UCITS) in 1985. UCITS is a set of •• Stage of development of stock market. As a recent ICI European Union Directives that provide collective investment study18 notes “there is strong evidence that the relative size schemes a passport to operate throughout the EU once in of a country’s capital market is correlated with the size of the compliance with the directive and authorized by a member state. mutual fund industry in that country.” A prerequisite to growth of the mutual fund industry around the world is access to an 5. Plantier, L. Christopher. 2014."Globalisation and the Global Growth adequate supply of tradable stocks and bonds. Capital markets of Long-Term Mutual Funds." ICI Global Research Perspective 1, no. also need to be liquid; that is, the supply of securities must trade 1 (March). Available at www.iciglobal.org/ pdf/icig_per01-01.pdf. with some regularity. If capital markets are not expanding, 6. Although this report seeks to broadly explore striking aspects mutual funds are also unlikely to expand. of the mutual fund sector in emerging markets, it does not go into specific issues related to mutual funds. Such specific issues •• Access to distribution. Mutual funds need distributors that include but are not limited to the debate on whether or not actively have an incentive to sell units to the public. If banks (which managed funds outperform passively managed funds, details on dominate the distribution of financial services) or financial the nature and development of relatively new mutual fund products advisers do not find it sufficiently remunerative to market such as exchange-traded funds, and delving into the nature of mutual funds to the public, this could reduce the potential offshore fund centers and the impediments to their development. for mutual fund expansion. Bank domination of distribution The report also does not examine specific learnings from mutual Executive Summary | 3 fund sector events in developed country contexts, such as the mutual fund market timing scandal of 2003 in the United States. 7. “Collective investment scheme” is the term used by IOSCO to designate such funds. 8. Funds can be further subdivided by investment objective (income, growth, capital preservation, or a mixture of these) or by geographic focus (e.g., global equity) or sector focus (e.g., technology stocks). 9. The operator (or “agent”) who manages the fund does not own the assets of the fund. The assets are either beneficially owned by those who own units in the fund—the investors (the “principals”)— or they are owned by the fund itself when it is a company, which is in turn owned by its shareholders (the investors in the fund). This dichotomy leads to the possibility of conflicts of interest. 10. Since these funds are set up under the same legal and regulatory requirements as publicly offered investment funds, these are included in this analysis. 11. Out of the 330 authorized mutual funds, about 145 were dedicated to a single investor, as of December 31, 2011. Dedicated mutual funds represented 41 percent of total assets under management in Morocco at end of 2011. 12. That is, stock market turnover as a percentage of market capitalization is less than 10 percent. 13. Total mutual fund assets under management as a percentage of gross domestic product over time. 14. Progression in the number of mutual fund operators over the previous the ten years, or since inception of the industry. 15. Mutual fund assets under management as a percentage of value of total bank deposits. 16. Indeed many markets have state-of-the-art regulation and no activity. 17. However, this is a complex area to develop and regulate since such advice should cover a wider range of financial services than mutual funds. 18. Plantier, L. Christopher. 2014. "Globalisation and the Global Growth of Long-Term Mutual Funds." ICI Global Research Perspective 1, no. 1 (March). Available at www.iciglobal.org/ pdf/icig_per01-01.pdf. 4 | MUTUAL FUNDS in developing markets: addressing challenges to growth Overview of Mutual Fund 1.  Sector Characteristics in Select Developing Countries Objective Mutual funds developed spontaneously in mature markets such as the United States and United Kingdom before legislation governing such funds developed. These funds became prevalent relatively late in developed markets—beginning in the 1920s—along with the formation of a sizeable middle class population, which diversified their investments through such funds; and the development of financial markets, which featured a broad range of liquid securities in which such funds could invest their capital. Many developing countries are currently seeking to foster a studies to examine developing country mutual fund sectors. The domestic mutual fund sector. This is because mutual funds objective of this report is to aid policy makers by laying out salient offer individual investors a diversified spread of professionally features of mutual fund sector growth in developing countries managed risk, thus mobilizing capital out of bank deposits and into and identifying some of the key impediments that typically stunt money and capital markets, where they finance governments and their growth so that these can be minimized or avoided. The study corporates and contribute to long-term economic development. explores the nature of mutual fund sectors in different developing Institutional investors and corporates may also invest in mutual countries, with specific focus on Brazil, Kenya, Morocco, Peru, and funds; typically this is because the mutual fund offers a specific Turkey,2 and presents, through illustrative examples, key lessons advantage to these organizations, such as lower cost or greater tax for policy makers that can be derived from these country cases.3 efficiency or greater flexibility than making direct investments on their own behalf. Definition In emerging markets, mutual funds are growing as economies A mutual fund is a form of collective investment scheme4 or develop, savings increase, and capital markets expand. In 2013 investment fund. A fund is a pool of savings collected from Investment Company Institute (ICI) data covering 46 countries multiple investors who buy units representing equal proportionate and territories indicated 14 middle-income countries with mutual rights over the income or capital gains generated by the fund. fund sectors in the global database.1 Policy makers in developing The resulting pool of money, or the fund’s capital, is collectively countries that wish to encourage capital mobilization through managed by a professional management company, in line with the mutual funds need to understand the key factors in their success. investment objective outlined in the fund’s prospectus. As a result of this professional management, the pool of capital earns income This study provides policy makers in developing countries with from (1) dividends received on the shares the fund has bought, (2) an overview of the diversity of factors that drive or impede the interest on bonds or deposits the fund holds, and/or (3) from rental development of the sector. The mutual fund sectors of different on real estate the fund owns. When shares, bonds, or real estate countries are not easy to compare. In each country they are an are sold by the fund at a profit (or a loss), the fund makes capital outcome of different combinations of different factors, such as gains (or losses). The fund may distribute income or capital gains to legal histories, cultural preferences, pension systems, and fiscal holders; alternatively these may be reinvested in the fund, in which treatment. In addition, statistical analyses may categorize mutual case, the investor “realizes” the income or gains when they sell the funds differently. Few reports so far have drawn on cross-country units they own. Chapter 1: Overview of Mutual Fund Sector Characteristics in Select Developing Countries | 5 More specifically, a mutual fund is a form of collective investment mutual funds only if they meet a diversity of ownership test, which scheme (CIS) that is closely regulated because it is legally eligible aims to prevent individuals or corporates from misusing funds’ tax to gather savings from the public and is required in turn to privileges to avoid or evade tax. In other countries a fund can be invest those savings predominantly in a diversified portfolio of created to be sold exclusively to a single institutional client under transferable/tradable securities.5 The term “mutual fund”6 used the same legislative and regulatory requirements as funds that in this report relies on the term typically used in Canada and the are offered to the public. This is the case in Brazil,15 where Article United States to refer to regulated and publicly offered collective 71 of Instrução 409 permits a fund to be created exclusively for a investment schemes. Usually structured as open-ended funds (see single client; and in Morocco, where a relatively large proportion of box 1.1), these funds meet regulatory requirements for unrestricted funds are set up as investment structures dedicated to a limited offer to the general public and are obliged to buy back shares number of investors (such as an insurance company, a public or units from their holders at request on a regular basis at the pension management institution, a government fund, or a private current value of those shares or units. These funds may take any foundation).16 These funds provide the convenience of having a of typically three legal structures: contractual, corporate, or trust portfolio managed within a well-structured and supervised legal (this is discussed more in chapter 2) and in some countries may be framework while providing the level of customization required by required to have diversified ownership. the investor, notably in terms of asset allocation, investment style, and risk profile. Permitting funds with a single investor can be a Although mutual funds meet requirements for funds offered to the way to kick-start mutual fund development before retail demand public, they may also be attractive to institutional investors. In for such vehicles develops. some countries mutual fund assets under management may derive more from institutional investors than from individual members of This study focuses primarily on domestic mutual funds, that is, the public. This is most likely to arise where such funds are a tax- mutual funds that are legally domiciled in the host country in efficient and cost-effective way of holding a portfolio of assets and which they are primarily sold.17 The study builds on the five country where they are permitted to meet the needs of a single investor. In case studies alluded to above as well as a global survey conducted by many countries funds can be licensed and taxed as publicly offered the International Organization of Securities Commissions (IOSCO) Box 1.1: History of Investment Funds7 History of Investment Funds The earliest investment fund was a closed-ended fund formed in the Netherlands in 1774. In 1868, such a fund was formed in Britain and in 1893 in the United States. The first open-ended mutual fund, which could continuously create and cancel units and thus vary its capital, was the Massachusetts Investment Trust created in the United States in 1924.8 The first British fund’s objective remains true for that of a modern investment fund, specifically “to provide the investor of moderate means the same advantage as the large capitalist in diminishing risk by spreading investment.”9 Following the Wall Street crash of 1929, legal and regulatory frameworks specific to mutual funds started to be introduced, for example, the U.S. Investment Company Act of 1940 and the U.K. Prevention of Fraud (Investments) Act of 1939.10 Open-Ended Mutual Fund Mutual funds are typically open-ended funds, that is, funds that are obliged to buy back their shares or units from holders on a regular (usually read as “daily”) basis. These funds can issue and redeem shares or units, allowing investors to invest in or divest from the fund. The fund assets are valued at their market price (mark-to-market) on a daily basis, hence allowing the daily calculation of net asset value of each share or unit in the fund that is the basis of the price at which investors buy or sell shares or units. This means that investors do not have to search for a seller of a share/unit in a mutual fund in the market. Instead the investors can purchase the share/ unit directly from the fund, usually through the fund management company. Conversely, the holder of a share in a mutual fund does not have to look for a buyer but can sell it directly to the mutual fund. Open-ended funds are managed either passively—that is, tracked to an index—or actively—whereby the fund management company employs a specific strategy to invest assets. To ensure they can meet the potential liquidity demands on the fund, these funds are required to invest predominantly in liquid securities such as high-quality bonds, equities, and commercial paper or short-term deposits.11 Volatile, illiquid, or shallow capital markets are thus not suitable to such funds because they cannot easily buy or sell assets to meet demand for sale or redemption. Another distinctive feature of open-ended funds is their pure equity capital structure: that is, they may raise money only by sale of shares or units and are not permitted to issue debt securities.12 Generally open-ended funds may only borrow up to 10 percent of their value, but only for the short term, and not to leverage returns.13 Together, these features assure an investor into a publicly offered open-ended mutual fund that they are undertaking an unleveraged, diversified, and highly liquid investment. This “open” and see-through structure means that when an investor purchases mutual fund shares, the capital of the fund increases, and when an investor redeems shares, the capital of the fund decreases: hence the term “variable capital” also applied to these funds.14 6 | MUTUAL FUNDS in developing markets: addressing challenges to growth on mutual fund markets in developing countries. Throughout the instance, in 2013, 81 percent of mutual fund–owning households report these case studies are referred to, to depict the heterogeneity owned shares or units in these funds through employer-sponsored as well as similarities in trends of mutual fund sectors globally. The defined contribution retirement plans.22 Mutual funds are also reader must note that these examples are not meant to reflect best underlying investments for other defined contribution pension or worst practice, but rather are used for illustrative purposes. schemes, such as the 401(k).23 As a key investment product in many retirement plans, American mutual funds play a critical role in the financial security of millions of individuals as they prepare Role of Mutual Funds them for retirement. A key reason for encouraging the development of mutual funds is that they mobilize the savings of small investors, which might Money market funds—mutual funds that invest predominantly otherwise remain in bank deposits, into capital markets. These in short-term debt instruments issued by governments, mobilized savings provide a source of longer-term financing for companies, and financial institutions such as banks—also serve companies and governments issuing bonds and for companies an important intermediary role by responding to the short-term issuing equities, thus supporting economic growth. Money market liquidity needs of these issuers. These funds play an important funds (MMFs), while typically investing only in instruments with cash management function in some countries because they are a duration of under one year, can also provide finance by buying used by many corporates for treasury management. They may short-term instruments such as Treasury bills (T-bills) and also assist in financing banks by investing in certificates of deposit corporate paper. Further, the returns earned by fund investors and as counterparts to sale and repurchase transactions that should over time reduce the potential for dependence upon the provide liquidity to banks.24 For retail, corporate, and institutional state in retirement and make household finances more resilient. In investors, MMFs represent a strong alternative to term deposits the United States, the biggest mutual fund market in the world, in the banking system if, for instance, these funds pay a higher mutual funds held almost 25 percent of all U.S. stock at the end interest rate than that available on a deposit,25 or if they are not of 2012, making them one of the largest investors in U.S. financial subject to withholding taxes payable on interest from deposits. markets. MMFs managed globally $4.76 trillion as of end 2013 (nearly 16 percent of total assets under management in mutual funds)26 and Mutual funds also have economic benefits for their investors: are one of the pillars of the shadow banking system. The downside They provide cost-efficient spread of risk for retail investors, to this is that if MMFs are major providers of short-term finance to institutional investors, and corporates. Generally most individual corporates or banks (as in the United States), and there is a run on investors do not have large sums of money to invest, and creating a one or more of such funds, this could disrupt the flow of short-term diversified portfolio of shares or bonds would require tens or hundreds funds to corporations, financial institutions, and governments, thus of thousands of U.S. dollars. Further, the cost of acquiring such a potentially presenting systemic risk. portfolio would be high relative to the amount these investors have available to invest, and the selection of the portfolio would require expertise that they may not have. Mutual funds, which typically Asset Accumulation accept subscriptions of $500 or $1,000, provide this diversification An estimated 76,200 mutual funds worldwide currently control for them. By investing through a mutual fund, retail investors are about $30 trillion27 in assets under management, representing assured that their savings are managed by investment professionals just over 20 percent of total global assets under management who diversify risk at relatively low transaction costs because they on behalf of investors worldwide (see figure 1.1).28 The mutual fund buy and sell assets in greater bulk than an individual investing small industry has been characterized as “one of the most successful amounts could achieve.18 Since mutual funds are generally invested financial innovations.”29 Various reasons have contributed to the in very liquid financial instruments, mutual fund shares or units are strong growth of the mutual fund industry globally. Fernando usually redeemable on a daily basis, and investors can redeem their et al. refer to the global development of capital markets, which shares at will.19 Institutional investors often invest in mutual funds has contributed to investor confidence in the integrity, liquidity, to also gain exposure to a particular asset class or geographical and efficiency of financial markets, and market-based financial region where the cost of investing via a mutual funds is lower than the cost of hiring experts to manage the desired portfolio.20 Studies Figure 1.1: Global Mutual Fund Assets under Management show that mutual funds have become “the primary financial wealth (in $ trillions) accumulation vehicle in American society, especially for middle- market consumers and the “emerging affluent.”21 30 31 26 27 25 24 Mutual funds can play a significant role in investing for 22 23 19 retirement. Both defined benefit and defined contribution pension 16 18 schemes may be investors in mutual funds. In the case of defined 12 12 14 11 benefit schemes, this is likely to be for the reasons given above. In the case of defined contribution schemes, individual scheme members may choose to hold shares or units in mutual funds in 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 their defined contribution accounts. In the United States, for Source: ICI 2014. Chapter 1: Overview of Mutual Fund Sector Characteristics in Select Developing Countries | 7 systems as being factors that led to this growth.30 At the level of Ninety percent of global mutual fund assets33 under management the individual investor, with globalization has also come increasing derive from developed markets. The United States has by far the awareness of investment products, rising personal incomes, largest mutual fund market worldwide with more than 50 percent and a stronger appetite for risk—all of which contribute to the of global mutual fund assets under management.34 European funds, attractiveness of investment products such as mutual funds. propelled by a cross-border regional market,35 collectively manage Following the 2007–2008 Global Financial Crisis, net sales were just over 30 percent of global mutual fund assets.36 Some European generally positive but somewhat volatile, and total global mutual markets have a high proportion of mutual fund assets expressed as fund assets under management took until 2012 to pass the a percentage of gross domestic product (GDP); for example, France’s previous peak of $26.2 trillion achieved in 2007.31 Mutual funds mutual fund sector has assets valued at almost 57 percent of GDP. sales worldwide have benefited from the opportunities presented by Figure 1.2 and box 1.2 show the other key worldwide markets for the growth of retirement assets, particularly defined contribution mutual funds. pension plans.32 Figure 1.2: 2013 Largest Mutual Fund Assets under Management by Country/Region 2% China 3% Other 3% Japan 3% Canada 3% Brazil 4% United Kingdom 5% France 50% United States 5% Australia 22% Other Europe Source: ICI 2014. Box 1.2: Key Mutual Fund Markets Worldwide United States With net assets of more than $15 trillion at year end 2013, or almost half of total global mutual fund assets under management, the world’s largest mutual funds industry is located in the United States. Just over 46 percent of all U.S. households owned mutual funds at that date, many of them through retirement plans.37 Europe Collectively European funds constituted just under a third of global mutual fund assets ($9.4 trillion) at year end 2013. Two international financial centers for funds sold across borders, Ireland and Luxembourg, respectively accounted for $1.4 trillion and $3 trillion of these assets.38 At year end 2013, France ($1.5 trillion) and the United Kingdom ($1.2 trillion) were the largest domestic mutual fund markets in Europe. Financial integration in Europe has also catalyzed the development of a single market for mutual funds. Under the Undertakings for Collective Investment in Transferable Securities (UCITS) directive, mutual funds can be marketed across borders; that is, a fund that is formed and approved in one European Economic Area (EEA)39 country under the directive can be marketed in another EEA member country, without additional approval. At the end of December 2013, the total value of European mutual funds was $9.3 trillion deriving from 34,743 funds, compared with $15 trillion invested in 7,582 U.S. mutual funds at the same date.40 Asia-Pacific At year end 2013, the Asia-Pacific region controlled $3.4 trillion in mutual fund assets, with approximately half the assets held by mutual funds in Australia ($1.6 trillion and 1,415 funds). China ($479 billion and 699 funds) and Japan ($774 billion and 4,922 funds) also have sizeable mutual fund sectors.41 8 | MUTUAL FUNDS in developing markets: addressing challenges to growth Mutual fund sectors are becoming increasingly common in fund sectors are much smaller in comparison to Brazil in terms of developing countries, despite still being quite small. According size. China ($479 billion) and Korea ($285 billion) are the largest to data collected by ICI, mutual fund assets under management mutual fund industries after Japan in Asia. In Africa, the largest in middle-income countries have grown from 2.3 percent of global market is South Africa, with $143 billion at year end 2013. Nigeria mutual fund assets in 2001 to 6.3 percent in 2012,42 although high- has the second largest market in Sub-Saharan Africa, with $953 income countries held over 93 percent of assets under management million in AUM at year end 2013,44 and Kenya, with approximately (see figure 1.3). But emerging markets, with the notable exception $270 million in AUM in mid-2012, is the smallest mutual fund sector of Brazil, often have relatively small mutual fund sectors. At year included in this analysis. In Europe, the smallest mutual fund sector end 2013, Brazil had the fifth largest domestic fund market globally among developing countries was Bulgaria with $504 million at and the largest mutual fund industry in the developing world, with year end 2013; Turkey, a case study country, with $14 billion under more than $1 trillion of assets under management and an unusually management, is the tenth smallest market in Europe.45 large number of funds, totaling just over 8,000.43 The next largest market in Latin America was Mexico, with roughly a tenth of Brazil’s Mutual fund sectors across developing countries have mutual fund assets (or $120 billion in assets under management experienced variable growth. As figure 1.4 shows, mutual fund [AUM]) at the end of 2013. Most other emerging market mutual sectors in several emerging markets have recorded double-digit Figure 1.3: Total Mutual Fund Assets under Management: High-Income MF sectors versus Middle-Income MF Sectors $, Billions Percentage of Total Global AUM $, Billions 35 30 30 6.5% 26 27 25 5.6% 25 7.5% 23 24 22 7.4% 7.5% 3.3% 7.0% 20 19 18 5.5% 16 3.1% 14 2.8% 15 12 2.7% 93.5% 11 94.4% 92.5% 2.3% 2.2% 92.6% 92.5% 10 96.7% 93.0% 96.9% 94.5% 97.2% 97.3% 5 97.7% 97.8% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 High Income Middle Income Total Net Assets Source: ICI data using World Bank group country classifications as of 2013. Note: This information is derived from the ICI Global Mutual Fund Sector database, which did not include any low-income countries. High-income countries are both OECD and non-OECD.46 Figure 1.4: 2012 Mutual Fund Assets and Compound Annual Growth Rate, 2002–2012 $, Millions Percent Growth 1,200,000 40 China 38% 35 1,000,000 30 Russia Slovenia Brazil 26% 26% 800,000 27% 25 Malaysia Nigeria South Africa 21% Pakistan 24% Morocco 22% 20 18% India 19% 600,000 15% Turkey Peru 15 Mexico Indonesia 12% 16% 14% 14% 400,000 10 Korea Hungary 6% 8% 5 200,000 0 Costa Rica 3% - -5 il a ea a a co a co a a ey ry ru n a ia a ria a az in ric di si bi si si ic y a en ga Pe or rk i oc en st e ay ne us R ex ra Ch In Br Af ig ov K un Tu ki or K a iA R M al do N st Pa Sl h M M H ud In ut Co So Sa AUM 2012 ($, Millions) CAGR AUM Growth 2002–2012 Sources: IOSCO Survey, ICI, trade associations, World Bank case studies, regulator websites and data. Source of 2002 data for developed countries is Investment Company Institute Fact Book 2005, table 44, http://www.ici.org/pdf/2005_factbook.pdf Note: For Morocco and Russia, 2011 numbers have been used, because data for 2012 were unavailable. Chapter 1: Overview of Mutual Fund Sector Characteristics in Select Developing Countries | 9 growth rates in the last 10 years, versus developed markets such Enabling a variety of fund structures allows greater flexibility in as France (6 percent), Japan (9 percent), the United Kingdom (13 marketing to investors and can help accumulate assets in both percent), and the United States (7 percent).47 For instance, figure developed countries and emerging markets. The master-feeder 1.4 shows that Brazil (27 percent) and China (38 percent) have structure, for instance, is a relatively rare structure globally that experienced considerable annual growth between 2002 and 2012 is widely used in Brazil and accounts partly for the proliferation in their mutual fund sectors. China’s growth has been particularly of funds in this market; it is used to enable investment in foreign striking, from $17 billion in 2002 to almost $440 billion in 2012, funds, which otherwise is not permitted in Brazil. The master- aided by strong sales in the mutual fund sector as shown in figure feeder structure allows one fund—the feeder, based in country 1.5. Although Nigeria, Pakistan, Russia, and Slovenia still had A—to have essentially only one investment—shares or units in relatively small mutual fund markets of around $700 million to $3 a “master” fund, based in country or territory B. Any number of billion in AUM at the end of 2012, these industries have experienced feeder funds can invest in a master fund. Thus, for example, within considerable growth over the last 10 years, as displayed in figure the EU, feeder UCITS created and based in France, Germany, Italy, 1.5. Nigeria’s mutual fund sector grew from $77 million in 2002 to Spain, and the United Kingdom could buy units in a master UCITS, over $600 million in 2012; Pakistan’s mutual fund sector grew from based in Luxembourg, which in turn invests in European equities. $425 million in 2002 to over $3 billion in 2012; Russia’s mutual fund This structure and other structural variants are discussed in more sector grew from $372 million in 2002 to more than $3 billion in detail in chapter 2. 2011,48 and Slovenia’s mutual fund sector experienced pronounced growth from $244 million in 2002 to over $2 billion in 2012. On the other hand, Korea’s mutual fund sector has experienced 6 percent Financial Intermediation and Mutual Fund growth, in line with developed nations, whereas Costa Rica’s Investments mutual fund sector shrank (−3 percent) over the last 10 years. The Mutual funds invest in tradable securities that are grouped by asset reasons for such growth vary from country to country and are class. Mutual funds typically consist of four main types of funds, due to complex interactions between a range of factors, such as which are defined by the regulator or trade association: (1) funds mutual funds’ relative tax efficiency, the availability of investments, that invest predominantly in equity securities, financing companies; whether pension funds and insurance companies have developed (2) funds that invest predominantly in debt securities, financing and if so whether they are able to invest in mutual funds, and the governments or companies; (3) funds that invest in a hybrid of both rates of return mutual funds can achieve relative to those available equity and debt securities; and (4) funds that invest in short-term debt on bank deposits and other competing investments. As an example, instruments (MMFs), financing governments and companies. Funds a key driver of sales of bond and equity funds in developed markets can be further subdivided by investment objective (income, growth, in recent years has been the very low levels of interest available on capital preservation, or a mixture of these) or by geographic focus (e.g., bank deposits, which has caused savers to seek out investments global equity) or sector focus (e.g., technology stocks). with higher yields. Figure 1.5: Annual Net Sales, 2001–2012 $, Millions 600,000 500,000 400,000 300,000 200,000 100,000 $, Millions 0 -100,000 y n ica ru a a ca ey a a o il ia o ia ia az ar di ni in re cc ic ta ys ss ab Pe ri rk aR ex In e Ch Ko ng Br kis o Af Ru ala ov Ar Tu or M Hu st Pa Sl h M M i ud ut Co So Sa 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sources: IOSCO survey, ICI, trade associations, World Bank case studies, regulator. Note: Indonesia, Kenya, and Nigeria are not included because net sales data are unavailable 10 | MUTUAL FUNDS in developing markets: addressing challenges to growth Mutual fund sectors in developed and developing markets U.S. mutual fund assets.49 Although the data for middle-income have varying asset class exposures. Figure 1.6 shows ICI data countries are limited to 14 countries in this database, it shows for mutual fund sectors in high-income versus middle-income that in these countries, assets invested in equity funds have been countries, broken down by asset class exposure. These data show limited to an average of approximately 20 percent over the last that over the last eight years high-income country mutual fund eight years, but assets invested in bond funds are almost double sectors have had on average over 40 percent of assets invested this at about 40 percent. Assets invested in MMFs were about 15 in to equity funds and roughly 20 percent or less invested in bond percent, whereas those invested in balanced funds were about 20 funds. MMFs ranged from 16 percent to 31 percent of assets, but percent. In emerging markets, mutual funds generally have higher only about 10 percent of assets was invested in hybrid funds. For exposures to fixed-income and money markets (short-term debt example, in the United States, equity funds constituted over 50 instruments) and less exposure to equities. Figure 1.7 shows the percent of U.S. mutual fund assets at year end 2013, and funds value of assets invested in the different categories of mutual fund that invested primarily in U.S. domestic equity held 38 percent of at year end 2012 for various economies. Exposure to equities is total mutual fund assets. Bond funds constituted 22 percent of often low in emerging markets, with among the lowest worldwide Figure 1.6: ICI Data for Mutual Fund Sector Asset Exposure: High-Income versus Middle-Income Countries Percent 100 90 80 70 60 50 40 30 20 10 0 High Income Middle Income High Income Middle Income High Income Middle Income High Income Middle Income High Income Middle Income High Income Middle Income High Income Middle Income High Income Middle Income High Income Middle Income 2005 2006 2007 2008 2009 2010 2011 2012 2013 Equity Bond Money Market Balanced/Mixed Other Source: ICI 2014. Figure 1.7: 2012 Mutual Fund Asset Exposure Broken Down by Asset Class Percent 100 90 80 70 60 50 40 30 20 10 0 il a ica ry a sia a ea ia ico co ria an u ia ia ia ca ey az in di ny r ys ss b en a Pe fri r oc rk ist ge e aR ex ra Ch In Ko ng Br Ke Ru on ala ov Tu hA or Ni k iA M Hu st Pa d Sl M M ud In ut Co So Sa Debt Funds Equity Funds Hybrid Funds Money Market Funds Other Funds Sources: IOSCO survey, ICI, trade associations, World Bank case studies, regulator. Note: For Malaysia, Morocco, Peru, and Russia, 2011 numbers were used because 2012 numbers were unavailable. For Kenya, June 2012 numbers from a World Bank case study were used. Chapter 1: Overview of Mutual Fund Sector Characteristics in Select Developing Countries | 11 being Costa Rica (1 percent), Mexico (7 percent), Peru (3 percent), whether, and to what extent, their legal and regulatory framework and Turkey (3 percent). In countries such as Brazil and Peru, mutual allows such investors to invest in mutual funds.52 Institutional funds have significant exposure to bonds. In Peru, for instance, 96 investors may be a significant force in mutual fund markets. The percent of assets under management in mutual funds are invested Moroccan mutual fund industry has achieved remarkable growth— in fixed-income or MMFs.50 Similarly, in Morocco 85 percent of the approximately 20 percent per annum over the last decade—largely total value of mutual funds is invested in fixed-income and MMFs. In because of institutional investors53 that own more than 90 percent fact, Moroccan mutual funds were heavily invested in government of total assets under management. In Brazil, only 18 percent of securities in the early 2000s and started to diversify only in the assets under management was held by retail investors; the rest middle of the last decade. However, since 2002, corporate securities was owned by pension funds, corporates, public institutions, have been growing steadily, and corporate bonds represent 13 foreign investors, and others.54 However, institutional investment is percent of total assets under management in Morocco.51 Chapter 3 not always dominant in mutual fund sectors. In 2012, institutional discusses some of the reasons for such trends. investment in mutual funds in Turkey was only 1 percent, which is probably partly because both pension schemes and life insurance High MMF exposures in many emerging markets imply that were at the early stages of development.55 This is very low when these sectors are as yet failing to mobilize savings into compared to France (69 percent) or Germany (54 percent) where longer-term instruments. Figure 1.7 shows this to be the case workplace pensions and special investment funds for institutional in countries such as Costa Rica (87 percent MMFs), Hungary (71 investors, respectively, are significant owners of mutual funds. It percent), Mexico (50 percent), Pakistan (72 percent), Turkey (58 is low even in comparison with Hungary (6 percent) and Romania percent), and Saudi Arabia (61 percent). In Turkey, the mutual (4 percent).56 Peruvian pension funds, on the other hand, typically fund sector has been dominated by MMFs—almost 60 percent of do not own domestic mutual funds, but instead channel their AUM at end 2012. In Morocco, MMFs represented more than 25 capital to foreign mutual funds such as UCITS based in Dublin or percent of total AUM at the end of 2011 and have been growing Luxemburg. Chapter 3 discusses some of the reasons for variance at an average annual rate of 23 percent since 2005. Chapter 3 in institutional demand. provides some reasons why MMFs tend to be successful in many emerging markets. Distribution of Mutual Funds Distribution of mutual funds primarily refers to how mutual Ownership of Mutual Funds: Institutional and Retail Investors funds are sold to the public, which may be through affiliated or unaffiliated entities (see box 1.3). Mutual funds may also be sold When analyzing mutual fund ownership, what is categorized “direct” through direct mail, advertising, or their website without the as an institutional or a retail investor may vary from country intervention of a distributor. to country. “Retail” investors are individuals that make their own decisions (whether with or without advice) to buy and sell mutual In many countries, individuals may choose mutual funds as fund shares or units. An institutional investor is an investment underlying assets of their pension plan. Employer-sponsored vehicle that gathers money from a number of persons (legal or defined contribution plans typically deduct savings from employee physical), and whose manager takes the investment decisions as paychecks to allocate toward retirement (the employer may also to what to buy and sell for the fund’s portfolio in alignment with contribute). The employee can then choose to invest these savings its objectives but without reference to members of the scheme. in a menu of funds. Similarly, individuals using a personal pension However, the distinction made between what is categorized as a plan can choose to use mutual funds as their underlying investment retail and institutional investment in a mutual fund can vary, so that (e.g., U.S. IRAs). This form of defined contribution scheme is in it is difficult to make definitive comparisons. In some cases, there effect a personal account that is a tax-efficient “wrapper.” The may, of course, simply be no data, if countries do not differentiate wrapper holds retirement savings that are chosen by the individual between retail and institutional sales in their statistics; this is concerned (with or without advice). This type of defined contribution the case, for instance, in Kenya. In some countries sales may be scheme is less common in developing markets, where the well- classified as retail, which in other countries may be classified as known Chilean model can be seen instead. For instance, in Peru and institutional. This is a particular problem for sales that are made in Turkey, individuals select the pension scheme that they wish to through defined contribution pension schemes, which, for example, invest in, and the manager invests their savings according to stated in the United States are categorized as retail (since the mutual objectives. fund investments held by the scheme are chosen by the individual), whereas in France these “workplace pensions” are categorized as Distribution channels are usually more diversified in developed institutional. Of course, at the end of the day, all demand derives countries with larger and more affluent populations and from individuals because it is their money that contributes to individuals can choose a pension plan. Although banks often pension schemes and pays for insurance policies. dominate retail distribution of funds in developed countries, this varies from country to country and over time. In continental Europe Institutional investors are often active and substantial owners when the first UCITS directive was passed in 1985, banks were the of mutual funds in both developed and developing countries, but predominant distributors of mutual funds. However, over time as in some emerging markets, retail investors are more dominant. investor affluence and knowledge have grown, more providers of Often a key driver of institutional investment into mutual funds is financial advice have developed and more investors have started to 12 | MUTUAL FUNDS in developing markets: addressing challenges to growth Box 1.3: Captive and Third-Party Distribution Channels A “captive” distribution channel is usually part of the same corporate group as the entity that operates the fund and typically will only sell the funds of the in-house fund operator. The most typical example of this is a bank that owns a fund management company and sells its mutual funds through bank branches. Another example would be an insurance company that owns a fund management company and uses its insurance direct sales force/agents to sell its funds. In contrast, a “third-party” distribution channel is independent of the operator of the fund and its affiliates. Third-party distribution channels include sales through independent financial advisors,57 private banks,58 wealth management firms, and securities brokers. In turn, these advisers may receive fees and commissions from the fund’s operator (or more rarely the fund) for successful sales59 or be remunerated by way of fees payable by the client. In many countries “fund supermarkets” provide third-party (usually online) platforms that house information on funds and allow different investment managers or fund families to sell their funds to individuals who use that platform. Such platforms may be owned by unaffiliated third parties, but they may also be owned by fund management companies; increasingly they provide services in more than one country in a region. seek out funds other than those offered and managed by affiliates funds that performed badly, clients might exit the bank relationship of the banks they use. The growth of distribution through private altogether. As figure 1.8 shows, the majority of retail distribution in banks, financial advisers, and fund supermarkets in recent decades the United Kingdom take place via independent financial advisers. is associated with these trends. Figure 1.8 shows that retail banks still dominate distribution in Germany, Italy, and Spain, but In emerging markets, the range of retail distribution channels tends distribution channels in France are more diverse. Bank sales of to be narrower, and banks tend to be dominant (see table 1.1). Less funds of funds (funds that invest in other funds that may or may developed emerging markets do not typically feature independent not be managed by nonaffiliated entities) and “open architecture” financial advisers or fund supermarkets, because these businesses sales by banks of nonbank managed funds may have assisted in would not be financially viable in a nascent financial market: There maintaining bank dominance. However, they have also enabled will simply not be enough demand for their services.60 In Uganda, for nonbank-managed funds to access bank distribution in recent example, the only major financial adviser is foreign owned and primarily years. In the United Kingdom, on the other hand, banks historically services those who invest offshore. Given that banks typically have a have not been major distributors of funds. This may partly have large and established client base and nationwide branch networks, been because U.K. banks preferred to retain deposits and maintain they are clearly well placed to sell financial products, such as mutual lending capacity, and partly because of concerns that if they sold funds, to their clients and indeed can add another revenue stream Figure 1.8: Distribution Channels for Mutual Funds in Selected European Countries, 2011 Percent 100 6 8 10 14 18 90 9 10 8 80 38 8 9 4 6 5 70 5 6 18 14 8 60 13 15 50 25 17 56 40 51 6 30 10 55 48 20 42 9 12 10 11 10 9 0 2 France Germany Italy Spain Switzerland United Kingdom Retail Bank Private Bank Insurance Wrapper IFC-advised Supermarket Direct Funds of Funds Institution/Corporation Source: MackayWilliams LLP. Chapter 1: Overview of Mutual Fund Sector Characteristics in Select Developing Countries | 13 Table 1.1: Main Distribution Channels for Mutual Funds by Country, Year End 2012 Insurance Securities Financial Fund Country Banks Sales Agents Companies Brokers Advisers Supermarket Brazil  China     Costa Rica    Hungary   India    Indonesia   Kenya    Korea     Malaysia    Morocco   Pakistan     Peru   Saudi Arabia   South Africa    Turkey   Source: IOSCO survey. by doing so.61 In Turkey until 2012 mutual funds were predominantly Institutional sales, such as to insurance companies or pension both founded by, and distributed by, banks; indeed only financial schemes or corporations and funds of funds, are usually also intermediary institutions such as banks and brokerage firms were made directly between the fund management company and the allowed to distribute funds. Similarly, in Brazil banks not only dominate potential client. For instance, Brazil’s “exclusive funds” discussed distribution of mutual funds to retail investors; they also administer above are sold directly to clients and not through third-party these funds. In Peru, mutual funds are sold almost exclusively to the distributors. Similarly, in Morocco, because institutional investors customers of the banks that own the fund management companies dominate, mutual funds are generally distributed directly by fund who control 96 percent of assets under management. Sales of mutual management companies to large investors such as insurance funds (and many other financial products) in nascent markets will companies, pension funds, and commercial companies. tend to be driven by commissions to distributors rather than suitable advice to potential investors. Chapter 3 discusses some of the ensuing consequences of this domination by banks, such as the rise of barriers Mutual Fund Charges to entry for new players and switching costs for clients. Operators of mutual funds typically receive two types of remuneration: (1) charges levied on investors as they buy fund Direct sales by fund management companies to retail investors shares or units, or sell fund shares or units and (2) annual usually represent a lower proportion of fund sales. Typically management charges. The entry charge levied on an investor “direct” sales are conducted through mail, e-mail, advertisements in when they buy shares or units in a fund is essentially designed print media, or the website of the promoter, but in recent years this to remunerate the fund management company for the cost of has not been a major distribution channel, as is indicated in figure attracting that investor to the fund. An exit charge, if payable, is 1.8 on European fund distribution. In Kenya, for instance, “direct” typically levied only on an investor who is redeeming a fund share sale of unit trusts is understood to be minimal. In Morocco, only or unit that was not subject to an entry charge.63 Such a charge one of the 16 asset management companies actually distributed is designed to disincentivize redemption in the short term. An its mutual funds through the Internet.62 “Pure” online sales of annual management charge is levied on the fund to compensate funds are usually not possible unless electronic signatures are the operating entity for the cost of managing the fund. From an legally enabled in the country concerned. In many (developed and investor’s point of view, the performance of the fund equals the developing) countries an investor can open an account to purchase returns on the fund, minus its charges and any other expenses. and redeem units only by providing a physical document with “wet Therefore the higher the costs related to entering or leaving a fund, ink” signature, although they can trade online using security codes or being an investor in a fund, the lower the return to the investor. thereafter. This highlights a fundamental conflict of interest between the fund management company and the investor: The fund management 14 | MUTUAL FUNDS in developing markets: addressing challenges to growth company is motivated to maximize potential profitability by funds of funds. When funds are small (e.g., $10 million or less) most levying as high a charge as is feasible whereas the investor wishes service providers will not earn enough from a percentage-based fee to pay the lowest charges possible to maximize returns. Funds may to cover their costs, so they will tend to charge a stated flat fee be able to issue different classes of units or shares, each of which for their services, which can lead to high annual costs for funds. A may have a different charging structure related to the way those study of European equity funds sold across borders showed that shares or units are distributed and the associated cost of this type funds with €10 million or less under management had additional of distribution. (See box 1.4 for details; table 1.2 shows typical fees annual operating costs (excluding the cost of buying and selling for different types of funds.) fund assets) of around 2 percent on top of annual management charges of around 1.4 percent, totaling 3.4 percent, whereas funds Annual management charges vary according to the class of with €500 million or more under management had additional costs assets in which the fund invests, and in most countries this of around 0.2 percent on top of annual management charges of charge is expressed as a stated percentage of assets under around 1.4 percent, totaling 1.6 percent.66 The U.S. mutual fund management, regardless of the size of the fund. In both emerging market is an exception, where a fund may report, for example, a markets and developed markets, charges are typically lower for management fee of 0.40 percent on the first $500 million in assets, MMFs, higher for bond funds, and highest for equity funds and for 0.35 percent on all assets between $500 million and $1 billion, and Box 1.4: Fund Charges and Share Classes Annual Management Charge The annual management charge, usually defined as a percentage of the value of fund assets, is paid by the fund to the fund management company or founder. This charge is primarily for selecting and managing the portfolio of the fund. Other Annual Costs Paid by Funds Although the cost of servicing investors in the fund is sometimes covered by the annual management charge, typically a separate administration or registration charge is made to the fund to covers such costs. The fund may also pay other charges separately for board remuneration and costs, fund administration, safe keeping of assets (custody), and supervision by a trustee or depositary (these may be a stated amount or a percentage of value or a mixture of these). One-off costs such as audit and legal fees are also typically paid by the fund. The investment research firm Morningstar finds that annual expenses are the most reliable predictor to a fund’s performance; thus investors are best off with funds that have low annual expenses.64 Entry Charge Fund management companies have historically paid sales commissions to those who sell funds on their behalf (distribution channels), although this trend is changing in some developed and developing markets. Typically the fund management company pays the distributor an introductory commission from the entry charge it receives from investors subscribing to the fund and/or a “trail” commission (a percentage of the annual management fee that is paid annually for as long as the investor remains in the fund). Usually the fund management company negotiates the level of commission payable with the distributor concerned. However, increasingly in developed markets regulation requires investors, rather than the fund management company, to agree to any fee or commission payable with the distributor.65 Exit Charges Exit and redemption charges are paid by the investor when they leave the fund. These charges help the fund management company manage the daily flows out of the fund. Share Classes and Charging Structures A fund can issue different classes of units or shares, each of which may have a different charging structure. As a general rule, the higher the charges of a fund, the more likely higher commissions are being paid to a distributor. For instance: •• Institutional investors: Funds can issue a class of shares to institutional investors with no entry and no exit charge and a lower annual management charge (since in this case distributors are not being paid commissions). •• Retail investors reached through a distributor: Funds can issue a class of shares to retail investors through a distributor, with higher entry charge and higher annual charge (used to pay commission to that distributor) but no exit charge. •• Retail investors reached directly: Funds can issue a class of shares sold directly to the retail investor by the fund management company that may have no entry charge, a fairly high annual charge, and an exit charge. Chapter 1: Overview of Mutual Fund Sector Characteristics in Select Developing Countries | 15 Table 1.2: Typical Fund Charge Rates Entry Charge Annual Management Charge Redemption Charge Fund Type Developed Emerging Developed Emerging Developed Emerging Money market funds 0–1% 0–5% 0.1–0.5% 0.25–2.68% 0% 0–3.6% Equity funds 0–6 0–6.5 0.1a–2 0.75–7.25 0–5 1–10 Bond funds 0–5 0–5 0.5–1.5 0.2–3.15 0–5 0–3.6 Mixed funds 0–6 0–5 0.5–2 0.39–7.15 0–5 0–4.2 Sources: World Bank–IOSCO survey and World Bank estimates. a. The lowest charges are typically associated with exchange traded funds or indexed (passively managed) funds. 0.30 percent on assets in excess of $1 billion. Thus, if the fund not offer sales commission to an advisor (e.g., direct sales), nor were contains $1.5 billion in total net assets, the management charge the investors charged for exiting the fund.70 is scaled back accordingly.67 This sliding scale is not, however, a common practice globally. Interdependency with Banks, Pension Annual management charges can often be higher in developing Funds, and Insurance Companies countries (see table 1.2). In developed markets, generally, a 2 Many mutual fund markets, both developed and developing, percent annual charge would be on the highest end of the scale. display a significant interdependency between banks and Funds in emerging markets may have few economies of scale mutual funds. This is partly because banks often own mutual fund and therefore may need to charge higher fees. In Kenya, annual management companies and distribute mutual funds but also management charges of most mutual funds can be as high as because mutual funds may invest in banks and also compete with 3.5 percent. In Turkey, banks used to charge 5.5 percent in annual bank products.71 For example, shares in banks may be listed and fees for MMFs (the most popular mutual fund in Turkey), which is form a major part of stock market capitalization and so form part exorbitant by international standards because typically annual of the portfolio of equity funds. In emerging markets, typically a costs for such funds are less than 0.8 percent; however, this level of few fund management companies control the bulk of mutual fund charges was acceptable in an environment where MMFs were sold assets, and banks often dominate the mutual fund sector either by banks for clients to receive interest where none was payable directly (as in Turkey where banks have been able to found funds) or on current accounts and when interest rates were as high as 50 through owning investment management firms (as in continental percent. The Turkish regulator subsequently capped the annual fees Europe). For instance, in Peru, at the time of the case study, four on these MMFs at 1.1 percent;68 this made operating such funds banks, each owning a fund management company,72 controlled 95 much less remunerative, and with spreads on lending becoming percent of assets under management. Banks also often dominate more attractive, banks had a greater incentive to promote deposits. mutual fund offering and distribution. This dynamic can pose Even in Brazil, where the mutual fund sector is large, the taxa de potential conflicts because MMFs are essentially a substitute for administração or annual management charge can range from 0 bank deposits.73 (See chapter 3 for more on this discussion.) MMFs percent to 3 or 4 percent for some retail equity funds.69 Cultural also may invest to a substantial extent in certificates of deposit attitudes to charges vary: In some countries, investors may resist (CD) and commercial paper issued by banks and in repos, creating high entry charges but not resist high annual management charges, another source of interdependency.74 A rapid decline of MMFs could whereas in others they may not resist high entry charges but are thus have an impact on liquidity for the banking sector. As at year deterred by high annual charges. Investor preference may also be end 2011, more than 50 percent of Turkish MMF assets were invested influenced by how long they intend to stay invested: Those that in reverse repos75 where banks were the main counterparties. In have shorter horizons would clearly prefer low or no entry charges, Morocco, mutual funds held more than an estimated 30 percent and longer-term investors would prefer the opposite. of assets under management in bank bonds or equity. Moroccan mutual funds have also provided significant liquidity to the banking We see a trend away from entry and exit fees caused by sector in the form of repos, term deposits, and CDs.76 regulatory change in some developed and emerging markets. Regulators increasingly are requiring investors to agree or to pay Mutual fund sectors also display significant interdependency commissions to distributors instead of the fund management with pension funds and insurance companies, because longer- company agreeing these with the distributor. This has the effect of term mutual funds compete with pension funds or insurance reducing or eliminating entry charges. In some markets regulators products, and mutual funds are often the underlying investment are concerned that if there are high exit fees these may deter for these institutional investors. In countries where contributions investors from exercising their key right—that is, to redeem—and to pension schemes are mandatory, individuals are less likely also regulators may seek to place limits on such charges. In Canada, as to voluntarily make additional investments such as in mutual funds. of December 2011, investors had purchased more than 30 percent In such cases, if these pension schemes cannot themselves invest of mutual fund assets at “no load”; that is, the fund or investor did into mutual funds (because of law or regulation) or do not invest in 16 | MUTUAL FUNDS in developing markets: addressing challenges to growth them (because they offer no advantage), it is not likely mutual fund funds that invest predominantly in equity securities, (2) sectors will expand—with the possible exception of MMFs, but these funds that invest predominantly in debt securities, (3) funds would have to be more tax efficient than bank deposits or produce that invest in a hybrid of both equity and debt securities, and higher levels of interest. In Peru, the domestic mutual fund sector (4) funds that invest in short-term debt instruments (MMFs). is small both because individuals are mandated to save 10 percent Mutual fund sectors in developed and developing markets of their salary into pension schemes and because these schemes have varying asset class exposures. In emerging markets, do not invest in domestic mutual funds (although they do invest these funds generally have higher exposures to fixed-income in mutual funds based outside Peru for international exposure). In and money markets. High MMF exposures in many emerging Australia, by contrast, where 9.5 percent (rising gradually to 12 markets imply that these sectors are as yet failing to mobilize percent in 2019) of one’s salary must be contributed to mandatory savings into longer-term instruments; however, they may also pension savings (known as superannuation), mutual funds have indicate investor aversion to the greater volatility or longer- been used extensively as an underlying investment, and the mutual term holding entailed in investing in bonds or equities, and/or a fund sector has expanded strongly, being the second largest lack of availability of bonds or equities in which to invest. domestic market in the world at the end of 2013. (This is discussed more in chapters 2 and 3.) Similarly, longer-term mutual funds may 4. Mutual funds are essentially designed to provide compete with life insurance savings products, while also benefiting diversification of risk for smaller savers who do not have from investments of insurance companies as institutional investors enough money to achieve this diversification themselves; or being used by them for unit-linked products. Insurance companies thus, they tend to be a middle class savings vehicle. However, may also own fund management companies and distribute mutual institutional investors are often active and substantial owners funds. In Kenya, for instance, three fund management companies of mutual funds in both developed and developing countries. owned by insurance firms managed an estimated 70 percent of In some emerging markets, institutional investors are not as mutual fund assets, and the majority of retail sales were thought dominant, sometimes because the institutional investor base to derive from insurance sales forces. Last, both pension funds and itself is small or because these investors channel investments insurance companies may outsource their asset management to elsewhere. fund management companies that run mutual funds. 5. Distribution channels for mutual funds are usually more diversified in developed countries with larger and more In Summary affluent populations, although banks often play a large part. 1. A mutual fund is a form of collective investment scheme In emerging markets, the range of retail distribution channels or investment fund; that is, it is a pool of savings typically tends to be narrower, and banks tend to be the dominant collected from multiple investors who buy shares or units distribution channel. Although the operator is responsible for representing proportionate ownership of the fund. The the sales policy and distribution of a mutual fund, licensed resulting pool of funds, or the fund’s capital, is collectively distributors usually sell the fund(s) on the operator’s behalf. managed by a professional management company, in line with 6. The scale and success of development of mutual funds in any the investment objective outlined in the fund’s prospectus. one country is the outcome of complex interactions between a This form of collective investment scheme is closely regulated variety of factors, such as mutual funds’ relative tax efficiency, because it is legally eligible to gather savings from the public the availability of investments and of investments that offer real and is required in turn to invest those savings in a diversified rates of return, whether pension funds and insurance companies portfolio of transferable/tradable securities. have developed and are able to invest in mutual funds, and 2. Mutual funds can be a major channel of intermediation the rates of return mutual funds can achieve relative to those between savers and borrowers, gathering savings and available on bank deposits and other competing investments. investing them into shorter- or longer-term securities issued 7. The next chapter provides an overview of the legal and by governments and corporates. These funds are a valuable regulatory drivers and impediments related to mutual fund investment vehicle for retail investors, institutional investors, sector growth. and corporates. They may play a significant role in investing for retirement as well as serving as an underlying investment vehicle for insurance companies. MMFs may play an important cash management function where they are used by corporates for treasury management. 3. Mutual funds typically consist of four main types of funds, which are defined by the regulator or trade association: (1) Chapter 1: Overview of Mutual Fund Sector Characteristics in Select Developing Countries | 17 Endnotes borrowing. The all-equity capital structure distinguishes such funds from hedge funds and closed-ended funds that typically 1. These middle-income countries included Argentina, Brazil, apply leverage to enhance returns. See Conrad S. Ciccotello, “The Bulgaria, China, Costa Rica, Hungary, India, Mexico, Pakistan, Nature of Mutual Funds,” in Mutual Funds: Structures, Analysis, Philippines, Romania, South Africa, and Turkey. The study uses Management, and Stewardship, ed. John A. Haslem (New York: World Bank definitions of developed countries as high-income Wiley, 2010), pp. 3–15. OECD and high-income non-OECD classification, and for 13. Ciccotello, “The Nature of Mutual Funds.” developing countries World Bank definitions of low-income and 14. In contrast, with a closed-ended fund, which is typically traded on middle-income economies (as of 2013) The ICI is a global trade a stock exchange, as Ciccotello explains in his article, “The Nature association for regulated investment funds, based in the United of Mutual Funds,” which has a fixed number of shares or units in States, that compiles international statistics on behalf of the issue (like an ordinary listed company) that are bought and sold International Investment Funds Association, an organization of on stock exchanges. national mutual fund associations. 15. Since these funds are set up under the same legal and regulatory 2. The World Bank undertook case studies on the mutual fund requirements as publicly offered investment funds, these are sectors of these countries in 2012. included in this analysis. 3. Although this report seeks to broadly explore striking aspects 16. Out of the 330 authorized mutual funds, about 145 were dedicated of the mutual fund sector in emerging markets, it does not go to a single investors, as of December 31, 2011. Dedicated mutual into specific issues related to mutual funds. Such specific issues funds represented 41 percent of total assets under management include but are not limited to the debate on whether or not in Morocco as at year end 2011. actively managed funds outperform passively managed funds, details on the nature and development of relatively new mutual 17. Foreign funds can be construed in two ways. One is a domestic fund products such as exchange traded funds, and delving into fund created in and operating in the host country but investing the nature of offshore fund centers and the impediments to their abroad; the other is a fund based outside the country concerned development. The report also does not examine specific learnings but sold into it. For example in Turkey, a “foreign fund” does not from mutual fund sector events in developed country contexts, operate in Turkey but is sold into Turkey. such as the mutual fund market timing scandal of 2003 in the 18. Deepthi Fernando, Leora Klapper, Victor Sulla and Dimitri Vittas United States. (2003), “The Global Growth of Mutual Funds”, World Bank Policy 4. “Collective investment scheme” is the term used by IOSCO to Research Working Paper (WPS3055). designate such funds. 19. Typically a feature of open-ended mutual funds, which are the 5. This description also broadly fits defined contribution pension main subject of this report. This is described in box 1.1. schemes, which operate in the same way as mutual funds but 20. Such investors may also be able to change their exposures to are subject to pension-specific tax treatment and to limitations particular assets or markets more easily and more rapidly by upon withdrawal from the scheme. Both defined benefit and disinvesting from one fund and investing in another fund than defined contribution pension schemes may be investors into by disinvesting from a directly held portfolio and buying a new mutual funds. The study does not include hedge funds, which are directly held portfolio. a generic term for a fund that may be open ended or closed ended 21. Ciccotello, “The Nature of Mutual Funds.” and may take a variety of legal structures including a limited 22. Michael Bogdan and Daniel Schrass, “Profile of Mutual Fund partnership but that do not meet the regulatory requirements for Shareholders, 2013,” ICI Research Report (February) (Washington, offer to the general public. DC: Investment Company Institute, 2014). 6. This is a generic term used worldwide, although it has no legal 23. Ciccotello, “The Nature of Mutual Funds.” significance. 24. Investment Company Institute. 7. This section is drawn from discussion of the history of investment funds in a World Bank study in Turkey. 25. Because they can access wholesale market interest rates that are not accessible otherwise. 8. A. Khorana, H. Servaes, and P. Tufano, “Explaining the Size of the Mutual Fund Industry around the World,” Journal of Financial 26. Investment Company Institute 2013. Economics 78 (2005): 145–85. 27. Investment Company Institute 2014. 9. Foreign & Colonial Investment Trust Prospectus 1868. 28. UK Fund Management 2014, The Financial Markets Series, 10. See chapter 2. TheCityUK, September 2014; the other 80 percent is pension funds, insurance funds, private equity funds, sovereign wealth 11. This liquidity/variable capital feature leads to important funds, hedge funds and private wealth. consequences in computing the net asset value of the fund, which is the basis of the sale and redemption price of such funds, as well 29. Khorana et al., “Explaining the Size of the Mutual Fund Industry as the performance of the fund, and its daily management. around the World.” 12. For instance, the U.S. Investment Company Act of 1940 prevents 30. Fernando et al., “The Global Growth of Mutual Funds.” these open-ended funds from issuing senior debt or any type of 18 | MUTUAL FUNDS in developing markets: addressing challenges to growth 31. This is partly because more countries are added to the Investment of total assets under management. Investments in equities Company Institute database but also because of growth in sales represented only 10 percent of total assets under management. (versus performance). 52. In the case of pensions, such limits will often relate to some degree 32. See McKinsey & Company report “Searching for Profitable to the nature of the pension—whether it is defined benefit or Growth in Asset Management: It’s about More than Investment defined contribution in type. In the case of some personal pensions, Alpha” (2012), http://www.mckinsey.com/insights/clientlink/ where the pension account belongs to the individual and is portable searching_for_profitable_growth_in_asset_management. as they move between jobs, pension savings may be permitted to 33. This is according to Investment Company Institute statistics, be invested wholly into mutual funds as in the case of the U.S. which record (as of 2013) 14 middle-income country mutual fund Independent Retirement Account (IRA). sectors and 33 high-income countries. The study uses World 53. Retail investors in Morocco tend to be steered by banks toward Bank definitions of developed countries as High-income OECD other financial products such as savings accounts, term and high-income non-OECD classification, and for developing deposits, or life insurance investment products. Most individual countries as WB definitions of low-income and middle-income investors also tend to be high net worth. Data show that the economies (as of 2013). average ownership of mutual fund assets per individual was 34. Investment Company Institute 2014. approximately $117,000. 35. The UCITS Directive allows mutual funds that comply with the 54. However, a further 15 percent of AUM was held by high net worth, directive to market freely across the European Economic Area. or “private” investors. 36. Lipper, “European Fund Market Review,” 2013 http://www. 55. European Fund and Asset Management Association, “Asset lipperweb.com/Handlers/GetReport.ashx?reportId=4480. Management in Europe 2014,” http://www.efama.org/Pages/ EFAMA%27s-Asset-Management-Report-2014.aspx (exhibit 25 37. 2014 Investment Company Institute Fact Book. for reference). 38. Investment Company Institute Worldwide Mutual Fund Market 56. “Asset Management in Europe.” Data. 57. An “independent financial adviser” is a firm licensed to give 39. European Union member countries plus Iceland, Lichtenstein, and independent financial advice to clients about a range of financial Norway. products. 40. Investment Company Institute. 58. “Private bank” is a bank (which may be owned by a “retail bank’) 41. Investment Company Institute. that serves only very affluent clients. 42. Investment Company Institute data for developing countries 59. This trend is declining in developed markets where increasingly started including Pakistan in 2006, China in 2007, and Bulgaria fund management firms are not permitted to agree to pay in 2008. commissions to advisers; instead any fee or commission must be 43. Investment Company Institute data for mutual funds; however agreed between the investor and the adviser. overall there are a total of 11,500 funds of various types in Brazil. 60. If they focused on advising on or selling only mutual funds, this 44. SEC Nigeria website data as of January 4, 2014. would be even more true 45. ICI data shows Bulgaria as the smallest mutual fund sector in 61. Although some regulatory frameworks establish requirements collected data worldwide, with 2013 AUM of $504 billion. governing this (these may be financial sector laws or broader 46. Middle-income countries (both lower middle-income and upper consumer laws such as that governing competition or unfair middle income) in the database included Argentina, Brazil, contracts). Bulgaria, China, Costa Rica, Hungary, India, Mexico, Pakistan, 62. Although almost all asset management companies advertise Philippines, Romania, South Africa, and Turkey. their mutual funds online, even though the level of information 47. Data from a combination of IOSCO survey and Investment available is limited. Company Institute. 63. In American terminology, this is a “no load” share class or fund. 48. For Russia, the 2011 number was used because the 2012 number 64. Morningstar, “Global Fund Investor Experience 2013 Report” was unavailable. (Chicago: Morningstar). 49. Investment Company Institute 2013. Money market funds held 65. Morningstar, “Global Fund Investor Experience 2013 Report.” 18 percent and hybrid funds 8 percent. 66. Lipper. 50. Source: FundPro Latam; see Peru Case Study, p. 18. 67. This also may explain why overall weighted average American 51. Moroccan mutual funds are heavily invested in fixed-income mutual fund fees are lower than many others internationally. securities. A little more than one-quarter of totals assets under 68. See the discussion in chapter 2 on issues arising in relation to management were invested in government bonds at the end of capping charges. 2011. Negotiable debt securities, which are by far dominated by 69. In Brazil, this encompasses all costs of administration, custody certificates of deposits issued banks, became the second asset and management except for transaction costs, unlike other class in size in 2011, representing slightly more than 22 percent regimes where the management charge does not express the Chapter 1: Overview of Mutual Fund Sector Characteristics in Select Developing Countries | 19 totality of charges made to the assets or income of the fund. The transaction cost is the cost of commissions or fees or taxes incurred in buying and selling assets for the portfolio of the fund. There is no need therefore to calculate a “total expense ratio” as is necessary in many other fund regimes. 70. Canadian Securities Administrators, Discussion Paper and Request for Comment 81-407, “Mutual Fund Fees,” December 13, 2012. 71. Bank ownership of mutual fund managers is not atypical in developed countries, but there is no clear pattern. In Europe banks predominate, but in some countries are losing such dominance. In the United Kingdom few fund management companies are owned by banks. U.S. ownership of mutual fund management companies is to a great extent a function of Glass Steagall. 72. The fund management companies are Credifondo (affiliated to Banco de Credito), BBVA Fondos Continental, Scotia Peru (Scotia Bank), and Interfondo (Interbank). 73. In Brazil, for instance, outflows in mutual funds were offset by inflows in bank deposits in three crisis events. In Morocco, investors redeemed their shares from money market funds in 2012 because term deposits started to provide higher interest. 74. Many countries’ funds have high exposures to banks as investments, hence the limit that is often placed on funds that they may not have more than a certain percentage of a fund invested in the issuance and deposits of any one issuer. 75. Repos are “a form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day. For the party selling the security (and agreeing to repurchase it in the future) it is a repurchase or repo; for the party on the other end of the transaction (buying the security and agreeing to sell in the future) it is a reverse repurchase or reverse repo agreement.” 76. The proportion of funds invested in cash, term deposits, repos almost doubled from 16 percent in 2002 to 31 percent in 2009, before falling back to 19 percent of total assets—showing the long-lasting appetite of mutual funds for liquid and “risk-free” investments. 20 | MUTUAL FUNDS in developing markets: addressing challenges to growth Legislation, Regulation, and 2.  Taxation of Mutual Funds Introduction A mutual fund sector will not expand strongly unless people are confident that mutual funds are worthy of their trust. Thus law and regulation must adequately protect investors, and a regulator must effectively and fairly enforce this legal and regulatory framework. A weak legal and regulatory framework or failure to enforce compliance with an adequate framework can negatively affect the mutual fund industry. When investors are not confident in the market, they either do not invest or pull out of mutual funds. In extreme scenarios, a loss of confidence in a mutual fund can lead to a “run” on the fund, similar to a “run” on a bank, which means the operator of the fund has to sell assets to meet redemption requests. If the operator cannot raise the cash to meet redemption demands, investors may further lose confidence, causing the “run” to accelerate. This could spill over to investors losing confidence in all mutual funds, giving rise to systemic risk.1 One of the key objectives of regulating publicly offered mutual Such schemes are commonly seen in both developed and emerging funds is to maximize the potential for confidence by effectively markets: They present dangers not only to investors but also to protecting the interests of the fund investors from conflicts of legitimate collective schemes that cannot pay similarly unrealistic interests and asymmetries of information. Mutual fund regimes levels of return and whose reputation may be damaged when the address asymmetries of information and conflicts of interest inevitable collapse occurs. Examples of such schemes in emerging between the fund operator and the investor and seek to prevent the markets include the MMM scheme in Russia in the 1990s, involving possibility of the fund operator (or its affiliates) stealing or misusing millions of Russians, which could partly explain the relatively weak fund assets. subsequent development of mutual funds in Russia. In Albania, investors lost an estimated $1.2 billion through a high-profile Fund regimes also seek to protect investors from being defrauded Ponzi scheme in the late 1990s. In Kenya and Tanzania, another or misled by unregulated collective investment schemes. The Ponzi scheme, the Development Entrepreneurship for Community law thus typically describes the characteristics of a collective Initiative, led to losses for thousands of investors. There were no investment scheme and requires that any vehicle that has the mutual funds yet in either Albania or Tanzania (apart from the stated characteristics and that is offered to the public must meet state-sponsored Unit Trust of Tanzania) as at the end of 2013, the requirements of the law applicable to such schemes. This and the Kenyan industry has been developing slowly. An OECD enables regulators to require any public offer of an unregulated study thus notes that “the toleration of collective investment scheme either to come into line with law and regulation or to be activities operating outside the recognised legal framework for CIS shut down. Therefore regulators are able to act against Ponzi2 undermines confidence in the entire financial system and may pose schemes which are unregulated investment vehicles that collect risks to financial stability.”3 (See box 2.1 for a history of mutual fund money from investors, by promising—usually unrealistically— legislation.) high returns. Instead of making investments, these schemes use new subscribers’ money to pay “returns” to existing investors and Regulatory frameworks need to align with the stage of market hence collapse when new inflows are insufficient to pay “returns.” development. The framework has to achieve a delicate balance Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 21 Box 2.1: History of Mutual Fund Legislation The first mutual funds were created before legislation specific to these vehicles was written. These funds were set up both in the United States and the United Kingdom in the 1920s and 1930s, respectively, using existing law governing either companies or trusts. However, during and following the Wall Street Crash of 1929, investors into many of these funds suffered major losses because the funds took on excessive leverage (borrowing), and because operators of these funds were self-dealing, churning investors (moving them from fund to fund to generate commissions for sales persons), and sometimes stealing from the fund outright. These events created the impetus to introduce legislation governing mutual funds and protecting their investors. In 1939 the U.K. Prevention of Fraud (Investments) Act was passed. Research conducted in the 1930s in the United States revealed rampant fraud among members of the investment company industry and was the basis for the U.S. Congress’s considering it necessary to regulate funds. This was the genesis of the Investment Company Act of 1940.4 Similar development patterns may be seen in some emerging markets. Unit trusts were set up in Zimbabwe, for instance, before the Collective Investment Schemes Act was passed in 1997. However, given lessons learned from global experiences with mutual funds, governments that want to develop mutual fund sectors typically seek to establish legal and regulatory frameworks to enable such funds before they start operation. between regulating enough to protect the investor, but also Legal and Regulatory Apparatus not overregulating to the extent that the industry is stifled or unable to operate. Overregulation can impose unnecessary costs, The mutual fund legal and regulatory apparatus consists of deter market entrants, and make mutual funds less attractive a series of components that together act to set and apply than other investment vehicles, thus preventing—or slowing— standards for the establishment of mutual funds, their offering, market development. Simply adopting international standards management, and governance. The presence of these components from mature markets in a newly emerging market can lead to will vary over time as mutual fund markets develop and in line with overregulation because of fundamental differences between the scale of the market (see table 2.1). countries in the early stages of market development and mature financial markets. For example, a nascent financial sector may not Primary Legislation have the range of investments and levels of liquidity that occur in developed markets. As discussed later in this report, Uganda As discussed above, the key objective of primary legislation is adopted much of the U.K. framework for publicly offered funds to define the nature of a collective investment scheme and to wholesale, which led to impracticable diversification and liquidity protect investors by requiring that only a scheme that has met requirements being imposed on the fund sector. Compliance with legal and regulatory requirements may be offered to the general IOSCO standards, which are general principles discussed later in public. Provided that this definition is well drafted, it will enable a this chapter, is possible without replication of the full panoply of regulator to act against unregulated investment vehicles that are developed markets’ regulatory frameworks. offered to the public, such as Ponzi schemes, requiring them either to come into compliance with the law or to cease such business. This chapter outlines key elements of the legal and regulatory Such legislation typically will also seek to protect investors by frameworks that typically govern mutual funds or affect requiring that only entities approved by the regulator may operate their development. The chapter discusses elements of good or provide certain services to such funds, and that these entities regulation, which lends comfort to an investor and results in the must comply with law and regulation. growth of the mutual fund sector, and bad regulation, which may include overregulation that presents barriers to entry for mutual Fund legislation should seek to address the principal-agency risk fund promoters and thus impedes competition, or poor quality embedded in the structure and organization of mutual funds by regulation, which fails to facilitate mutual funds’ development. It placing an overriding duty on those who operate funds to act in draws on examples from the country studies and from a selected the interests of fund investors and with due diligence, expertise, series of other emerging markets that participated in a World and professionalism. The operator (or “agent”) who manages the Bank–IOSCO survey and seeks to identify factors that may impede fund does not own the assets of the fund. The assets derive from the development of mutual fund sectors. The chapter discusses those who have bought shares or units in the fund and are either the principles developed by IOSCO for regulating and supervising beneficially owned by fund investors (the “principals”), or they are collective investment schemes.5 The chapter also illustrates owned by the fund itself when it is a company, which is in turn owned examples from developed countries that have longer histories of by its shareholders (the investors in the fund). This dichotomy leads regulating the mutual fund industry. It looks at the importance of to the possibility of conflicts of interest, where the operator could effective, even, fair, and consistent application of this framework use fund assets to the advantage of itself or its affiliates rather than by a competent and adequately resourced regulator. Last, although the advantage of fund investors: Hence the legal requirement to act this report does not focus on taxation, the chapter considers in the interest of fund investors. Another risk is theft, namely, that elements of the tax regime of mutual funds and their effect on the an unscrupulous operator holding the assets of funds could easily industry’s growth. misappropriate these assets: Hence the IOSCO requirement (see box 22 | MUTUAL FUNDS in developing markets: addressing challenges to growth Table 2.1: Components of the Legal and Regulatory Apparatus for Mutual Funds Primary legislation • Lays out basic principles of mutual fund structure and governance and establishes definitions. Secondary legislation • Lays out detailed rules on fund operations and management, in tandem with legislation. Regulator • Typically develops (and sometimes passes) secondary legislation and detailed guidance in tandem with primary legislation. • Is responsible for enforcing the legal and regulatory framework, specifically by issuing licenses, regulating operators and service providers of mutual funds, and applying sanctions on those who fail to comply. Self-Regulatory Organization • In some cases, the regulator may delegate to an SRO the power to regulate operators or service (SRO)a providers of mutual funds. In this case, the regulator issues the license or permission to undertake the business. However, the license holder is required to become a member of an SRO (or the SRO) and is subject to its rulebook and supervision. Trade association of mutual • May establish standards and monitor their members’ compliance with these standards. funds/operators • Sometimes also provides guidance to members on how to implement regulation. • May also develop proposals for new or amended law or regulation. Third-party regulation • Law or regulation may place a duty on a depositary or a trustee to a mutual fund to undertake a day-to-day supervisory role, which includes being responsible for safekeeping the fund assets (such entities are also subject to regulatory supervision). • Law or regulation usually requires that an independent auditor audits each mutual fund and prepares annual financial statements for fund investors and the regulator. In some cases, the auditor may also be responsible for checking fund compliance with laws and regulations, and may be obliged to report any irregularity directly to the regulator. Judicial system of courts and • Addresses investor grievances. other arbiters6 • Conducts civil or criminal proceedings upon application of the regulator. a. A body whose role is defined in the relevant law and whose sole objective is to regulate the conduct of its members. 2.2) that fund assets are segregated and held and safeguarded by •• Financial services legislation. In this relatively rare case, the a third party approved by the regulator to undertake that activity overarching law that governs the financial services sector— (a depositary, trustee, or custodian, depending on the nature of banks, capital markets, insurance, pensions, etc.—also the fund). Those who operate funds know much more about the governs mutual funds and their operators. Examples include fund than potential or existing fund investors and can exploit that the U.K. Financial Services and Markets Act 2000 and the asymmetry in knowledge; legislation and regulation again seek Republic of Korea Financial Investment Business and Capital to minimize the potential for this by requiring that operators act Markets Act 2007. Such legislation typically also empowers a in the interests of fund investors (see IOSCO conflicts of interest “megaregulator,” such as a central bank, ministry of finance, or requirements in box 2.2). Legislation also seeks to address the risk a government agency—to supervise the whole sector.8 that one holder in a fund may be advantaged to the detriment of another: For instance, the operator may share information with some •• Securities markets (or capital markets) legislation. In this investors and not others. An OECD study7 elegantly summarizes the more common approach, the law governing securities (or capital) problems fund legislation has to address: The mutual fund sector “is markets also governs mutual funds and their operators. Examples characterised by complex agency relationships and asymmetries of include the Kenya Capital Markets Act 2000 and Turkey Capital information and market power. Large amounts of assets are owned Markets Act 2012. Such legislation typically empowers a by a dispersed group of investors with incomplete information. The securities or capital market regulator to supervise the sector. assets are under the control of institutions with considerable power •• Fund-specific legislation. In another common approach, a to control flows of information. These asymmetries of power and fund-specific law will govern mutual funds and their operators.9 information require transparent and disciplined procedures to ensure Examples include China’s Securities Investment Fund Law equitable treatment of investors.” of 2012, Morocco’s Law no. 1-93-213 dated 1993, and South Law governing mutual funds is usually established through one of Africa’s Collective Investment Schemes Control Act No. 4 of three approaches, summarized as follows. The approach chosen 2002. In this case the law will also empower a regulator to by any one country will depend upon its legal traditions, the level supervise mutual funds and their operators. This may be a of development of financial markets, and its existing institutional central bank, ministry of finance, a “megaregulator,” a nonbank framework, among other factors (see table 2.2). financial services regulator, a market conduct regulator, or a securities regulator. Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 23 Box 2.2: IOSCO Principles on Collective Investment Schemes (CIS) Principle Purpose of a CIS Legal and Regulatory Regime Coverage Legal form and Provide for the legal form and structure to provide certainty to investors in assessing their Law structure interest in the CIS and enable the pool of investors’ funds to be distinguished from the assets of other entities (“segregation” of assets). Custodian, Ensure the physical and legal integrity of the assets of the CIS is protected and separated Law depositary or trustee from the assets of the operator and its affiliates, other CIS, the custodian, depositary, or trustee, and all other entities. CIS assets must be held by a custodian, depositary, or trustee that is required to meet fit and proper and resources and diligence requirements and to be at least functionally independent of the operator. Eligibility to act as Establish that the operator of a CIS must meet fit and proper resources and diligence Law and regulation an operator requirements on an ongoing basis and establish their powers and duties and requirements to operate the scheme and achieve ongoing compliance. Delegation Require that the operator is responsible for exercising the powers and undertaking the duties Law or regulation under law or regulation, and that while it may delegate activities it remains responsible for oversight of these and the competence of any entity to which it delegates. Such delegation must not diminish the effectiveness of supervision of the CIS. Supervision Provide for a regulatory authority with adequate powers to take overall responsibility for Law supervision of CIS in its jurisdiction and to license, monitor, inspect, and investigate CIS and their compliance with law and regulation. Third-party supervision of the operator of a CIS by the depositary or trustee and sometimes by auditors may also be envisaged. Conflicts of interest Ensure that the exercise of responsibilities is undertaken with full regard to the best Law and regulation interests of CIS investors and establish prohibitions or controls on situations and transactions that may give rise to conflicts of interest. Asset valuation and Provide a system for valuation of CIS assets based on market value, and for pricing CIS Regulation pricing shares or units, and procedures for entering or exiting a CIS that are fair to entering, exiting, and ongoing investors. Provide that CIS must redeem upon request and suspend such redemption only in certain stated circumstances and follow certain procedures, must sell and redeem shares or units at net asset value plus or minus a charge as appropriate, and provide for distribution or reinvestment of income. Investment and Establish investment restrictions, portfolio diversification requirements, and borrowing Law and regulation borrowing limitations that address the investment goals, the risk profile, and the degree of liquidity required for a CIS to meet redemptions in all market conditions. The need for liquidity typically contemplates a CIS investing primarily in transferable securities, money market instruments, and derivatives. Borrowing should be limited in extent and only permitted on a temporary basis. Investor rights Provide investors with certain rights including the right to redeem and to participate in Law and regulation decision taking in certain circumstances and as relevant to the legal structure of the fund; specify access to remedies. Marketing and Require full, accurate, and timely (prospectus) disclosure to prospective investors providing Regulation disclosure all the information necessary to make an informed investment decision. Require that annual or semiannual financial reports on the management and operations of the CIS are provided to investors and filed with the regulator; these reports should be subject to review by an independent third party (auditor). Annual or semiannual reports must contain accounting information that must be prepared in accordance with applicable accounting standards. Source: IOSCO Principles for Collective Investment Schemes 1994. 24 | MUTUAL FUNDS in developing markets: addressing challenges to growth are essentially derived from a survey of common global regulatory Table 2.2: Legislation Enabling Mutual Funds in standards—note what aspects of the legal and regulatory framework Selected Emerging Markets are more commonly covered by law or regulation.10 When mutual fund provisions are part of a more comprehensive capital markets or Financial Services Securities Markets Fund-Specific Legislation Legislation Legislation securities law, regulations will typically hold most of the details. On the other hand, if the law is specific to mutual funds, primary legislation Korea Brazil Malaysia China may contain more detail. In general, civil code jurisdictions tend to Costa Rica Nigeria Mexico have more detail in primary legislation and may then specify the Hungary Pakistan Morocco areas to be regulated, whereas common law jurisdictions tend to leave India Peru Russia detail to the regulations, and it may be necessary only to empower the Indonesia Saudi Arabia Slovenia regulator to promulgate these regulations. Kenya Turkey South Africa Ideally a single set of rules covers all mutual fund–related Sources: World Bank case studies, country legislation, various sources as at year end 2012. provisions, rather than provisions being dispersed in a variety of regulations, rules, instructions, and guidance; good practice also suggests timely (but not very frequent) updates of regulation.11 A country’s legal tradition will influence the legal structure Consolidating market rules allows new entrants or participants of mutual funds that can be enabled. The legal tradition could to clearly identify the rules applicable to them. Peru and Turkey, be civil code, which is widespread, for instance, in continental for example, largely cover all relevant provisions in a single set of Europe and which was adopted in other countries influenced by rules. On the other hand, Brazil and India have a complex series their legislation such as Eastern Europe (which has tended to of documents diversely covering different aspects of funds; this follow Germanic legal tradition), and Latin America (which has makes it difficult to identify what element of which document is followed Spanish or Portuguese traditions). Or the legal tradition relevant to a particular issue.12 could be common law, which originated in England and is found primarily in former British colonies. Table 2.3 shows some of the variations in the structures in which mutual funds are enabled Regulators as a result of a country’s legal tradition. A later section of this Primary legislation should empower a regulator—the entity chapter discusses mutual fund legal structures in more detail. varies depending on country—to monitor and enforce compliance with the legal and regulatory framework governing mutual funds and their service providers. The responsibilities Secondary Legislation and Regulation of the regulator may vary from country to country but should be Although there is no one clear rule as to what is in primary versus clearly and objectively stated in law. Regulators typically develop secondary mutual fund legislation, it is usually better to establish detailed regulations or rules governing mutual funds and their basic principles in primary legislation (which is not easily changed) operation and may also issue “guidance,” which further interprets and set out details in secondary legislation, which can be changed as these rules. The regulations will establish minimum entry standards the market evolves. Primary legislation should ideally create a sound for mutual fund operators and service providers and to set up a legal basis for mutual funds to be established, licensed, supervised, mutual fund. The regulator will license entities that meet these operated, and wound up. Secondary legislation—called regulations requirements, monitor their activities and compliance with law and or rules—would then set out more detailed requirements such as regulation through regular reports and inspections, and if necessary aspects of fund operation or standards applicable to operators and investigate failures and enforce compliance (see table 2.4). The third-party supervisors of funds, because primary legislation cannot nature of the regulator will also vary from country to country easily be changed to respond to changing environment or to bring and may change over time: In the United Kingdom, for instance, industry practice up to date without the national legislative body being when the first legislation governing funds was passed in 1939, the involved. No clear line is seen between the content of primary and regulator was a government ministry, the Board of Trade. However, secondary legislation (regulation) because this varies across countries several permutations later, the regulator is now a market conduct and their legal traditions. The IOSCO principles given in box 2.2—which regulator under the Financial Services Act 2012. In the United Table 2.3: Variations in Primary Legislation Enabling Mutual Funds as at Year End 2012 Country Legal Tradition Primary Legislation Enabling Mutual Funds Brazil Civil code Law 6.385 of 1976 enables open-ended funds in the form of condominiums Kenya Common law Capital Markets Act 2000 enables open-ended funds in trust and corporate structure Morocco Civil code Law no. 1-93-213 of 1993 enables open-ended funds in corporate and contractual form Peru Civil code Law on the Securities Market enables open-ended funds of contractual type Turkey Civil code Capital Markets Act of 2012 enables open-ended funds in contractual and corporate form Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 25 States, the regulator was and remains the Securities and Exchange clear and gaps or inequities avoided. Variants in regulatory entities Commission (SEC), a specialist securities regulator created under responsible for regulation of mutual funds include the following: the Securities Exchange Act of 1934. In Zimbabwe, the Registrar of Collective Investment Schemes, an employee of the Reserve Bank •• Central banks: An example is the Monetary Authority of of Zimbabwe (the Central Bank), was the identified regulator when Singapore, which is also a megaregulator, and governs mutual the Collective Investment Schemes Act was enacted in 1997, but funds through the Securities and Futures Act of 2002. Another the regulator subsequently became the Securities and Exchange example is the Central Bank of Russia, also a megaregulator, Commission. which took over securities markets regulation in 2013. In Brazil the Central Bank regulated mutual funds until the early 1990s, In general, five possible types of entities can regulate the mutual following which the Securities and Exchange Commission of fund sector, although most often mutual funds are governed by Brazil became the regulator. the securities markets regulator, which may be a government agency or under the purview of the Ministry of Finance. Good •• “Megaregulators”: These are empowered by an overarching practice suggests the mutual fund industry should be regulated law governing the financial services sector (e.g., the Financial by one entity, rather than multiple entities. This helps concentrate Services Authority under the U.K. Financial Services and regulatory power in one entity and simplifies the regulatory burden Markets Act 2000) or by a law specifically creating the regulator and cost of compliance for market participants.13 IOSCO principles (e.g., South Korea’s Act on the Establishment of the Financial require that if there are divisions of responsibility, these should be Services Commission of 2008). •• Nonbank financial institutions regulatory authorities: Table 2.4: Mutual Fund Regulators in Selected These regulators are generally empowered by a law that Markets14 creates the regulator and are mandated by that law to apply specified financial sector laws, for instance, laws governing Regulator of Mutual Funds pensions, insurance, and securities markets, including collective Securities Central Market Mega- Nonbank investment schemes. Examples include the Financial Services Markets Bank Conduct regulator Financial Board of South Africa under the Financial Services Board Act of Authority Regulator Services 1990 and the Securities and Exchange Commission of Pakistan Regulator created under a 1997 Act. Brazil  China  •• Securities markets regulatory authorities: These regulators may be empowered by securities legislation that both governs Costa  the sector and establishes the regulator and its powers; an Rica example is the Capital Markets Act 2000 of Kenya. Alternatively, Hungary  a law could also be specifically enacted to empower such a India  regulator, for example, the Securities Commission of Malaysia Indonesia  under the Securities Commission Act of 1993. Kenya  •• A market conduct regulator: Under the “twin peaks” model of Korea  financial regulation, a prudential regulator focuses on capital Malaysia  and systemic risk, and a separate market conduct regulator would typically regulate securities markets, including collective Mexico a investment schemes and their operators. Examples are the Morocco   U.K. Financial Conduct Authority formed under the Financial Nigeria  Services Act of 2012 and the Australian Securities and Investments Commission under the Australian Securities and Pakistan  Investments Commission Act of 2001. In 2013 South Africa was Peru  in the process of moving to this model. Russia  IOSCO principles15 require that a regulator should have adequate Saudi  powers, proper resources, and the capacity to perform its functions Arabia and exercise its powers. These powers should include comprehensive Slovenia  inspection, investigation, surveillance, and enforcement powers that South  include in relation to mutual funds and their operators and service Africa providers the power to approve such funds, monitor and supervise Turkey  their operation, and investigate and fine misdemeanours. However, Sources: World Bank case studies, country legislation, various sources as at year the power of regulators in fact may vary, for instance, in relation to end 2012. the ability to pass regulations and the ability to impose sanctions a. Regulates securities markets and banking but not insurance and pensions. such as fines. In addition, although the role of the regulator is 26 | MUTUAL FUNDS in developing markets: addressing challenges to growth primarily to ensure that the investor is protected, it may be tasked with other objectives, such as fostering competition in the industry. Table 2.5: Ability of the Regulator to Issue Regula- For instance, the U.S. regulator is required to consider “efficiency, tions in Case Study Markets as at Year End 2012 competition, and capital formation” in the industry.16 This can be Ability to Pass important because regulation can be a mechanism by which entry of Country Regulator Regulations new competitors in an industry is restricted, increasing concentration Brazil Securities and Exchange Yes and decreasing competition. Regulators may also be given market Commission development mandates, as in Kenya, although this may create an uneasy tension between protecting investors and adopting a more Kenya Capital Markets Authority No permissive stance to allow the market to expand. Morocco Securities Ethical Council Yes Peru Securities Market Yes Where possible, primary legislation should give the regulator Superintendency the legal standing to pass regulation, so that regulations can be updated in a timely manner in keeping with market trends (see Turkey Capital Markets Board Yes table 2.5). However, it is quite common for only a ministry to have Source: Relevant legislation. such a power in which case if the regulator is not given this status, it will have to compete for the attention of the relevant ministry as tribunals and ombudsmen) will be needed if the regulator has very (usually Ministry of Finance) to get regulations adopted. The risk strong powers (see box 2.3). In Brazil the law governing mutual funds in this case is that regulations may take a long time to pass, which empowers the regulator, the Securities and Exchange Commission, may hinder the ability to respond to change and to innovation in to investigate and, if appropriate, punish irregularity. Penalties range the market. It is preferable also for regulators to be empowered to from warnings and fines to revoking licenses. issue whatever regulations are needed to protect investors or to fulfil its responsibilities, rather than being empowered only to pass regulations governing a specified list of areas, which again may Self-Regulatory Organizations and Trade limit a regulator’s ability to accommodate market innovation. Associations In some countries, legislation enables regulators to delegate some Regulators with inadequate resources and powers are unlikely of their powers to self-regulatory organizations (SROs). SROs are to be able to create and maintain the market confidence crucial essentially regulators funded through regulatory fees paid by the sector to mutual fund sector development. The regulator’s task can be that they regulate. They typically monitor and inspect members and quite enormous, given that one may find large numbers of operators may have powers to discipline them through fines or other measures. and of mutual funds. Brazil’s Securities and Exchange Commission, These organizations can be effective only if all licensed entities of a for instance, had the task in 2012 of supervising an industry with specified category are mandated to join them. If given a choice of more than 400 managers and more than 11,500 separate funds.17 which SRO to join, market participants could engage in regulatory In practice, regulatory powers to enforce and impose sanctions vary arbitrage, exploiting any uneven standards of regulation. The regulator greatly. If the regulator is not given adequate powers in legislation, will typically set the licensing requirements for entities subject to self- as well as adequate resources to apply those powers, market regulation, and the law will require that all licensed entities have to participants can misbehave without deterrent and public confidence join an SRO and obey its rules. The Capital Markets Law of 2012 of in the market will dwindle: For instance, a regulator cannot effectively Turkey, for example, requires all relevant institutions to join the SRO, deter misbehavior if their only real disciplinary power is to apply fines the Capital Markets Association of Turkey.20 IOSCO principles require of a few hundred U.S. dollars. Conversely, checks and balances (such that regulators have oversight over SROs. Box 2.3: Regulating by “Function” or “Institution” When a country is considering establishing or regulating financial or securities markets, it will need to decide on an optimal regulatory approach, as well as how to empower, resource, and establish the regulator. In considering the regulatory approach to the financial services industry, policy makers will need to consider whether to regulate by function or by institution: •• If regulating by function, each financial services activity, which may (or may not) be under a financial services conglomerate—whether banking, insurance, or mutual fund management—will need to be clearly distinguished18 and be separately subject to regulation and a specific regulator for that function (for example, securities business under a securities regulator and banking under a banking regulator).19 •• If regulating by institution, the financial services institution—typically a bank—will be given blanket permission under a single banking license to carry out all categories of financial services business, which will be regulated by the banking regulator. Generally, regulating the mutual fund sector by “function” rather than by “institution” is preferable because it allows clearer definition and helps to eliminate conflicts of interest by creating internal “Chinese walls.” Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 27 In some jurisdictions, a trade association may take on some aspects of self-regulation, while not formally acting as an SRO. Table 2.6: SROs and Trade Associations in Selected Trade associations may be composed of members that are either Markets at Year End 2013 the mutual funds themselves (e.g., the U.S. Investment Company Trade Institute) or, more commonly, the managers of mutual funds (e.g., Country Self-Regulatory Organization Association India’s Association of Mutual Funds)21 or wider groupings such as Brazil  (voluntary)a  asset managers. Trade associations typically promote the sector and seek to facilitate its development, not regulate it. They often collect, China  (statutory)  analyze, and publish data on mutual funds and their performance.22 Costa Rica  However, trade associations may sometimes carry out a degree Hungary  of self-regulation by setting codes and standards (for instance, for advertising) and monitoring compliance. In some cases regulation India b  may even require members to adhere to trade association standards. Indonesia  However, trade associations are different from SROs: Usually Kenya c membership of trade associations is voluntary, unlike with an SRO, Korea  (statutory)  and they rarely have the power to discipline their members other than by expelling them from membership.23 Examples of trade associations Malaysia  (statutory)  include Singapore, where all licensed funds join the Investment Mexico  Management Association of Singapore, which develops voluntary Morocco  codes of conduct and guidelines.24 In Morocco, all asset management companies are members of the trade association, ASFIM, which Nigeria None represents the industry in its relations with policy makers. Brazil’s Pakistan  Association of Financial and Capital Markets (ANBIMA) is a trade Peru  association of funds (and other securities activities), which also has Russia  a self-regulatory role. It publishes voluntary codes and standards for its members on aspects such as marketing, valuation, investment Saudi Arabia None management, and distribution. Although not a statutory regulator, Slovenia  ANBIMA’s contract25 with its members even allows it to discipline and South Africa  fine its members in case of misconduct. Some trade associations, such Turkey  (statutory)  as India’s Association of Mutual Funds, establish criteria for mutual fund distributors and may also register and monitor fund distributors. Sources: World Bank case studies, country legislation, various sources. Table 2.6 shows SROs and trade associations in select countries. a. ANBIMA is both a trade association and an SRO. b. Distribution-related only. Ideally there should be only one mutual fund trade association (unlike c. Kenya had two fund trade associations that were understood to be in the in Kenya, which had two at the time of the case study) because process of merging. the regulator can “divide and rule” if the two organizations lobby for different things. Although self-regulation has benefits, it is possible that self- “Third-Party” Regulation regulation can be undermined by member self-interest. SROs “Third-party” regulation refers to the day-to-day supervisory can relieve the regulator’s capacity constraints because they allow role entrusted to a mutual fund’s depositary or trustee in many more of the cost of regulation to be borne by the sector instead countries. The depositary or trustee is usually required to have the of the government. Second, SROs are more likely to be aware of appropriate license and is responsible for holding all a fund’s assets, the trends in the sector and thus may be better equipped than including cash, and keeping them safe and segregated. Given that the regulator to identify misbehavior. However, SROs may also be it holds all the assets and cash, the depositary of trustee either inclined to keep out new market entrants (which are required to has to deliver assets when they are sold or pay cash when they are be a member of the SRO) to protect the business interests of their bought. This allows the entity to gauge whether a fund complies with existing members. SROs may also not wish to punish their fellow investment and borrowing regulations better than the regulator. The members for activities in which they themselves may indulge. trustee or depositary should be required by regulation to supervise certain aspects of the fund’s operations such as the process of creating The sector must have sufficient scale to support a self-regulator or canceling shares or units, the valuation and pricing of shares or units, and/ or a trade association in addition to the regulator. In compliance with investment limits, and the payment of income to considering the role of SROs, policy makers may also wish to investors. It is important to note that not all law or regulation holds the consider whether the sector to be governed by the SRO has sufficient trustee or depositary responsible for such oversight. Where the fund scale to finance this, because the SRO will be solely dependent on has a board of directors or of individual trustees, the board will have revenues from members; if it lacks resources, it is unlikely to be able supervisory duties either instead of, or in addition to, the depositary; to be effective. Where securities markets are small, governments where the fund is contractual a fund council (similar to a board) may can and often do subsidize the regulator, and trade associations undertake such oversight; and sometimes the founder or sponsor of may be operated on a low-cost basis through members providing the fund is responsible for supervising fund operations. In these cases, services, so financing these institutions may be less of an issue. the fund will have a custodian that only safe keeps assets and does 28 | MUTUAL FUNDS in developing markets: addressing challenges to growth not have third-party supervisory duties. In some cases, as in Brazil and the mutual fund model, defines investor rights, and determines the in Turkey, the custodian is a central securities depository and not a arrangement for three key responsibilities.27 These are the following: commercial provider of custody services. •• Operating the mutual fund: This typically means being The auditor of the fund is also sometimes referred to as a “third- responsible for managing the investments and marketing and party” regulator and may be required to undertake compliance administrating the fund, although some of these activities checks. IOSCO requires that auditors should be independent of may be delegated. The entity termed the “operator” in this the entity that they audit and should be subject to adequate levels study—commonly a fund management company— is usually of oversight. Law or regulation should require audited financial responsible for operating the mutual fund. statements depicting the fund’s financial health to be provided to fund investors annually and filed with the regulator, usually •• Safeguarding mutual fund assets: The depositary or trustee is within stated deadlines. In some regimes the auditor may also typically legally responsible for this, or a custodian that has no be responsible for checking the fund’s compliance with laws and other function than safeguarding the assets (in some countries regulations. In addition, they may be obliged to report irregularity the custodian may be a central securities depository, which directly to the regulator. For example, in Morocco, the statutory may be helpful in markets where commercial custody services auditor must report any irregularity it finds during audit to the have not yet developed). supervisory authority, Le Conseil Déontologique des Valeurs •• Third-party supervision of the conduct of the mutual fund: If Mobilières (CDVM or Securities Ethical Council). a mutual fund does not have a board of directors or supervisory Effective third-party regulation must be consistently maintained. council, third-party supervision is usually required to be Regulation should require that if a mutual fund’s trustee, depositary, undertaken by a depositary or trustee. or auditor resigns, they inform the regulator why they have chosen The legal tradition of the country typically drives the legal to resign and whether they have concerns about the operation of structure for a mutual fund, with the most common structures the fund; they may also not be allowed to resign unless an eligible being trust, corporate, and contractual. Funds can be formed as replacement has agreed to serve in their place. companies under both common law and civil code legal traditions, but funds traditionally take the trust form only in common law Key Aspects of the Legal/Regulatory countries, such as India and Kenya. Civil code countries that do Framework not have trust law or precedent create mutual funds in contractual form, such as in Indonesia, Peru, and Russia.28 The condominium Defining a Collective Investment Scheme form used in Brazil is similar to the contractual fund, but derives from Portuguese legal traditions where the Roman law concept of It is useful for legislation to describe what a collective investment condominium was recognised. However, some countries deliberately scheme is and require that any publicly offered scheme must meet introduce legal structures for funds (and other uses) that do not specified requirements and be approved by the regulator.26 As derive from the legal traditions of the country concerned. For noted above, defining a collective investment scheme is important instance, Korea introduced trust law and trust-type mutual funds, because it enables the regulator to require entities operating as such and the United Kingdom (a common law country) has introduced schemes without a license either to become licensed or to cease contractual schemes (although these cannot be used by mutual undertaking such business. However, the definition of a collective funds that are eligible for public offer). Variations on fund legal investment scheme can be rather broad and may catch a range of structures are many and various. The summary given below does vehicles in its regulatory net, such as pension schemes, cooperatives, not seek to itemize every variation but to outline the key features or microfinance organizations, which would need to be excluded. If of each element of the structure and their significance. not carefully drafted, such provisions may require all schemes— whether publicly or nonpublicly offered—to meet requirements for In the investment company structure, the fund is a legal entity, publicly offered schemes (as was the case in Kenya). This would capable of taking its own decisions through directors and effectively prevent the domestic operation of higher risk funds that shareholders, and may be taxable. The investor acquires shares are not publicly offered and that are offered only to professional in the open-ended investment company and typically has the right or qualified investors. In turn, this may reduce the range of funds to redeem these shares upon request, as well as shareholder rights operating domestically and the diversification of revenue streams to under ordinary company law (unless the law governing mutual operators (and, indeed, send such business offshore). funds states otherwise). In many countries, this will include the right to vote at annual general meetings and at extraordinary general Enabling Mutual Funds and Determining Roles and meetings. Given that investment companies are a special form of Responsibilities in Different Legal Structures company, however, mutual fund law or regulation may augment the usual shareholder voting rights for companies by providing One of the key functions of the legal and regulatory framework additional rights to vote on changes to investment objectives or is to define the legal structures in which mutual funds can policy and increases in costs.29 The investment company structure be created. The legal structure of the fund typically embeds has three variants: the U.S. model, the continental Europe model, governance requirements to deal with some of the risks inherent in and the U.K. model (see box 2.4). Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 29 Box 2.4: Variants on Mutual Funds Formed as Open-Ended Investment Companies U.S. Model The U.S. model is most like an ordinary company, with a board of directors. Typically an operator takes the initiative to create the fund. The board of directors is responsible for protecting fund investors. The Investment Company Act of 1940 requires 40 percent30 of these directors to be independent of the operator. The law also requires fund directors to supervise fund operations and oversee areas of conflict of interest (such as fees) between the operator and investors. The U.S. model relies heavily on the availability of competent and experienced persons to serve as fund directors, which would be more challenging in emerging markets with nascent mutual fund sectors. Since the U.S. model places strong fiduciary duty upon the directors also, it requires products such as directors’ liability insurance, which may not be available in a developing market. Hence the U.S. model may be difficult to replicate in developing countries. •• Operating the fund: The board of directors is responsible, and contracts the various providers of services to the fund. •• Safeguarding assets: The board of directors contracts a custodian to safeguard the assets. •• Third-party supervision: This role is undertaken by the directors of the fund. Continental Europe Model In the continental European model, the operator (typically the fund management company) will again take the initiative to create the fund and will appoint directors. Although the investment company has a board of directors, this model gives the depositary a high level of responsibility. The depositary is responsible both for safekeeping the assets of the fund and supervising its operation. The depositary is required to be at least functionally independent31 from the operator of the fund. •• Operating the fund: • For an externally managed fund, the directors will enter into contracts with various entities to provide services to the fund (this variation is “externally managed”). • For a self-managed fund, the directors appoint staff to manage the investments of the fund and operate the fund, although some activities may be contracted out. Although this model is unusual, investment companies can be self-managed in some continental European countries (e.g., Luxembourg). •• Safeguarding assets: The depositary is responsible for safeguarding the assets. •• Third-party supervision: This role is undertaken by the depositary. U.K. Model The U.K. model32 includes the novel concept of an Authorised Corporate Director (ACD). Although the U.K. investment company with variable capital can have individual directors, it is required to have an ACD or a legal entity licensed to manage a CIS. The ACD is thus the operator of the fund. Because the ACD cannot as a director supervise the operator of the fund (itself), the depositary, which is required to be legally independent of the ACD, is required to undertake this role. The logic behind this approach is that it is easier to regulate a licensed entity, and require this entity to have adequate capital and insurance, than to regulate individual fund directors or recover substantial damages from them. •• Operating the fund: The ACD is responsible for operating the fund. •• Safeguarding assets: The depositary is responsible for safeguarding the assets. •• Third-party supervision: This role is undertaken by the depositary. U.S. investment company Continental Europe investment company U.K. investment company with variable capital with variable capital with variable capital 30 | MUTUAL FUNDS in developing markets: addressing challenges to growth When formed as a unit trust, the fund is not a legal entity (but general meetings on fundamental changes proposed to the fund is taxable), and decisions can be implemented only through the such as changes to investment objectives or policy and increases trustee (or trustees) and the operator. A unit trust, being a trust, in costs from those stated in the prospectus. There are essentially must have a trustee or trustees, whether corporate or individual. three variants on the unit trust form. The first two relate to the In this structure, the investor acquires units in the fund and is ability to use either a licensed corporate trustee or a board of technically the beneficiary of the trust with legal rights as such and individual trustees (very similar to a board of directors). In the can redeem their units upon request. Typically investors have the third variant a “responsible entity,” which is in effect the corporate right to vote only at extraordinary general meetings, because such trustee and the operator of the fund combined, operates the fund. funds do not usually have annual general meetings (Kenya is an Box 2.5 describes these variants in unit trust form. exception). Investors usually have the right to vote at extraordinary Box 2.5: Variants on Mutual Funds Formed as Unit Trusts Unit Trust Formed by Trust Deed between Operator and Licensed Corporate Trustee This is the most common variant and is used in the United Kingdom and in various emerging markets including Kenya and Nigeria. The trustee usually must be completely legally independent of the operator of the fund. •• Operating the fund: The fund management company is responsible for operating the fund. •• Safeguarding assets: The trustee is responsible for safeguarding the assets. •• Third-party supervision: The trustee is responsible for supervising the operation of the fund. Unit Trust Formed by Trust Deed between Operator (or “Sponsor” of the Fund) and Individual Trustees This is an uncommon variant seen, for instance, in India. In India the trust deed may be either between the “sponsor” of the fund and a licensed corporate trustee (who must be fully independent of each other), or between the “sponsor” and a board of individual trustees (at least two-thirds must be independent of the sponsor). In the second case, the board of trustees functions similarly to the board of directors of investment companies. The “sponsor” must be an entity holding a financial services license that meets certain fit and proper requirements and that owns at least 40 percent of the appointed investment management firm. •• Operating the fund: The fund management company or sponsor is responsible for operating the fund. •• Safeguarding assets: The assets must be held by a custodian, which can be affiliated to the operator or sponsor but must act independently of the sponsor. •• Third-party supervision: The individual trustees or the corporate trustee are responsible for supervising the operation of the fund. Unit Trust Formed by Its Constitution and the Responsible Entity In this last variant, the trustee and the operator are “rolled up” into a single licensed firm known as “the responsible entity,” as seen in Australia. The fund is formed through a constitution, or a legally enforceable document between the responsible entity and the fund members. The constitution lays out the rights, duties, and liabilities of the responsible entity in operating the fund. •• Operating the fund: The responsible entity operates the fund. •• Safeguarding assets: The assets are held by a custodian, appointed by the responsible entity. The custodian must be functionally independent from the responsible entity. •• Third-party supervision: The responsible entity supervises the operation of the fund Unit trust formed by trust deed between Unit trust formed by its constitution operator and licensed corporate trustee and the responsible entity Units Money Units Money Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 31 A contractual fund is not a legal entity and is regarded for tax as contractual funds in Turkey. Similarly, in Kenya, although again purposes as a collection of individuals; only the individuals are the law enabled open-ended investment companies (as well as unit taxable, not the fund. The contractual fund does not typically exist trusts), the CIS regulations at the time of the case study did not lay in ordinary law, so the nature and functioning of the fund has to be out clear requirements for these investment companies. Hence no completely enabled by fund law and regulation. In the contractual mutual funds were structured as open-ended companies.36 In some form, the investor acquires units in the fund and is known as countries where both corporate and contractual funds are enabled, a unitholder or participant. Investor rights completely depend the contractual form may be more commonly used because of tax upon provisions made in the law and regulation governing such advantages or because it is cheaper or less complicated to operate. funds but always feature the right to redeem units upon request. For example, in Morocco, primary legislation allowed the creation of Typically such funds do not have annual general meetings, so mutual funds as investment companies (SICAVs) or as contractual investors may be able to vote on fundamental changes to the fund funds (FCPs). Although the very first mutual funds were created in only at extraordinary general meetings. However, in many cases, company form, market professionals rapidly stopped launching legislation and regulation governing contractual funds do not even new investment companies and have used the contractual form, require an extraordinary general meeting for such decisions.33 which is more flexible and less costly, ever since. In some cases, There are essentially three variants of the contractual fund, with a corporate structure fund may be more suited to holding certain the second variant being only a slight adjustment on the first. The assets, such as real estate, because of tax efficiency, and so enabling condominium form used in Brazil is also discussed as a contractual more than one form may be necessary rather than optional. fund (see box 2.6 for details). Despite the prevalence of different legal structures, the operational Structural Variations That Facilitate Economies of characteristics of mutual fund structures are becoming Scale increasingly similar, as regulatory frameworks cohere around the In addition to the structures discussed above, legal and IOSCO principles and, increasingly, regional standards. (See table regulatory frameworks for mutual funds may permit additional 2.7 on the key roles and responsibilities associated with the different structural options to allow the mutual fund sector to achieve legal structures.) IOSCO’s international principles on Collective economies of scale. These structural options are the “umbrella Investment Schemes (1994) established a series of benchmarks for fund,” the “multishare (unit) class” structure, and the “master/ the quality of regulation of mutual funds (see box 2.2)34 and continue feeder” structure. to inform the way in which regulation is structured and implemented regardless of the legal form of the fund. To facilitate regionalization, An umbrella fund is a single mutual fund with multiple investment trade blocs, such as the European Union, increasingly set common compartments, which can cater to different investor needs operational and supervisory standards. The European Undertakings without the costs associated with creating separate funds. The for Collective Investment in Transferable Securities Directive (UCITS) umbrella fund37 contains a number of “subfunds,” all of which fall regards all legal structures of fund—contractual, company, and under the umbrella fund’s single legal structure—corporate, trust, trust—as equal in terms of investor protection; provided such funds or contractual—and have the same operator and depositary/ are created in a member state and comply with the directive, they trustee/custodian. The subfunds under the umbrella structure each can be sold in any other member country. A study undertaken by have a distinct investment objective and portfolio that is separately the OECD35 concluded that “no legal form or governance structure managed, reported on, and accounted for. The operator benefits for collective investment schemes has been accepted as inherently from the umbrella fund structure because the regulatory process superior to other systems.” is undertaken once in full when the umbrella fund is approved, and subsequent funds can be added by a shorter notification process. Although more than one legal structure may be permitted by law, Investors benefit because they can move from one subfund to not all the legal forms may actually be in use by the mutual fund another if they wish to change their investments and they also industry of a particular country (see tables 2.7 and 2.8). Among benefit from greater economies of scale within the umbrella fund.38 the 19 sample countries shown here, even if the corporate model was enabled, the most prevalent structure in practice was the A single fund or subfund can achieve greater economies of scale if contractual or trust fund. In fact, among the sample countries, only regulation enables it to issue different classes of shares or units, the mutual fund sectors in Mexico, Morocco, and Korea operated the each with a different charging structure and/or denominated in a corporate structure. Various reasons—tax efficiency, profitability different currency so it can attract capital from a wider range of for operator, flexibility of use, and the like—may account for one target markets. This enables these units/shares to be sold across legal form being used over another, if multiple legal structures are borders or to clients with different currency preferences and to suit offered by law. In some countries, one form may be more clearly different client or distributor needs, and it prevents the need to defined by regulation. For instance, in Turkey, although the new have multiple separate funds for different investors or for different Capital Markets Law of 2012 permitted open-ended funds to be currencies. The lack of ability to issue unit classes in different structured either as investment companies or contractual funds, currencies was cited by operators as one barrier to developing the regulations for investment companies were not in place at the time mutual fund market in Turkey. of the case study. Hence in 2012 mutual funds were formed only 32 | MUTUAL FUNDS in developing markets: addressing challenges to growth Box 2.6: Variants on Mutual Funds Formed as Contractual Funds Classical Contractual Fund This is a common form in continental Europe and countries influenced by continental European tradition, such as most of Central and Eastern Europe, Russia, Latin America, and Asia. These funds have different names in different countries; in France and Luxembourg, they are “Fonds Communs de Placement” (FCP); in Germany, they are “Investmentfonds”; in Spain they are known as “Fondos Communes de Inversión” (FCI). Depending on the law of the country, the fund is typically created either by a contract between (1) the operator and the depositary, with the investor becoming a party to the contract by buying units in the fund or (2) the operator and the investor, where the investor buys units in the fund under the constitution and/or the prospectus of the fund. •• Operating the fund: The operator is responsible for operating the fund. •• Safeguarding assets: The depositary is responsible for safekeeping assets of the fund. •• Third-party supervision: The depositary is responsible for supervising the operation of the fund. Contractual Fund Formed by Contract between Operator and Depositary Units Money Variant on Classical Contractual Fund In this fairly rare variation, the fund is created by a contract between the operator and the custodian,a or sometimes the operator and the investors. The fund must have a custodian to safeguard assets but does not require a depositary to supervise operation of the fund. In some cases, supervision is by the founder of the fund, as in Turkey until 2012. In others, as in Peru and Saudi Arabia, the fund has a “council” or “board” of individuals who may be elected by fund investors to oversee the operation of the fund and therefore have a supervisory role. This may be considered a weaker governance structure in terms of protecting investors because while the depositary supervises day-to-day fund operations, the council may meet intermittently and will depend on information provided to them by the operator. •• Operating the fund: The operator is responsible for operation of the fund. •• Safeguarding assets: The custodiana is responsible for safekeeping assets of the fund. •• Third-party supervision: The council or the founder of the fund is responsible for supervising the fund. Brazilian Condominium The Brazilian condominium,39 a form of joint ownership deriving from Roman law, is very similar to a contractual fund. A licensed entity, known as the “administrator,” creates the fund through a constitution. The administrator is responsible for both operating and supervising the fund. This is similar to the Australian “responsible entity,” which combines the roles of operator and trustee within a single entity. In the Brazilian model the administrator may appoint an investment management firm (to which it may or may not be affiliated) to manage the assets of the fund. The administrator will also appoint a depositary, which has both safekeeping and supervisory duties. The Brazilian administrator-based structure offers considerable flexibility and encourages sector development, because the administrators can create and operate mutual funds for independent investment managers that meet fit and proper and regulatory requirements. •• Operating the fund: The administrator is responsible for operation of the fund. •• Safeguarding assets: The custodiana is responsible for safekeeping assets of the fund. •• Third-party supervision: The administrator is responsible for supervising the fund. a. The custodian may be a central securities depositary. Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 33 Table 2.7: Legal Structures of Mutual Funds Envisaged in Selected Emerging Markets Countries as at Year End 2012 Legal Structure Envisaged by Law In Use Corporate Kenyaa Nigeriaa Mexico Indonesiaa South Africaa Moroccob Mexico Korea b Koreab Morocco b Turkey a Contractual China Peru China Peru Costa Rica Russia Costa Rica Russia Hungary Saudi Arabia Hungary Saudi Arabia Indonesiaa Slovenia Indonesiaa Slovenia Morocco b Turkey a Morocco b Turkeya Trust India Pakistan India Pakistan Kenya a South Africa a Kenya a South Africa Malaysia Koreab Malaysia Koreab Nigeria a Nigeria a Condominium Brazil Brazil Sources: World Bank country case studies, country legislation, various sources. a. More than one legal structure enabled. b. More than one legal structure used in practice. Table 2.8: Key Roles and Responsibilities of Different Parties to Mutual Funds Worldwide, by Legal Structure Supervision of Investment Legal Structure Operator of Fund Administration Custody Operator Management Trust Fund management Trustee/s or Fund management Fund management Trustee or responsible company or sponsor responsible entity company or sponsor company or sponsor entity or responsible entity or responsible entity or responsible entity Corporate Self-managed by Board or depositary if Board Board Board or depositary if board law requires law requires Board Board or depositary Board Board Depositary or custodian ACD (fund Depositary ACD ACD Depositary management company) Contractual Fund management Depositary or fund Fund management Fund management Depositary or company or founder council or founder company or founder company or founder custodian Condominium Administrator Administrator Administrator Administrator Custodian Sources: World Bank studies, various sources. Enabling the master/feeder structure when mutual funds are investment management level. For example, feeder UCITS could be sold across borders generates economies of scale in investment created and based in France, Germany, Italy, Spain, and the United management. This structure allows one fund (the feeder) to have Kingdom; each of these funds may buy units in a single master only one investment, that is, shares or units in the master fund. fund based in Luxembourg, whose objective is to invest in European Generally, a fund must have a diversified portfolio: The feeder fund equities. Each feeder fund investor will be subject to tax on their is permitted to meet this diversity requirement by investing in the feeder fund investment in their country of residence. However, the master fund, which has to meet diversified portfolio requirements.40 master fund in this structure must not be subject to tax, because Because investment management is essentially done only at the otherwise investors in the feeders will suffer tax on their returns master fund level, instead of separately by each feeder fund, both at the master and at the feeder level.41 this structure permits economies of scale to be generated at the 34 | MUTUAL FUNDS in developing markets: addressing challenges to growth Enabling Funds of Funds May Improve Competition enjoy a tax advantage compared to direct investment in mutual funds (as in America) or where they provide a cheaper method of Funds of funds are funds that are created specifically to invest passive management than indexed mutual funds. in other investment funds, including mutual funds; they can be useful in facilitating the development of smaller specialist The full range of structural variations is rarely seen in early fund management companies and increasing competition. emerging markets but is more common in more mature emerging Funds of funds cannot operate unless they are permitted to invest markets such as Brazil. As can be seen from table 2.9, broadly, the predominantly in other funds. In Kenya, funds of funds cannot more developed the capital market in the country concerned, the operate because regulation states that a fund cannot invest more greater the variety of these structures that are enabled. than 25 percent of its value in collective investment schemes. Funds of funds have been very successful in Brazil, where they represent around 45 percent of all funds by number. They have two key uses. Permitted Founders of Mutual Funds One is in asset allocation funds or multiasset class funds, because Law governing mutual funds should identify which entities or using funds as underlying assets enables more rapid and easier persons may found mutual funds. Usually this may be done only changes to asset allocations; units in an equity fund can be sold by an entity that has a specified type of license except where and units in a fixed income fund bought instead more quickly than individual directors of a corporate fund are founders. However, the selling a portfolio of equities and buying a portfolio of bonds. The nature of the license required may vary from country to country second use of funds of funds is the so-called “best of breed” fund (see table 2.10). In the United Kingdom, for instance, only an entity of funds, where a fund operator owned by a bank, which has its that has a license that permits it to operate a collective investment own distribution, will create the fund of funds under its own brand, scheme may create a mutual fund; Peru has a similar requirement. but the fund of funds will then invest in a range of funds managed However, in Brazil, investment funds are required to be founded by by other—often specialist—operators. This offers bank clients the an entity licensed as a fund administrator under Instrução 306;42 reassurance of the bank’s brand together with the performance of these are typically major financial institutions, such as banks. The the “best” of other funds. This is one way that independent fund administrator is responsible for operating the fund and complying managers who lack their own distribution networks can access the with regulations, but it may delegate investment management to distribution power of banks. another entity.43 In Brazil, the administrator can also create funds at the request of suitable independent investment managers. In Exchange-Traded Funds (ETFs) are Another Variant Kenya, although an entity holding a license as a fund manager could found an open-ended publicly offered fund, entities licensed on the Mutual Fund Form as securities broker or investment banks could also do so (although Exchange-traded funds are a variant on the mutual fund only an entity with a fund manager’s license could manage the structure found only in more developed emerging markets assets of these funds). such as China, India, Korea, South Africa, and Turkey as well as mature markets such as the United States. Smaller ETF markets include Hungary and Nigeria (with only one domestic ETF each) and Licensing Requirements for Fund Operators, Malaysia. This is because such funds usually track a named index, Custodians, Depositaries, and Trustees and so, like other passively managed mutual funds, they need both Fund operators and the corporate entities that provide trustee an index to track and the ability to trade the constituents of the and depositary services and take custody of mutual fund assets index daily to replicate the index accurately. These needs cannot be are required to be licensed to carry out their business. IOSCO reliably met in early emerging markets. Although ETFs have much principles require that both the operator of the fund and the entity in common with mutual funds, differences are found in the way that that plays the role of custodian, depositary, or trustee must have they are created and in the way fund shares or units are bought human, financial, and technical resources necessary to operate and and sold, which is on an exchange (hence the name) rather than provide services to the fund and to ensure, on an ongoing basis, that through the operator. ETFs are also more successful where they the fund complies with the legal and regulatory framework. They Table 2.9: Presence of Structural Variations in Case Study Markets as at Year End 2012 Multiple Share or Master-Feeder Domestically Country Umbrella Funds Funds of Funds Unit Classes Structures Based ETFs Brazil      Kenya      Morocco      Peru      Turkey      Source: Case studies. Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 35 Table 2.10: Required Licensed Status for Entities Responsible for Mutual Fund Operation for Selected Countries Responsible for Mutual Fund Marketing and Country Creation Investment Management Administration Distribution Brazil Administrator Administrator Administrator Administrator Kenya Promoter: fund Fund management Fund management Promoter management company, company company securities broker or investment bank Morocco Fund management Fund management Fund management Fund management company and depositary company company company bank Peru Fund management Fund management Fund management Fund management company company company company Turkey Previously founder (a Previously founder, Previously founder, Previously founder, bank, insurance company, now fund management now fund management now fund management securities broker or company company company pension or charitable fund), now fund management company Source: World Bank case studies as at year end 2012. must also meet standards for honesty, integrity, and competence, increased as assets under management grew. And in Peru, although which would include a check to establish that the owners of the the minimum capital required for a fund management company is entity are “fit and proper.” S/.750,000 ($260,000 approximately), the paid-in capital must always be 2 percent of funds under management. Regulation usually requires the fund’s operator to have a minimum amount of capital to be licensed; however, a very Mutual fund assets must typically be segregated and held large initial capital prerequisite can be a barrier to entry and by a licensed trustee, depositary, or custodian (depending can perpetuate dominance by banks and insurance companies. on the nature of the fund). Regulation usually requires these Because operating a mutual fund is not in itself very capital entities to have a higher minimum capital requirement than fund intensive (unless delegation is not permitted, in which case systems management companies because generally they hold high values of and staffing demands may be greater), the minimum capital assets on behalf of their clients. Typically the depositary or trustee requirement largely plays a prudential role. Ideally, it ensures that or custodian to a fund will hold (and safeguard) its assets as a an operator has sufficient liquid resources to continue to operate nominee.45 the fund even if there has been significant loss of revenue, or during an interim period if it is to be replaced by another operator.44 The fund’s trustee, custodian, or depositary must be at least However, a very high capital requirement can deter new entrants functionally independent of the operator to minimize potential in the market. China has one of the highest capital requirements; for collusion. A 2013 Morningstar report found that more than founding a fund management company requires an initial fully paid half the countries surveyed allowed the management company in capital of Y 100 million (roughly $16 million). Malaysia, on the and the custodian to be owned by a common entity.46 Under the other hand, requires shareholder funds of RM 10 million (roughly UCITS directive the depositary is not required to be fully legally $3 million) to manage a mutual fund. High capital requirements independent of the operator but must be at least functionally present barriers to entry to small entrepreneurial start-ups and independent from it. In the vast majority of countries with unit trust thus may limit competition and perpetuate dominance by major type funds, however, trust law or precedent requires the trustee to financial institutions such as banks and insurance companies. be fully legally and functionally independent of the operator. Kenya is unusual in this regard, because one entity is allowed to own up to Some regimes require the fund management company to 10 percent of the other.47 have minimum capital that is proportionate to funds under management. For instance, in the EU, fund management companies It is generally easier for the regulator if banks—which most must have a minimum initial capital of €125,000 (roughly commonly provide depositary, trustee, or custodian services— $168,000 at the time of writing); however, this capital requirement undertake these activities through a separately capitalized increases as funds under management increase (up to a maximum subsidiary, because this subsidiary can be licensed and supervised of €10 million or $11 million). Similarly in Turkey, the minimum under securities and mutual fund related law and regulation.48 capital required was TL 397,000 ($186,000 approximately), which With a separately capitalized subsidiary, it is easier to identify 36 | MUTUAL FUNDS in developing markets: addressing challenges to growth conflicts of interest because revenue flows to the subsidiary are financial regulator, and have not been refused a license or had a easier to identify. Conflicts of interest could arise, for example, if a license withdrawn. The “fit and proper” test may be conducted by bank as depositary or custodian is privy to fund portfolios or trades self-certification,49 or, more commonly, the regulator may verify that may be of interest to its investment banking operation or its the suitability of key personnel through police checks or through proprietary trading desk and could make use of this knowledge. information from other authorities. In addition, key personnel If banks do not have to form a separate subsidiary to undertake must establish competence through professional qualifications. trustee, depositary, or custodian work, and the regulator does not These qualifications are usually specific to the particular role50 also govern banking, it may be difficult to ensure that the trustee, and may consist of academic degrees or other qualifications and depositary, or custodian is accountable to the regulator of mutual practical experience. China, for instance, requires a fund’s senior funds. In some countries, including Turkey, custody of mutual management to have a “fund practising qualification.” In Brazil, fund assets is undertaken by a specialized division of the central the trade association, ANBIMA, devises and administers a wide set securities depositary. This may be the most practicable way of examination syllabuses to qualify personnel for different levels forward in nascent markets where there may be a lack of providers of management and administration. In Turkey the self-regulatory of safekeeping or supervisory services (see table 2.11). body, the Turkish Capital Markets Association, similarly trains fund market professionals. In the United Kingdom, the Chartered Whatever the structure used, it is important that all fund assets Institute of Finance and Investment, which is a parallel standard- are safeguarded, not just the securities portfolio. For instance, setting, regulator-approved institute, designs a wide variety of at the time of the case study, the Kenyan CIS regime did not hold specific qualifications. Less mature fund markets, such as Kenya, trustees responsible for safeguarding all fund assets, but instead do not tend to have this level of qualification requirement. required them only to ensure that “the custodian takes into custody all the collective investment scheme portfolio.” This language could Operators, custodians, depositaries, and trustees should be be interpreted as the custodian being required to hold only the required to demonstrate continuous compliance with law and securities held by the fund, and not the cash, which clearly reduces regulation. Before licensing, the applicant must usually present investor protection. Fund assets should also be segregated from the a business plan that shows the organizational structure and assets of the fund’s operator, depositary, or trustee or custodian, resources, including procedures and systems, such as internal as well as other clients of the depositary or trustee or custodian. audit and risk control. Regulations should require licensed entities Regulation should ensure that if the entity that holds fund assets to present regular compliance reports. The contents of such reports were to become bankrupt, the fund’s assets should be clearly and of inspections of entities may be used to facilitate “risk-based distinguishable and must not be part of the bankruptcy estate of supervision,” whereby the regulator categorizes regulated entities the entity concerned. according to the perceived risk they present to the regulator’s objectives (for instance, financial stability or consumer confidence). IOSCO standards require the operator, custodian, depositary, The regulator can more effectively allocate its limited resources to and trustee to employ “fit and proper” and competent key senior paying the most attention to those entities that pose the highest personnel. “Fit and proper” implies that these personnel must have risk to their objectives, because they cannot realistically check clean personal records: They have not declared bankruptcy, have everything in detail in rapidly growing markets. For example, in no convictions for financial crime, have not been censured by a Table 2.11: Custody Arrangements for Different Legal Structures Country Fund Legal Structure Supervision of Fund Operation Safekeeping of Fund Assets Brazil Condominium Administrator Central securities depositaries for domestic assets Custodian bank for foreign assets Kenya Unit trust Trustee Trustee responsible for appointing custodian Investment company Directors Custodian Morocco Investment company and contractual Regulator, directors (investment Custodian bank fund company), auditors Peru Contractual fund Regulator (no third-party supervision) Custodian Turkey Contractual fund Founder a Custodiana (usually the central Depositary b securities depositary) Depositaryb Source: Case studies. a. Until year end 2012. b. Under Capital Markets Law December 2012. Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 37 Brazil, with more than 11,500 funds, the regulator has had to principles require full, accurate, and timely disclosure to prospective develop and use sophisticated IT systems that identify anomalies. investors with all the information necessary to make an informed investment decision. The offering document containing this In general, operators of mutual funds should not be permitted information is commonly called a prospectus, and the operator must to undertake other business activities that may pose conflict of submit this document to the regulator for registration or approval.54 interests. In some countries the regulatory framework may permit Although regulation requires a full prospectus, this can be very long the operator to undertake a wide range of activities; for instance, and detailed and is unlikely to be easily read or understood by the in Kenya fund operators can be investment banks. However, if the average investor. Many regulators therefore now consider that a fund operators can undertake securities brokerage or investment shorter version written in plain language, containing all the relevant banking, they may risk amplifying conflict of interest with fund information and consistent with the full prospectus, may serve investors.51 Thus fund regulation usually restricts the operator’s ordinary investors better. In addition, standard content and flow activities to only operating CIS and providing ancillary services can help the investor more easily compare one fund’s prospectus and managing other portfolios, which allows it to diversify its with another. The U.S. and Canadian mutual fund regimes permit revenue streams within limits that may make the business more summary prospectuses, which are just a few pages long and contain sustainable, particularly in smaller markets. This requirement also key information about a fund. The Hong Kong regime also permits has the effect of ensuring the operator focuses on developing the a simplified prospectus; in India the Key Information Memorandum fund business. serves the same purpose; and the majority of Brazilian trade association, ANBIMA’s, members have agreed to a standardised Licenses may need to be renewed annually or may be perpetual short form prospectus. The Key Investor Information document (unless withdrawn or canceled). In some legislative systems required to be used by UCITS has a standardized format, with all licenses can be granted only for a year or other specified period. relevant information on two sides of A4 paper. This approach is now This was the case, for instance, in Kenya, which required annual being copied in various countries.55 licensing at the time of the case study. Although this allowed the regulator to withhold the license renewal in case of misbehavior, it also meant that the (often underresourced) regulator would be Regulating Investment, Borrowing, and Liquidity burdened every year with relicensing52 and that fund operators It is extremely important that law or regulation establishes suffered from lack of certainty of renewal. a requirement that a publicly offered mutual fund must have a diversified portfolio, and that it must invest and borrow Enabling operators to delegate activities—but not only in conformity with limits set by law or regulation. If there responsibilities—may enable a wider range of entities to enter is no requirement for a diversified portfolio, and only one or the market and facilitate competition. Although some countries’ two investments are held, then investors are paying an annual legislative systems place the responsibility for operating, management fee for very little reason and are not being provided managing, and marketing the fund all on one entity (commonly with the diversification of risk that is the absolutely key function the fund management company), they allow delegation of of a mutual fund. If clear limits are not placed on eligibility of many of these activities to specialist service providers. Thus, for investments and on amounts, types, and duration of borrowing, instance, a new entrant to the mutual fund management market it is difficult for the regulator to prevent unsuitable investments can reduce market entry costs by appointing a service provider being made—for instance, highly illiquid assets—or prevent instead of setting up its own registration system. Mutual fund law excessive borrowing. Over the long term, a weakness of this type or regulation should therefore specify the entity responsible for an is likely to lead to loss of confidence as investors experience activity but permit this responsible entity to delegate the activity unexpectedly volatile or poor returns or are unable to exercise their to another entity that meets appropriate eligibility requirements. absolute right to redeem from a fund if—at the extreme—a fund is The delegator remains responsible and must monitor that the completely hollowed out by borrowing. It is for these reasons that delegate complies with all relevant regulatory requirements. IOSCO principles require clear rules around types of investments, Another alternative, as discussed earlier, is to permit entities diversifying the portfolio, and restricting borrowing to “address the such as the “administrator” in Brazil or the “responsible entity” investment goals, the risk profile and the degree of liquidity required in Australia, which may operate funds on behalf of selected for a CIS to meet redemptions in all market conditions” (see box investment managers, thus facilitating more market entrants 2.2). Chapter 3 discusses this in more detail. and potentially greater competition. Regulation should establish that funds of a specified type must Regulating Marketing and Fund Prospectus invest only as permitted by regulation. For instance, the key concept of a MMF is that it should have minimal risk to capital; Funds should be required to have a regulator-approved offering thus if the investor puts $1 in, he or she will get at least $1 out (that document that ensures “that there is full, accurate and timely is, the fund will seek to maintain a “constant value”). If regulation disclosure to prospective investors providing all the information does not establish that such funds may only hold investments of a necessary for an investor to make an informed investment limited duration (at the time of acquisition of 365 days or less), then decision.”53 Regulation may also permit or require a summary, operators of such funds could buy longer-term instruments that reader-friendly, document that presents information with standard may pay a higher interest rate (and so be attractive to investors) content and flow to allow investors to easily compare funds. IOSCO 38 | MUTUAL FUNDS in developing markets: addressing challenges to growth but whose capital value is more likely to fluctuate. This, in turn, of total assets under management was invested outside of Morocco, could risk the fund’s ability to maintain a constant share or unit mainly in euro-denominated funds or fixed-income securities. If value, which investors may not understand, particularly if this is domestic funds do not offer international exposure, investors often not required to be fully disclosed. The Kenyan fund market has buy foreign domiciled funds instead, which clearly reduces the scope faced this problem, because regulations at the time of the case for developing domestic funds. The legal and regulatory framework study did not specify the investments that a MMF is required to may also place limits on cumulative or individual fund exposure to hold, and MMFs apparently frequently hold bonds of up to five foreign assets. For example, Securities and Exchange Board of India years’ duration. The regulator has no power to prevent these being (SEBI) regulations in India cap foreign investment by mutual funds presented as “MMFs” because there is no definition of such funds or to a cumulative total across all mutual funds of $7 billion, with a cap of the investments they are permitted to hold. IOSCO requires that of $300 million per mutual fund. In addition, SEBI regulations cap a MMF be explicitly defined and that limits be set on the types of investment in foreign exchange-traded funds (ETFs) to a cumulative assets in which they invest and the duration and maturity of assets total of $1 billion across all mutual funds, and a maximum per fund held56 and recommends that where feasible such funds should be of $50 million.59 variable rather than constant net asset value. Regulation should allow a fund only to borrow up to about 10 Regulation will also need to specify those types of mutual funds percent of fund assets,60 and only for specific purposes such as to that need very specific investment powers, otherwise such funds meet redemptions and only for the short term, primarily because will be unable to function. This includes feeder funds that invest open-ended funds are obliged to buy back investor shares on a only in one other fund (the master fund) or cash and so would not regular basis. If borrowing were not limited in this way, and if fund normally be permitted to operate because funds can typically have assets declined because of redemptions, the debt-to-asset ratio only up to 20 percent of fund value in exposure to another fund. It could increase to unsustainable levels. At year-end 2012, Turkish also includes funds of funds (which invest only in other funds, which mutual funds were permitted to borrow up to 25 percent of asset again, may be cumulatively limited to 20 percent of fund value), value, which is unusually high; Kenyan regulations are silent on the MMFs (see above), and indexed funds (which may need to invest subject. more than 10 percent of their value in any one issuer to match the index they track, which is not usually permitted). Regulation should not permit mutual funds to lend in any way, other than by making deposits or buying debt securities. Here Typically regulations should also specify what percentage of a again, the danger is that the lending could, because of redemptions, fund’s assets may be invested in any one issuer’s securities and become an ever higher proportion of the fund; fund investors assets set caps on the percentage of any one issuer’s securities that the could erode or lending may not be able to be repaid. fund can hold.57 This is, first, because mutual funds should diversify risk and, second, because they are usually tax privileged, so tax Regulation should forbid or severely limit mutual funds from authorities are concerned that they should not be used as holding investing in illiquid assets; however, in many developing countries, companies or as vehicles to avoid tax. For this same reason, many funds may find few liquid assets to invest. As discussed above, regimes also require that funds are owned by a diversity of investors. open-ended mutual funds give their investors the right to invest or On the other hand, some regimes such as Brazil and Morocco permit redeem, usually on a daily basis. This, in turn, means that the fund funds to be created for a single institution or individual. must hold investments that are easy to buy or sell in reasonable quantity at any time without significantly affecting the market Investment in foreign assets should not be prevented by mutual price. IOSCO, in a recent report on CIS liquidity,61 notes: fund law or regulation because this may reduce the potential for the sector to develop and its ability to compete with foreign- In the context of liquidity, CIS differ fundamentally from banks domiciled funds. Other barriers to foreign investment may exist in in that “maturity transformation”62 is not an inherent feature the form of exchange controls, or because of relative tax efficiency of their operation, and the majority of CIS do not engage in compared to investing in domestic assets, or perhaps because of such transformation to the extent that banks do. For example, cost or lack of expertise in investing in such assets, which may be many CIS use investors’ subscriptions to invest in highly liquid better provided by foreign fund competitors. Historically, institutional large capitalization listed company shares, which can quickly investors have often invested in mutual funds partly because these be sold if necessary to provide liquidity for meeting redemption funds offer a cost effective method to gain exposure to certain requests from investors in the CIS. Neither does the majority regions, countries, or asset classes. In Turkey, for instance, law and of CIS provide any “promise” or guarantee that investors will regulation allows mutual funds to invest abroad and Turkish pension get back (at least) the same amount of money as they initially schemes might thus find it attractive to invest in domestic mutual invested. An investor in a CIS is a shareholder; as opposed to funds which invest in foreign assets, if it were not for the 10 percent a depositor in a bank, who is a creditor. … Liquidity crises are cap on pension scheme investment in mutual funds. However, in therefore less likely to cause systemic confidence problems some countries mutual fund regulation does prevent funds investing in CIS than in banking. Nevertheless, a CIS may experience abroad: For example, Brazilian funds generally cannot invest abroad, liquidity problems. Liquidity risk management in CIS is a although the “multimercado”58 type of fund, which can invest up to complex area: poor liquidity can arise from many different 20 percent abroad, has proved successful in recent years. Moroccan sources, some of which are outside the control of the entity mutual funds cannot invest more than 10 percent of the assets they operating the CIS.63 manage in foreign currencies. At the end of 2010, less than 1 percent Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 39 If liquid assets are lacking in a market, it may be best to enable funds or set investment requirements for these. Global databases65 closed-ended funds (see box 2.7), which are better suited to also broadly categorize funds into long-term funds (equity, bond, investing in illiquid markets and assets such as real estate and and mixed) and short-term funds (MMFs). However, this basic venture capital because they have no obligation to redeem their categorization does not cover the many gradations of objectives shares or units and pay out cash to investors. When creating a new of funds within each broad category. In markets with a vast range legal and regulatory regime governing funds, it is best to recognize of funds, investors need to know more precisely what their chosen closed-ended vehicles as funds and regulate them under that fund is going to invest in, and what the risks are, and so funds may regime. be further divided into subcategories: by sizes of company (e.g., midcap), by sector (e.g., energy), or by geographic focus (e.g., United States). Typically the trade association establishes more detailed The Need to Categorize and Classify Funds categories, such as is the case in Brazil. In Peru the regulator Regulation typically defines types of funds to identify relevant categorizes funds into 12 types, with further subcategorizations investment limits applicable to them; however, funds also need based on the duration of bond and fixed income funds. Although the to be categorized in more detail so that investors know what they Kenyan trade association does divide funds into categories, these are investing in, understand what risk they are taking, and can categories are not clearly defined and have no regulatory standing make effective comparisons between similar funds. Regulation and so cannot be enforced. Some regimes go further and define requires fund offering documents to state what their investment a risk classification system; for instance, the Malaysian trade objective is—for instance, income, growth, a mixture of these, or association (now an SRO) publishes detailed fund categories and capital preservation—and what investment policy they will pursue has also developed a risk classification system based on historical to achieve this—that is, by investing in equities, bonds, money volatility. In the EU, a UCIT’s “synthetic risk reward indicator,” market instruments, or a mixture of these. Usually rules will require calculated through a mandated risk classification system, must be a mutual fund to invest not less than a stated percentage, often 80 shown in the key investor information document. percent, in the assets relating to that fund category, for instance, in emerging markets equities. When countries do not have a standard classification system for mutual funds (such as Kenya and Turkey Regulating Fund Valuation, Pricing, and Fees at the time of the case study), it becomes difficult for investors to Regulators pay close attention to how a fund’s assets are valued understand what they are investing in and the associated risks, and, in turn, how each share or unit in the fund is priced, because and to make comparisons of performance and of cost. Kenya’s each category of investor in a fund—whether entering, exiting, or regulatory regime, for instance, does not clearly define types of ongoing—must be treated fairly. IOSCO principles require that the Box 2.7: Closed-Ended Funds and U.K. Example Closed-Ended Funds Closed-ended funds essentially operate like an ordinary public company: They market a one-off issue of securities (similar to an initial public offering) to attract a minimum value of capital that makes the fund commercially viable. If they succeed in attracting this minimum amount, the fund is formed either with a permanent life, or a fixed life of a specified period stated in the prospectus (usually five to 50 years). The fund is then listed, adding to the range of securities available in the market. Because the fund does not have to redeem its shares or units, it does not need liquid underlying assets. Thus the fund can invest in infrastructure, real estate, and venture capital–type companies although such funds may also invest in liquid securities. If the portfolios of such funds do become liquid over time, then they can convert to open-ended form. Before fund-specific law existed, closed-ended funds were created either using trust or corporate law. Thus in some countries (such as the United Kingdom), law and regulation do not include closed-ended funds within the definition of a collective investment scheme, and thus law relating to CIS does not apply to closed-ended funds. This is why countries that have, for historical reasons, followed the United Kingdom’s approach to regulating collective investment schemes have regulatory frameworks which do not govern closed-ended funds. Closed-Ended Funds in the United Kingdom In the United Kingdom, closed-ended funds are known as “investment companies,” that is, companies that exist to make investments, instead of creating goods or providing services. They operate under company law. Although the market conduct regulator governs the investment management of closed-ended funds formed as investment companies, the investment companies themselves are regulated only by company law and tax and listing requirements. Tax rules require that these funds may not be a close company,64 may not invest more than 15 percent of their value in any one issuer, and must be listed on a stock exchange. “Investment companies” are a specialist subset of listed securities that have their own listing rules because, for instance, they do not have trading histories when they are listed, unlike ordinary companies. 40 | MUTUAL FUNDS in developing markets: addressing challenges to growth regulator provides a methodology to calculate a fund’s net asset fund and servicing the investors, and costs of fee-based services such value (NAV) and a pricing methodology and system for entering as custodian, depositary, or trustee. In addition, the fund generally pays or exiting a fund that allows fair treatment for new, exiting, and for the cost of buying and selling investments, duties or taxes, legal ongoing investors.66 Essentially, the NAV is the value of the fund’s advice to the fund, regulatory fees, performance fees71 and producing assets at the most recent market price, less the debts owed by the offering document. In some jurisdictions, the fund is permitted the fund.67 NAV should be calculated as often as the fund deals in to pay for marketing (advertising, promotion) and distribution (sales shares or units, which is typically daily,68 and will vary as the value commissions) costs. In others, the operator is instead expected to of fund assets varies. When an investor buys a share or unit, an pay for these activities out of their revenues because these activities entry charge may be added to the net asset value per share or typically lead to an increase in sales, and therefore fund value, which in unit; conversely, when the investor redeems a share or unit, an exit turn benefits the operator (because operator fees are a percentage of charge may be deducted from the NAV. When regulation does not the value of the fund). It is important that permitted charges are not specify a methodology for calculating NAV, investors may suffer only defined, but required to be disclosed, and that regulation states from inconsistent pricing. In Kenya, for instance, regulation does that any cost that has not been disclosed cannot be levied. not specify whether to value the fund’s portfolio based on offer and bid or mid prices, nor does it specify whether the costs of buying and Setting regulatory caps on charges has pros and cons. Some selling the fund’s portfolio should be factored into the valuation. So regulators may cap the level of fees that may be charged on a any comparison of one fund’s price per unit against another’s may fund, either per charge or across all charges as a cumulative total be misleading, because one may include a charge and another may percentage of the fund’s value to protect investors’ interests not. One of the problems in many emerging markets is that trade in (see table 2.12). However, market participants may then simply securities may not be very frequent, and prices therefore may not charge the maximum allowable fees, restricting competition and be formed often, which may make valuation difficult.69 If the share maximizing profitability, or, if the limits are set too low, it may or unit price derived from the NAV is wrong, an investor entering the become unprofitable to operate mutual funds and the sector fund may either pay too little or too much, and an investor exiting will fail to develop. For instance, in Morocco, law no. 1-93-213 the fund may receive too much or too little. In turn, this will reduce requires the articles of association of open-ended corporate and or enhance the value for ongoing investors, so all investors will not contractual funds to clearly outline what fees will be charged for be treated fairly. The valuation and pricing of fund shares or units buying or selling fund shares or units, as well as the maximum of a fund is arguably the single most important aspect of mutual annual management fees. The law also requires the Minister of fund operation and of key concern to regulators.70 Finance to set the maximum fees and authorize the methodology to compute management fees.72 In Turkey, where mutual funds One of the key roles of regulation is to define what charges may be are mostly operated by affiliates of banks, the regulator did not levied on funds and on investors as they enter or exit the fund. In originally limit annual charges. This led to a situation where general, regulation allows funds to levy a charge on investors as they Turkish MMFs levied charges of around 5.5 percent—exorbitant enter or exit a fund (although some types of funds, such as MMFs, do for MMFs by international standards. The Turkish regulator, the not levy these). Such charges, discussed in more detail in chapter 1, are Capital Markets Board, therefore capped charges on MMFs at 1.1 usually expressed as a percentage of the net asset value of the share percent (and set other limits on equity and fixed income funds). or unit. Regulation should also establish what charges or costs may This improved returns to investors, who were now charged 4.4 be paid out of the fund to meet its cost of operation. This typically percent less. However, banks have found marketing MMFs much includes the costs of managing fund investments, administering the less profitable, and sales of such funds have fallen. Table 2.12: Charges Limited by Regulation and General Level of Charges in Case Study Countries as at Year End 2012 Country Entry Fee Annual Management Charge Exit Fee Brazil Not limited Not limited Not limited Sometimes charged 0.5–4.0% Usually not charged Kenya Not limited Not limited Not limited Up to 6% charged Up to 3.5% charged Not charged Morocco Not limited Limited to 2% maximum Not limited Up to 2.15% Up to 1.22% Peru Not limited Not limited Not limited 1–3% 0.5–3% Not charged Turkey Not limited Limited: 1.1% money market; 2.2% for Not limited Rarely charged short-term bond; 3.65% for equity Not charged Source: Case studies. Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 41 It is useful for regulation to require disclosure of the total annual contractual funds. Similarly, in Turkey, the Capital Markets Law operating cost of a fund. Regulation may permit many different governs the sale of mutual fund units. Fund law or regulation should charges—in addition to the annual management charge paid ideally permit the operator of a fund—that is, the fund management to the operator—to be levied on funds, and so many regulatory company—to sell shares or units in its funds (typically broking or frameworks require the fund’s total annual cost of operation to dealing in securities is otherwise limited by securities law to entities be calculated, based on the previous year’s audited accounts. The with these licenses). In Turkey, law and regulation did not permit fund’s annual report and offering document must disclose this total this until the new Capital Markets Law in 2012 was passed; this annual cost of operation to investors (an estimate has to be given prevented the fund management company from making direct sales for a new fund). This enables investors to make fair comparisons of fund units through, for instance, its own website. across funds. Such a requirement is more common in developed markets than in emerging markets; for example, the European Although the operator is responsible for the sales policy and Securities and Markets Authority requires the Key Investor distribution of a mutual fund, licensed distributors usually sell Information document to disclose “ongoing charges.”73 the fund(s) on the operator’s behalf. In some countries, distribution is regulated by an SRO. The operator enters into contracts with distributors to sell the fund(s) on their behalf. Typically these Regulating Advertising and Promotion distributors may include bank branches, insurance sales forces, Regulatory requirements that apply to securities offering, specialist sales agents, securities brokers and dealers, private banks, and sometimes to financial products in general, will usually and financial advisers. Law and regulation should make it illegal for apply to fund advertising, with some additional fund-specific those without appropriate license to sell or deal in shares or units in requirements relating to performance and risk disclosure. The funds or to advise on buying and selling them. Licensed distributors general regulatory principle is that advertising and promotions will have to comply with the terms of their license, including conduct- should be fair, clear, and not misleading. IOSCO requires that of-business rules and reporting.75 In some countries, such as Brazil, advertising be consistent with the fund’s offering document (which the self-regulatory body (ANBIMA) regulates distribution. ANBIMA’s is essentially the terms and conditions under which investment in recent Code of Conduct76 provides standards for distributors the fund is made and not a promotional tool). Regulation should targeting retail investors of investment funds to ensure they provide also ban forecasting performance or guaranteeing (or implying appropriate information and deal with these investors fairly. ANBIMA guaranteed) results. Most regulators mandate a series of standard also certifies professionals who market and distribute investment statements (risk warnings) to be made in fund advertising products to qualified investors, as well as branch managers who materials that caution investors that fund values and income service high-net-worth individuals and institutional investors. In from funds can fluctuate, that investors may not get back the addition, ANBIMA inspects its 117 investment fund distributors. amount that they invested, and that past performance is not a Financial advisors who advise on investing in mutual funds are also predictor of future performance. The China Securities Regulatory generally regulated. As discussed earlier, increasingly regulation in Commission, for instance, forbids the use of words such as “safe,” developed markets requires an independent advisor to be the agent “ensure,” “promise,” “free of risks,” “safeguard,” “high yield,” and “no of the client, and remunerated by the client, not the operator. Even risk”—any or all of which may lead the investors to believe there is in developed markets, specialist financial advisers and regulation no risk. Regulators in nascent markets may wish to approve fund governing them is relatively recent; thus, this type of entity in publicity material before publication; however, for underresourced emerging markets is correspondingly rare. Typically the entities that regulators in large markets, this activity would be unsustainable. advise investors on mutual funds may also advise them on financial In addition, regulators typically wish to avoid giving the impression planning, mortgages, pensions, insurance, and other savings, and so that they have endorsed a mutual fund. Instead, a delegated regulation of these entities can be complex, covering a wide range of trade association or SRO may monitor advertisements and other different financial products. Regulation usually requires the adviser publicity material. to have the necessary professional qualification to give advice across the relevant range of products. A key consideration for regulation Regulating Sales and Distribution is whether the adviser is the agent of the operator of the fund Shares or units in mutual funds are commonly defined as (compensated by commission); or the agent of the client (and paid by securities, and so the securities law of a country, or a broader the client). In developed markets, advisers were typically the agents financial services law, typically governs the way mutual fund of operators. However, increasingly, regulation requires advisers who shares or units are distributed; that is, it dictates who is eligible claim to give independent advice—that is, unbiased advice across a to sell these units/shares or advise prospective investors. This is range of product providers—to be the agent of the client and requires usually the case for an investment company, because a share in a the remuneration of these advisers to be agreed between the client company is a security under securities law.74 This may not, however, and the adviser. be the case for a unit in a unit trust or in a contractual fund unless To maximize distribution potential, financial regulation should the law governing unit trusts or contractual funds or the securities or not prevent the development of fund supermarkets or the financial services law specifies that these are securities or specifies listing of mutual funds on stock exchanges. Fund supermarkets other provisions instead. In Morocco the law for securities offering are Internet-based platforms that provide information on mutual governs the distribution of shares of open-ended corporate and funds and dealing services and record keeping for those that wish 42 | MUTUAL FUNDS in developing markets: addressing challenges to growth to buy and sell such funds. Generally such platforms provide only if they are comparing like with like and may therefore be misled information and guidance (using decision trees, for instance) and do either accidentally or deliberately. External, independent providers not provide advice, but they do arrange and perform transactions of data, found typically in developed fund markets, often play a key in securities and therefore are usually governed by securities law. role in ensuring that such critical data are analyzed and presented In general, however, these platforms are unlikely to develop until in a consistent, fair, and clear manner. Major global providers of fund a sufficient range of funds and investors is in place to support performance information include Lipper, Morningstar, Trustnet, their operation, so these are usually seen only in more developed and Standard & Poor’s. In some countries local providers of such emerging markets. In some countries, allowing mutual fund shares services have developed, including CRISIL in India (now owned by or units to be listed on a specialized section of exchanges can also Standard & Poor’s). increase the visibility of mutual funds and assist in developing demand for funds. This will require developing special listing Regulation should require operators to send fund investors annual requirements, sometimes referred to as “technical listings” because audited financial reports. IOSCO requires that these reports should the shares or units of the funds are still bought and sold via the be prepared to internationally accepted standards, but at the time of fund management company. A fund that has a technical listing the study there are no International Financial Reporting Standards on an exchange may become eligible for investment to institutions specific to mutual funds, and so fund accounts are prepared using that may only invest in listed or traded securities. Indeed, in some the relevant standards required in each country. In addition to cases it may be possible to encourage exchanges to develop what the prospectus, the operator must provide investors (and file with is essentially a fund supermarket as a subset of their operations. the regulator) annual audited and half-yearly unaudited financial reports of each fund (or each subfund of an umbrella fund) on the management and operations of the CIS.78 It is useful to require the Regulating Disclosure, Reports, and Ongoing operator to present the report in standard form and order, which Information to Investors makes it easier to compare one fund with another. Regulation should Regulation should require operators to publish regular information require reports from the fund operator and trustee or depositary on a fund’s share or unit price in an accessible medium together stating their obligations and how they have fulfilled these. The with the offering document or a short form offering document. regulator should require the auditor to report on whether the accounts Ideally this information will be available along with statistics on other give a “true and fair” view of the fund’s capital and income position. funds to allow investors to easily compare funds. Investors into a fund Regulation should set standard and practical disclosure will need to follow the progress of their fund, and typically their first requirements as much as possible. Methods used in developed priority is the price of the share or unit of the fund, which indicates markets such as postal mail may be unreliable in some markets, whether they are making a profit or a loss. Therefore most regulators and other delivery methods such as couriers may be too expensive. require operators to show regular share or unit price information in an In such circumstances, it may be better to allow reports to be sent accessible medium, such as a widely circulated national newspaper, or via e-mail (not simply by display on websites, where investors may the operator’s website, or better still on a website that carries prices not be aware of new documents being displayed) or published in of all funds. Ideally the performance of the fund will be published national media (although this also may be costly). Chapter 3 revisits relative to others so that investors can compare funds and make this discussion. informed decisions. Trade associations or commercial providers may host websites that show such comparative data; sometimes this information must be disclosed on a special section of the regulator’s Competent Supervision website. If this type of disclosure is not required, potential investors In new markets lack of understanding of mutual funds is likely to be will find it difficult to find and compare information on funds and a problem. If mutual funds have not previously operated in a country, so may be deterred from investing. Without this type of disclosure, or are relatively new, policy makers and regulators are unlikely to investors may also only be able to find promotional material that may have an understanding of why elements of law and regulation matter emphasize benefits but fail to highlight risks effectively. In Kenya, for (which this publication seeks to address) or how funds work. This can instance, at the time of the case study operators’ websites showed lead to laws and regulations being poorly drafted that can lead to only marketing information and did not disclose prospectuses, any mutual funds not being formed or only some types of mutual fund form of offering document, or annual reports. not being formed, and it also makes enforcing compliance difficult. Regulation should require operators to calculate and present Regulators who do not understand funds also may not act to stop or data on fund performance consistently, accurately, fairly, and prevent abuses because they may fail to recognize their significance. with clarity, so that investors can make meaningful comparisons Neither of these are conducive to sector development. across funds. Investors who do not have access to independent and comprehensive information about fund performance are more Internationalization of Fund Markets vulnerable to being sold the latest product. The regulator therefore typically mandates that performance information is disclosed on Legislation for mutual funds is typically formed at the country level; a consistent basis.77 In Kenya, no rules specify whether to include however, increasingly supranational standards are being developed reinvestment of income, or whether performance is given gross or to create regional fund markets and consolidate smaller mutual net of charges, or gross or net of tax. Thus investors cannot know fund sectors. The EU is the leader in creating regional standards with respect to mutual funds. In 1985 the EU adopted the first directive Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 43 to harmonize standards on UCITS – generally, open-ended publicly Table 2.13: Ability to Offer Foreign Mutual Funds offered funds that invest in transferable securities within specified to the Domestic Public Subject to Registration with limits.79 The UCITS directive aims to achieve a single market for the Regulator as at Year End 2012 mutual funds across the EU. It allows shares or units of open-ended collective investment funds created in any EEA member state,80 Ability to Offer Eligible Foreign Country which comply with the directive’s standards,81 to be distributed in all Funds Publicly other EEA countries. This ability to distribute UCITS across borders Brazil No has resulted in significant growth in the EU mutual industry, allowing Kenya No multinational asset management companies to distribute funds Morocco No across Europe. In 2012, 45 percent of assets under management in UCITS in Europe was invested in funds sold across borders, up Peru No from 21 percent in 2001.82 Further, many countries outside Europe Turkey Yes accept the UCITS standard for inward sale: In 2012, an estimated 40 percent of UCITS sales were outside the EU,83 including Latin them; however, pension funds can access foreign funds by investing America, the Middle East, and East Asia. Similar to the EU regional in a domestic fund of funds that invests into foreign funds. market, regulators in Hong Kong, China, and China are developing a platform to mutually recognize mutual funds operating in either “Recognizing” foreign funds becomes more important because jurisdiction.84 The Asia-Pacific Economic Cooperation (APEC) region publicly offered funds are increasingly distributed across borders; also plans to harmonize collective investment funds, to permit their however, regulators will also need to consider how this may affect distribution across borders, through an Asia Region Funds Passport the sales of domestic mutual funds. If foreign domiciled funds are applicable to all APEC countries.85 Chile, Colombia, and Peru, which allowed to be sold domestically, the domestic fund market may be established the Mercado Integrado de Latin America86 to integrate threatened by the competition from foreign funds. As table 2.13 stock market transactions, could similarly agree to conform to indicates, outside regional trading blocs, it is relatively rare for common standards87 to authorize and regulate mutual funds. Thus foreign funds to be permitted to be publicly offered, and statistics on authorized mutual funds domiciled in one member country could such sales in emerging markets are not generally publicly available. be freely and automatically distributed in other member countries. Anecdotal evidence from Lebanon, which allows this practice, is Integrating these three mutual fund markets would consolidate that people invest in foreign funds largely for foreign investment, relatively small domestic mutual fund industries into one larger and domestic-based funds are used for domestic investment. Thus market of roughly $60 billion in assets under management. Another in Lebanon, the key area of competition may be between domestic example is the East African Community, which plans to harmonize funds that invest abroad and foreign funds that invest abroad. regulations to permit funds domiciled in a member country to be distributed in other member countries using the EU concept of home/ In many countries, foreign funds may also be sold privately to host country regulation; however, the scale of mutual fund sectors in investors without any regulatory recognition. In both Kenya and this region is very small (Kenya being the largest). Peru, although foreign funds could not be publicly offered, more affluent investors could invest in foreign funds through private wealth managers and private banks. In Peru, for instance, the total Permitting the Offering of Foreign Funds in Domestic value of the domestic mutual fund market in 2012 was $6.5 billion, Markets whereas individual Peruvian investors had invested an estimated Law can enable sales of foreign funds into a domestic market $10–15 billion offshore in foreign mutual funds (no exchange through “recognizing” foreign funds governed by jurisdictions controls are in place in Peru). This may be because investors wish to that provide equivalent investor protection standards as keep money offshore or hold assets in foreign currencies, or because domestic fund law. The law may also allow foreign funds to be sold domestic mutual funds, which historically invest only domestically, only to professional investors. Commonly, it is illegal to publicly offer do not offer the international diversification that some Peruvian a fund that is not approved by the domestic regulator. This means investors seek. it would be illegal for foreign funds without a domestic license to be sold to retail investors in that country. However, governments may Other Laws that Affect Mutual Fund wish to allow foreign funds to be sold to the public, for example, Development to facilitate a regional single market, as described above. Thus the law must make provisions for the regulator to “recognize” other Although the creation and operation of mutual funds is mainly fund jurisdictions, meaning a mutual fund that can be sold to the governed by financial, securities, or mutual fund law, other law public in one jurisdiction would be recognized as eligible for sale to can hinder the operation of mutual funds unless it is disapplied the public in another (see table 2.13).88 In some countries, regulation where necessary. The main difficulty is the application of company may not permit foreign funds to be sold to the public, but they may law to open-ended investment companies (see discussion above be allowed to market to professional investors: Thus UCITS can be on legal structures of funds for details) because company law is sold to pension funds in several Latin American countries such as usually designed for ordinary companies that have a fixed number Chile, Colombia, Mexico, and Peru. In Brazil, foreign funds cannot be of shares in issue, whereas open-ended investment companies offered to domestic investors, and pension funds cannot invest in constantly create and cancel shares and so have variable capital. 44 | MUTUAL FUNDS in developing markets: addressing challenges to growth Some of the other operational features of mutual funds are also have been able to withdraw contributions when they change jobs. difficult to accommodate under normal company law, such as selling In such cases, pension savings effectively become short term and redeeming shares at net asset value. The most common way of investments and can substitute for mutual fund vehicles. Third, dealing with this is by issuing exemptions or exclusions from company although in some countries pension schemes are simply required to law (see box 2.8). In Kenya, the Capital Markets Act exempts “mutual prudently diversify investment risk, with no investment limitations funds” (open-ended investment companies) from Companies Act (and so are free to invest in mutual funds), in others pension law/ provisions relating to sale and redemption of shares. Similarly, in regulation may establish the permitted investments of such schemes Turkey, mutual funds that take the form of investment companies (whether defined benefit or defined contribution), which may or may are governed also by corporate law with some exemptions. not include mutual funds. Particularly when saving into a pension scheme is mandatory and represents a relatively high proportion of The success of the mutual fund sector is often a consequence of salary, the ability of pension schemes to invest in mutual funds can whether the law permits these funds to play a role in retirement be critical to developing the mutual fund sector. In countries where saving. First, when retirement-related law or employment conditions mutual funds play a large role in retirement savings, significant require individuals to contribute a high portion of their salary to a growth in the sector can occur (see box 2.9). In other countries, such national pension scheme, mutual funds and other savings vehicles as Turkey, individual retirement schemes may not invest more than may be “crowded out.” In Uganda where employees of companies 20 percent of their assets in mutual funds. Since 2013 the Turkish with more than five workers had to contribute 15 percent of salary government has also offered top-ups to contributors to the individual to the National Social Security Fund, this may have “crowded out” retirement system. Thus, within limits, if contributors meet certain mutual funds. In Kenya, on the other hand, mandatory contributions requirements, the government contributes 25 of value for every to the National Social Security Fund were K Sh 400 or roughly $4, 100 of value contributed. Contributions to mutual funds, therefore, leaving space for private pension schemes and mutual funds to become much less attractive, particularly because Turkish pension develop. Second, mutual funds also become less competitive when scheme members can withdraw their contributions, with penalties, individuals are allowed to withdraw their contributions from pension before retirement. Hence retirement savings are relatively accessible schemes with limited penalty, such as in Tanzania, where individuals rather than being locked away until retirement. Box 2.8: Mutual Funds Formed as Investment Companies Enabling mutual funds as investment companies with variable capital is often challenging, because company law will typically apply to such companies. The formation process can be both expensive and cumbersome because of added procedures required under company law. For instance, the fund will need to register with the registrar of companies, as well as seek regulatory approval. These issues can be dealt with in various ways: •• Add special clauses to company law or commercial codes: This is often difficult, given the complexity of corporate law and the time taken to pass or to amend such laws. •• Law that governs mutual funds can disapply the relevant sections of corporate law: This is quite a common approach but needs expertise to ensure all relevant matters are considered. The disapplication must be addressed in law rather than regulation.89 •• Exclude mutual funds from company law: In effect, mutual funds formed as investment companies would then operate only under mutual fund law and regulation. However, in this case, investors would be vulnerable unless mutual fund law addresses the governance, creation, operation, and winding up of such funds (as it would with contractual funds). Box 2.9: Mutual Funds and Retirement Savings In countries where mutual funds play a large role in retirement savings, the sector has witnessed significant growth. Australia’s mutual fund market, for instance, has become one of the largest in the world, in good part due to the role these funds play in “superannuation” or retirement savings. Similarly in the United States, retirement assets held in 2012 through defined contribution pensions and IRAs amounted to 48 percent of the value of all long-term mutual funds (investing in equities, bonds, and a mixture of these) and 14 percent of the value of all MMFs.90 In the United States, many defined contribution–type retirement plans, such as IRAs, also invest directly into mutual funds. These personal pension plans are tax-privileged “wrappers,” which are essentially an individual account owned by the contributor; the plan is the “wrapper” like an envelope within which law permits certain assets to be held. One of these assets is mutual funds. Research dating from 201391 also showed that 92 percent of households that owned mutual funds were using them to save for retirement purposes and that 81 percent of households that owned mutual funds held those funds within employer-sponsored retirement plans, demonstrating the importance of retirement-related savings incentives. Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 45 It is important, therefore, to think through the policy implications compared with an investor directly buying those same assets. If of the design of pension systems for the development of mutual it were disadvantageous to invest indirectly via a mutual fund, funds. Box 2.9 illustrates the importance of the role mutual funds everyone would invest directly instead. In Morocco, for example, play in developed markets. although mutual funds were in principle tax transparent, a quasi- tax was imposed on several mutual funds in 2011 and 2012, in the form of a special contribution to a social fund called the Fonds Taxation de Cohésion Social. This went against the principle known as In general, if funds (or any form of savings on investment) suffer “fiscal neutrality,” which is extremely important in fund taxation. more tax than competing savings products, they will fail to attract In general, therefore, funds are “see-through” entities, which are investors. The tax regime of mutual funds is usually determined not subject to tax on income and capital gains that result from by the relevant tax authority and plays an important role in the their own portfolio transactions. This implies that the tax point is competitiveness of the mutual fund sector. Taxation is a major generally the investor and not the fund. influence on the flow of savings. No investors wish to pay tax that they do not have to pay, and conversely, investors are attracted to products b. For a fund to avail “fiscal neutrality” status, the tax framework that have favorable tax status. If tax treatment is unattractive, has to clearly define the vehicle to which this tax treatment investors and funds will seek domiciles or instruments where tax or exemption applies. The tax framework may simply define liability is lower. Fund operators thus seek to minimize the tax liability this vehicle by referring to a fund licensed or approved by the of funds and maximize returns to attract investors. In some countries domestic regulator.93 To avail tax transparent status, a fund funds may not be able to receive favorable tax status: for instance, may also have to meet other stated criteria. For example, in Saudi Arabia, where there is no income tax at all, investors cannot publicly offered closed-ended funds may need to be listed or receive a more favorable tax treatment of fund income. In many meet certain diversification and ownership requirements. This developing countries where significant portions of the population means, of course, that a fund that ceases to have the defined are in the informal economy and do not pay tax, or if tax evasion is status will also cease to get the favourable tax treatment, which widespread, investing in funds may be unattractive because it could can, in turn, be an incentive to be regulated. draw unwanted attention to taxable capital and income. Governments thus have to achieve a delicate balance between collecting fair and c. The tax framework must be clear as to whether the mutual timely revenues from investors, while also not impeding the ability of fund or the fund investor pays tax. If an investor is uncertain funds to mobilize capital by imposing unattractive tax liabilities. whether tax is payable by a fund or by a fund investor or both, they may find mutual funds less attractive as a savings vehicle. Unless a fund tax framework is carefully considered, funds and their investors may suffer multiple levels of tax on the income or d. The tax regime must be fair and relatively simple, and tax capital gains proceeds of a fund.92 The simplest way to illustrate authorities must be consistent in their treatment of mutual this is diagrammatically (see table 2.14). funds. Very convoluted taxation treatment will deter the mutual fund market’s development because it may make fund returns The basic principles of fund taxation are as follows: less attractive and make funds more expensive to operate and administer. Brazil and Peru’s mutual fund taxation regimes were a. In general, funds should be “fiscally neutral” or “tax transparent.” good examples of such unnecessary complexity at the time of The key principle in fund taxation is that an investor investing in the case study (although Peru’s taxation regime has changed assets indirectly via a mutual fund should not be at a disadvantage Table 2.14: Levels at Which Tax May Have an Impact on Funds and Their Investors Income Capital Gains Withhold tax at source Tax may be withheld on interest or dividends Unusual for tax to be withheld at source paid to funds Taxed at the level of the fund, whether or not Income (e.g., dividends, interest) is taxed at Capital gains when the fund’s assets are sold distributed to shareholder fund level. is taxed at fund level. This is unattractive if investor must pay This is unattractive if investor must pay additional tax after receiving income from the additional tax on receipt or when realizing profit fund. on sale of shares or units. Withhold tax before payment to investor On income or on both income and capital gains, if both are accrued and not taxed, until they are in the hands of the investor Taxed at level of investor Income is taxed upon receipt by the investor. Capital gains are taxed upon receipt by the This is usually the case, except dividends may investor at the time of distribution or at the be tax free, as a capital market development time of sale of shares or units at a profit. incentive, or if the fund shares or units are within This is usually the case except if the fund shares a wrapper or units are held within a wrapper 46 | MUTUAL FUNDS in developing markets: addressing challenges to growth Box 2.10: Brazil and Peru Taxation Regime for Mutual Funds Brazil Come Cotas System Under Brazil’s system, tax is levied from a fund, at regular intervals, on the calculated returns—both income and gains—which accumulate in the unit value. Cash is raised to pay this tax by redeeming the appropriate number of units. Called come cotas—literally “eating units”—it sounds simple. But this tax is not levied on equity funds or on closed-ended funds and is in effect a tax on accumulated interest. The tax rate levied is between 15 and 22.5 percent and is complicated to calculate, applying differently to those who hold through the tax period versus those that redeem within it, and it may vary according to fund maturities. Although complicated, this system does ensure that tax payment is not deferred until the unit is redeemed from the fund, which is a benefit for the tax authorities. Peru In Peru, each mutual fund was previously required to separately calculate the taxable income of each type of investor (corporations and individuals) and separately withhold this tax. This was because tax authorities wanted to effectively levy tax at the fund level—even though funds were not taxable—because it was easier to deal with a single fund than with hundreds or thousands of investors receiving returns. This complicated system was made more complicated because different investor types were taxable at different rates on income and on gains, although those with an income or gains of less than S/.20,000 (around $675) were exempt. In addition, bank deposits were not subject to such taxes, and contributions to the mandatory pension system was tax exempt and proceeds tax free, both of which made mutual funds less attractive to investors. This system was changed in 2013, and the mutual fund’s administrative burden has reduced because now the fund is only required to deduct a flat 5 percent from profits (both income and realized gains) when an investor redeems. The new system reduces the administrative burden, as well as achieves an attractive tax rate by international standards. However, the tax treatment of bank deposits still remains more favorable. since then; see box 2.10). If investors are uncertain about tax annually, and investors are taxed for income and realized capital treatment, they may also invest in an alternate vehicle where gains every year. The U.S. mutual fund industry has continuously tax treatment is clearer. In Kenya, for instance, the tax authority complained that this is both unfair and complicated and acts as was inconsistent in interpreting tax law for unit trusts, which a deterrent to investing in mutual funds.94 However, many people caused a lack of clarity for fund operators and investors. invest in mutual funds via retirement plans, which makes them exempt from these taxes (although they will be taxable on income e. The tax system should avoid requirements that impose taken from the scheme once in retirement). excessive administrative burden. For example, in Kenya, once the fund is more than six months old, investors may not own 2. The fund suffers no tax. The fund distributes income to the more than 12.5 percent of the fund, and the fund must have at investor, which is subject to tax at the relevant tax rate; the least 25 unitholders or shareholders. This type of requirement fund accrues capital gains, and the investor pays capital necessitates daily monitoring and possible refusal or reversal of gains tax when they sell units/shares. This regime is found in transactions, which is an unnecessary administrative burden. many European and other countries, where income must be distributed and is subject to tax in the hands of the investor The tax framework deals with capital gains or income in multiple at their relevant tax rate when distributed. But capital gains ways. This chapter does not deal with every variant of fund are not permitted to be distributed and must instead accrue in taxation, but three of the main approaches used are summarized the fund. The investor pays capital gains tax when they sell the below. Table 2.15 also gives a general description of tax systems units or shares at a profit, because the price of the units/shares worldwide. Investments are either “taxable” (“T”) or “exempt” (“E”). by that stage will include all accrued gains.95 Thus if the contribution to the investment is made pretax, the contribution is exempt; if it is made posttax, the contribution is 3. The fund suffers no tax. The fund accrues both capital gains taxable. Similarly, the money while inside the investment can be and income. When the investor sells units or shares, the either taxable or exempt from tax, and when the investor receives difference between purchase price and sale price per unit proceeds of the investment—income or capital gains—these can be or share indicates the gain that is taxable at the level of the taxable or exempt from tax. The three key variants are the following: investor.96 This is the case, for example, in Peru and Turkey where tax is withheld at a standard modest rate: 5 percent 1. The fund suffers no tax. The fund distributes capital gains and in Peru and 10 percent in Turkey.97 This tax approach is easier income to the investor, who is then taxed on both capital gains and less expensive for the tax authority because it collects and income, at their taxable rate. This tax treatment is known tax at an easily identifiable point, instead of seeking to claim as “pass-through” and is the tax regime in the United States. small amounts of tax from thousands of (possibly recalcitrant) Thus U.S. mutual funds distribute all realized gains and dividends individuals. Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 47 Table 2.15: Description of Taxation Systems of Funds in Selected Countries as at Year End 2012 Differentiation Country Income Capital Gains between Short and Who Pays the Tax Long Term Brazil Retained in fund Retained in fund Yes, depending on Fund investor twice yearly on total return type of fund or at redemption for certain funds Kenya Distributed and Not taxed No Fund investor on redemption taxable Morocco Distributed to Retained in fund No Fund investor in year of receipt of income; shareholders at time of redemption or sale if capital gain Perua Retained in fund Retained in fund No Fund investor upon redemption Turkey Retained in fund Retained in fund No Fund investor on redemption United Kingdom Distributed to Retained in fund No Fund investor in year of receipt of income; and some European shareholders shareholder at time of redemption if capital countries gain United States Distributed to Distributed to Yes Fund investor in year of receipt and certain other shareholders shareholders countries Source: World Bank study. a. Under new system. It is important to note in the above cases that if funds are are considered mutual fund substitutes, such as short-term structured as companies or as trusts, they would potentially bank deposits compared with MMFs, or pension fund investment need to be exempted from tax applied to normal corporations. compared with longer term mutual funds. For instance, given As discussed earlier in the chapter, funds formed as companies or that the predominant savings vehicle is typically a bank deposit unit trusts could be potentially liable for tax. Thus these funds will or savings account, if bank interest is tax-free whereas dividends need to be specifically exempted or else should be allowed to offset or proceeds on sale of funds are taxed (as is the case in Peru), or reclaim any tax payable. investors will find MMFs relatively unattractive. The reverse is the case in China, where bank interest is taxable and dividends Investors can also hold shares or units in a fund through a range (including dividends from MMFs) are tax free. In addition, in China, of tax-incentivized ways, such as pension schemes or retirement bank interest rates are capped but MMFs can offer much higher plans or other tax-incentivized “wrappers,” which allows them rates. These factors combined account for the phenomenal growth to be exempt from capital gains tax, if applicable, or to receive of MMFs in China. Similarly, long-term savings such as pensions are income tax-free, or be able to reclaim tax paid. For instance, tax- usually granted a favorable tax status. Pension funds are usually efficient wrappers, such as those used for retirement accounts (e.g., tax exempt, and contributions to a pension fund are tax deductible, IRAs or the 401(k) in the United States) provide tax protection from allowing investors to reduce taxable income. If, in addition, pension income and capital gains tax. Thus investors do not get taxed in the contributions are compulsory, as they are in many countries such current year for their interest/dividends received but instead are as in Latin America, mutual fund growth can be stunted (although taxed when they remove the money from the tax-deferred account if pension schemes can and do invest in mutual funds, the impact as ordinary income.98 Governments have recently attempted of this may be reduced). In Turkey, longer-term mutual funds to reinvigorate capital markets and mobilize savings in several compete with individual retirement savings accounts to attract countries through tax incentives for wrappers such as Japan’s voluntary savings; the latter, which offer a government incentive of Nippon Individual Savings Account, South Africa’s Tax Preferred a contribution of a free 25 of value for every 100 contributed, are Savings Account, Canada’s Tax Free Savings Account, and the clearly rather more attractive. United Kingdom’s Individual Savings Account. Tax policy considerations in an early emerging market Government often use tax frameworks to influence investor where mutual funds are just developing will require careful behavior, for example, to encourage investment in long-term consideration. Overly strong incentives, designed to encourage the assets. In some cases, if competing savings vehicles have a market, may be exploited by those who are more sophisticated and more favorable tax treatment than funds, mutual fund asset more affluent and may be perceived as unfair to those who cannot growth may diminish; however, in many cases it can also result in afford to save; they may also lead to unacceptably high reduction growth of mutual fund assets because funds may be used as the of tax revenues. Very strong incentives may also have the effect of underlying investment vehicle for other forms of savings. Favorable redirecting savings flows in a way that may, at an extreme, threaten tax treatment can amplify the attractiveness of products that financial stability (for instance, a mass shift from bank deposits to 48 | MUTUAL FUNDS in developing markets: addressing challenges to growth MMFs); it may also create an unsustainably high level of demand set out more detailed requirements such as aspects of fund for a limited supply of assets that could result in asset bubbles. operation or standards applicable to operators and supervisors Lack of incentives may result in failure to mobilize savings out of of funds. bank deposits and into capital markets, with reduced potential for economic development. 5. The regulator, empowered by primary legislation, enforces the legal and regulatory framework governing mutual funds A key policy consideration is also the capacity of the taxation and their service providers. It is vital that regulation is applied system. As noted above, many governments structure tax fairly, evenly, and consistently, otherwise neither investors nor treatments so that tax is taken at the fund level, for ease of market participants will have sufficient confidence to commit collection. Many tax systems lack the capacity to deal with tens or their resources to the market. It is important to have a legal hundreds of thousands of individual tax accounts and tax returns; and regulatory framework of good quality, but this will not in such cases, creating tax treatments for individual accounts may encourage mutual fund development if failure to comply with it be too complex and expensive. Where few people in a country pay goes unpunished. The regulator must have adequate resources income tax, it may be necessary to offer incentives other than to conduct its duties and the power to enforce compliance taxation such as matched contributions to pension schemes or and impose and enforce sanctions when market participants savings plans or bonus allocations. misbehave. 6. The legal and regulatory framework must also define the In Summary legal structures in which mutual funds can be created. The 1. A mutual fund sector will not expand strongly unless people most common legal structures are the trust, corporate, and are confident that mutual funds are worthy of their trust. contractual types. Despite the prevalence of different legal Much of this confidence is instilled by a belief that fund investors’ structures, the operational characteristics of mutual fund interests are adequately protected by law and regulation and structures are becoming increasingly similar, as regulatory that any failure in this respect will be effectively addressed frameworks cohere around the IOSCO principles and, by a government or regulator. A weak legal and regulatory increasingly, regional standards. environment can negatively affect the mutual fund industry. When investors are not confident in the market, they either do 7. Legal and regulatory frameworks for mutual funds may also not invest or pull out of mutual funds. permit additional structural options to allow the mutual fund sector to benefit from economies of scale; these include 2. The key objective of regulating publicly offered mutual funds umbrella funds, multishare or unit classes, and the master/ is to protect the interests of the individuals who buy, hold, feeder structures. and sell shares or units of such funds. Law and regulation seek to ensure that action can be taken against unregulated vehicles 8. It is extremely important that law or regulation establishes that may defraud investors. Legal and regulatory regimes for a requirement that a publicly offered mutual fund must have mutual funds seek to maximize confidence in mutual funds by a diversified portfolio, and that it must invest and borrow addressing asymmetries of information and conflicts of interest only in conformity with its specified type (equity, bond, mixed between operator and investor and preventing the possibility asset funds, etc.) and within limits set by law or regulation. of the fund operator (or its affiliates) stealing or misusing fund Regulations should also specify what percentage of a fund’s assets by requiring a third party to safeguard the assets. assets may be invested in any one issuer’s securities and set caps on the percentage of any one issuer’s securities that the 3. However, overregulation can be costly, deter market fund can hold. entrants, and push investors toward other investment vehicles, thus preventing—or slowing—market development. 9. A mutual fund legal and regulatory framework can allow Regulatory frameworks also need to align with the stage of foreign funds to be publicly sold in a country by “recognizing” market development. When designing fund frameworks, policy foreign funds as being governed by a jurisdiction that provides makers must take into account the practical implications of equivalent investor protection standards as domestic fund operating funds in a domestic market and, where necessary, law. This “recognition” of foreign funds is becoming more disapply international practices where they are not practical. important as publicly offered funds are increasingly distributed This requires knowledge both of how mutual funds typically across borders; however, regulators will also need to consider work and of how the domestic market functions. how this may affect the sales of domestic mutual funds. 4. Primary legislation defines the nature of a mutual fund and 10. Although the creation and operation of mutual funds is mainly protects investors by requiring that only a fund that has met governed by financial, securities, or mutual fund law, other legal and regulatory requirements for publicly offered open- laws can affect the operation of mutual funds. For instance, ended funds may be offered to the general public. Primary the success of the mutual fund industry is often linked to the legislation should create a sound legal basis for mutual funds size and nature of the pension fund industry. Particularly when to be established, licensed, supervised, operated, and wound up. saving into a pension scheme is mandatory and represents a Secondary legislation, called regulations or rules, would then relatively high proportion of salary, the ability of these schemes Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 49 to invest in mutual funds can be critical to developing the mutual 7. “White Paper on Governance of Collective Investment Schemes,” fund sector. In countries where mutual funds play a large role in 2005. retirement savings, significant growth in the sector can occur. 8. The United Kingdom has moved to a “twin peaks” model with Thus laws governing pension schemes, insurance companies, separate prudential and market conduct regulators. and other entities—specifically pertaining to their ability to 9. It should be noted that such legislation may enable funds other offer competing savings products or to invest in mutual funds— than mutual funds, for instance, closed-ended investment can also affect the competitive positioning of the mutual fund companies. sector. 10. Note that subsequently IOSCO has passed a large number of 11. In general, if funds (or any form of savings on investment) other standard-setting documents for collective investment suffer more tax than competing savings products, they will schemes; the Principles referred to underlie these. fail to attract investors. The tax regime of mutual funds is 11. Morningstar, “Global Fund Investor Experience 2013 Report.” usually determined by the relevant tax authority and plays an 12. India issues an annual consolidated update, however. important role in the competitiveness of the mutual fund sector. Unless a fund tax framework is carefully considered, funds and 13. Morningstar, “Global Fund Investor Experience 2013 Report.” their investors may suffer multiple levels of tax on the income or 14. Note that the regulator identified in the table may report to a capital gains proceeds of a fund. ministry or may be a government agency. 15. IOSCO, “Objectives and Principles of Securities Regulation,” June 12. The next chapter discusses the market-related drivers and 2010. impediments for mutual fund sectors. In some cases these drivers and impediments are related very closely to the legal and 16. Investment Company Act of 1940 Section 2 (c). regulatory environment; hence some of the discussion above is 17. For perspective, at the end of 2012 there were about 73,000 revisited in the next chapter from a different angle. investment funds globally, and the United States, which represented roughly half of total assets under management of Endnotes some $23 trillion, had around 7,600 funds. 18. In legal, accounting and operational terms. 1. A classic example of this arose in the United States during the 19. This will apply even if there is a multifunctional or megaregulator. Credit Crunch when there was a run on a money market mutual 20. Despite its name this is a self-regulatory organization and not a fund—Reserve Primary Fund on Tuesday, September 16, 2008— trade association. which held Lehm an paper, which became valueless; investors feared that similar funds would also be affected, and a “run” on 21. Despite its name, this association is for managers of mutual that fund and on all MMFs started to develop. MMFs at that funds. time were estimated to provide a third of short-term corporate 22. As an example, some of the data used in this study are collected financing in America, so such a run had systemic implications. by trade associations worldwide and published through the The government was forced to step in and guarantee repayment International Investment Funds Association, which has 41 of investors’ money for a period, which achieved the desired members which are fund-related trade associations around the result and put an end to the run (no claims were made against world. this guarantee). 23. This may not be an effective deterrent and would deprive the 2. Named after Charles Ponzi, who promoted such schemes in trade association of membership fees, and so may be against the America in the 1920s. interests of the association. 3. OECD, “White Paper on Collective Investment Scheme 24. Morningstar, “Global Fund Investor Experience 2013 Report.” Governance,” 2005. 25. In the case of ANBIMA and many other SROs members contract 4. See Clifford E. Kirsch and Sutherland Bibb L. Strench, An to obey the rules as a condition of membership of the SRO, which Introduction to Mutual Funds, chapter 6, http://www.lopdf.net makes them subject to the SRO’s disciplinary procedures for any /preview/OBNcUiVUZFpj9dS14z9JY7dYw breach of that contract. _FPsh1PBLadtQqfRVM,/An-Introduction-to-Mutual-Funds 26. Sometimes termed “the Duck Clause,” that is, if it looks like -Practising-Law-Institute.html?query=Types-of-Income-Funds. a duck, swims like a duck, and quacks like a duck, it is a duck 5. “Collective investment scheme” in the IOSCO context generally regardless of what it is called; so if it looks and acts like a refers to open-ended publicly offered funds (the mutual funds collective investment scheme, it is a collective investment covered by this study) and to listed and traded closed-ended scheme. This gives the regulator or courts clear power to act funds (which are not the subject of this study). against unlicensed schemes, requiring them to become licensed 6. This chapter does not discuss the judicial system’s role, but if or to cease and desist from such activity. enforcement of legal requirements through the courts is weak, 27. These are identified in the IOSCO Principles in section 1. To a it is likely that confidence in mutual funds will be lower than it lesser extent, this is based on policy decisions about mutual fund might otherwise be. laws and their content. 50 | MUTUAL FUNDS in developing markets: addressing challenges to growth 28. Also in Korea before it adopted trust law. 42. There were 35 administrators in Brazil at the time of writing of 29. However, in some cases, the United Kingdom, for example, the case study. investment companies are not required to have annual general 43. The administrator remains primarily responsible for compliance meetings, so shareholders in these funds have rights only to vote even if it subcontracts an independent investment manager to at extraordinary general meetings that are called only to vote on manage the investments. fundamental changes to the fund, again, typically, changes to 44. Even very high capital requirements, unless they are so high as investment objectives or policy and increases in costs. to deter any entrants at all, would be insufficient to compensate 30. Good practice set by the Investment Company Institute, the investors in the event of a major loss that was caused by trade association of U.S. mutual funds, is two-thirds. deliberate action or complete failure of an operator. 31. Functional independence means the operator and the depositary 45. This will require a law enabling a nominee function that may or can be subsidiaries of the same company, but must be completely may not exist. operationally separate (systems, people, offices, etc.). Proponents 46. Morningstar, “Global Fund Investor Experience 2013 Report.” of functional independence believe being subsidiaries of the 47. Kenya Case Study. same company fosters strong vested interest in the reputation of the group and could possibly be more effective than requiring 48. From the banking regulatory perspective, it also isolates potential full independence. On the other hand, being part of the same risks from bank capital. company could lead to cover ups to preserve reputations. 49. On the understanding that if a lie is subsequently detected their 32. Also adopted in Uganda. employer will be obliged to dismiss them. 33. In this case, it is usually a requirement that a minimum period of 50. For instance, the Chartered Financial Analyst suite of notice is given before any such change is made, so that investors qualifications is regarded as the globally recognized standard for who do not like the change have the option to redeem their investment professionals. units without penalty before the change is implemented. While 51. An operator may still be the member of a group, within which pragmatic, this approach means that the investor may have to similar conflicts may arise. make a choice between incurring a tax liability upon redemption 52. Other means can be used to correct misbehavior. For instance, of units and accepting a change they do not like. regulators receive reports and inspect entities during the period 34. As part of the quality of regulation on securities markets. between licensing renewal years and can take steps to require 35. “White Paper on Governance of Collective Investment Schemes,” correction if needed. In addition, the threat not to renew a license 2005. could also be used for the wrong reasons. 36. The draft Securities Bill (Collective Investment Schemes) 53. IOSCO Principles for Collective Investment Schemes (1994). Regulations in Kenya has sought to make more provisions for 54. Alternatively, to save regulatory resources, an attestation by a these funds. lawyer that the prospectus is fully compliant may be sufficient to 37. This structure resembles the handle and frame of the umbrella; allow the regulator to approve the prospectus. In either case, the the subfunds are the different colored fabric panels of the golf prospectus may be required to state that registration or approval umbrella. of the prospectus by the regulator does not constitute approval or endorsement of that fund by the regulator. 38. Most, but not all (in Canada for example) taxation authorities, however, will regard this move from one subfund to another, 55. Of course, the full prospectus still needs to be prepared and made even though it is within the same umbrella structure, as a available to prospective investors on request. “crystallization” of such gains for tax purposes (if such taxes 56. IOSCO, “Policy Recommendations for Money Market Funds,” are levied). One of the risks of the umbrella structure is that a October 2012. subfund within the umbrella may become liable for the debts of 57. This may be cumulative across all the funds managed by any one another subfund since they are all part of a single overall fund. operator. “Protected cell” regimes seek to deal with this risk. 58. A multiasset class fund that can change allocations from one 39. Within the voluntary condominiums under the Brazilian civil code, asset class to another. owners of fractions can partake in the profits of the condominium 59. Securities and Exchange Board of India, “Master Circular for according to the fraction they own. Mutual Funds to March 31, 2013.” 40. The feeder fund may also hold cash for liquidity and derivatives 60. In Brazil some multimercado funds are permitted to leverage using for risk management. derivatives. Regulations normally limit derivative use to “efficient 41. For this reason, master funds are often created in the contractual portfolio management” or insurance to reduce, but not increase, form; indeed the United Kingdom recently introduced this form of risk. fund specifically for this purpose. 61. IOSCO, “Principles of Liquidity Risk Management for Collective Investment Schemes,” March 2013. Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 51 62. At its simplest, using short-term liabilities to invest in long-term 76. For retail distribution of 12 categories of financial instruments, assets (taking in short-term deposits and making longer term including mutual funds. loans). 77. Among key issues identified by another IOSCO report, 63. For instance, closure of a market in which a CIS is invested “Performance Presentation Standards for Collective Investment because of extreme weather or power failure. Schemes” (2004), are standardized time periods for presenting 64. A company under the control of five or fewer participators or any performance information, performance benchmarks to compare number of participators if they are directors. performance of one fund with another or an objective benchmark such as a interest rates or inflation. 65. Such as that published by the U.S. Investment Company Institute and that used in the IOSCO survey. 78. The report and accounts will also contain a report from the operator explaining what has been done with the portfolio and 66. IOSCO requires that the regulation must “provide a system for why during the period and also some general comments on the valuation of CIS assets based on market value and for pricing immediate outlook. of shares or units and procedures for entering or exiting a CIS which are fair to entering, existing and ongoing investors. CIS 79. The EU has amended this directive subsequently several times as must redeem upon request and only suspend such redemption the market evolved; at the time of the study UCITS V is in the in certain stated circumstances and follow certain procedures; process of implementation. for sale and redemption of shares or units which must be at 80. The 28 members of the EU plus Iceland, Lichtenstein, and Norway. net asset value plus or minus a charge as appropriate; and for 81. Eligibility requirements for cross-border distribution include for distribution or reinvestment of income.” investment diversification, type of allowed investments, allowed 67. Therefore the NAV per share or unit is the market value of assets borrowing, the use of derivatives for leverage, etc. of a scheme, less its debts, divided by the total number of shares 82. Lipper, “European Fund Market Review 2013 Edition,” http:// or units of the scheme on any particular date. share.thomsonreuters.com/PR/Lipper/European_Fund_Market_ 68. Generally the price has to be calculated on any day on which Review_2013.pdf. trading in shares or units is allowed. One key issue is the valuation 83. UCITS Fund Distribution 2012, PwC. of unlisted or irregularly traded assets for which reliable prices 84. Chinese domestic mutual funds and funds approved for marketing are not available. in Hong Kong, China. 69. In the case of shares, it may be necessary to permit pricing by 85. Australia, China, Taiwan, China, Hong Kong, China, Indonesia, reference to recent prices of similar assets by what is called fair Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore, value pricing. In the case of bonds this may be done through the Thailand, and Vietnam. This will, of course, take time, just as mandatory use of agencies whose job it is to calculate “prices” UCITS took more than 10 years to have a significant impact and based on a standardized approach based on coupon, credit not all members of APEC will initially open their markets. rating, and duration (these “prices” may not be correct, but every fund is then incorrect to the same degree). 86. MILA’s objective is to create economies of scale and scope for equities trading on the exchanges and firms operating within the 70. The generally accepted key principles based on IOSCO’s 2013 region. more detailed report, “Principles for the Valuation of Collective Investment Schemes,” are the following: there should be 87. These provide equal protection to investors in each member comprehensive, documented policies that should seek to address country. conflicts of interest and be consistent, and there should be 88. Of course, a fund that can be sold only to professional investors appropriate procedures for review upon detection of error. in one jurisdiction should not be permitted to be sold to the public 71. An extra fee paid to the investment manager if the fund in another. outperforms its benchmark, usually an index, by a stated 89. If done in regulation, a court is likely to opine that provisions of a percentage, which is expressed as a percentage of the total value law will dominate over the provisions of a regulation. of that outperformance. 90. Other data in this paragraph are from the 2013 Investment 72. Order no. 1872-04 of the Minister of Finance dated October 25, Company Fact Book. 2004 (11 ramadan 1425). 91. Michael Bogdan and Daniel Schrass. “Profile of Mutual Fund 73. http://www.esma.europa.eu/node/49059. Shareholders, 2013,” ICI Research Report (February) (Washington, 74. So its sale and advice upon investing in such shares is therefore DC: Investment Company Institute, 2014). governed by securities law unless otherwise stated. 92. In contrast, when an individual directly invests in a security, 75. Another key issue will be whether such entities are permitted to there are only two levels of taxation possibly applicable: at the hold client money, in which case ring-fenced client accounts will company level and at the individual level. Situations in which the be required, or hold client assets in their own name, in which case investor ends up paying taxes twice for his or her investment, both the regulations for holding as nominees will need to be clear. through taxes withheld by the investee company on dividends paid to fund and taxes withheld by fund on dividends paid to the investor, are termed “double taxation.” 52 | MUTUAL FUNDS in developing markets: addressing challenges to growth 93. Example: “A fund licensed by … .” 94. Investors do not have control over when the portfolio manager decides to realize capital gains, and they do not have control over when they are taxed. See Robert Pozen and Theresa Hamacher, The Fund Industry: How Your Money Is Managed (New York: Wiley, 2011). 95. However, common numerous incentives or exemptions may eliminate or minimize the impact of any tax due, including holding fund shares or units through retirement plans. 96. Indexation against inflation may be permitted. 97. In Turkey, however, if a fund invests 75 percent or more in domestic equities, there is no withholding tax to make such funds competitive with direct investment in equities, which is also exempt from the 10 percent withholding tax; also corporates will have to pay the difference between the 10 percent withheld and the 20 percent corporate tax rate. 98. Conrad S. Ciccotello, “The Nature of Mutual Funds,” in Mutual Funds: Structures, Analysis, Management, and Stewardship, ed. John A. Haslem (New York: Wiley, 2010), pp. 3–15 Chapter 2: Legislation, Regulation, and Taxation of Mutual Funds | 53 Market Drivers and 3.  Impediments to Mutual Fund Development Introduction This chapter explores the nature and significance of market, or nonlegal/regulatory, drivers and impediments in developing the domestic mutual fund sector. These impediments are divided into three categories. The first type of impediment is the level of demand for mutual funds; that is, whether the number of investors in a country that are aware of mutual funds and have the resources to invest in them is sufficient. These investors may be institutional—such as pension schemes, insurance companies, and other mutual funds—or they may be corporate entities.1 They may also be individuals, who are saving to meet short- or long-term needs. A second type of impediment is the nature and quality of investable assets for mutual funds, that is, whether the range of investable assets is sufficient for funds to spread risk adequately and whether those assets are liquid enough to facilitate the operation of open-ended funds. These assets are typically money market instruments, government and corporate bonds, equities, and sometimes derivatives and real estate. The third type of impediment is the market structure of the mutual fund sector and the market infrastructure of the country within which it operates. This market structure or infrastructure may restrict the potential for development of the sector, for instance, by restricting access to distribution channels or posing barriers to entry. Each of these factors is explored in the following sections. Demand Countries differ in whether mutual fund ownership derives In these countries, retail demand is clearly strong and institutional predominantly from institutional or retail investors, which are investor demand weak. Although Kenya had no published data on the two primary sources of mutual fund demand. Although in ownership, its mutual funds were also thought mostly to be owned theory the distinction between the two is simple, in practice the by individuals through insurance-linked products. At the other end difference is difficult to classify (see box 3.1). Per available statistics of the spectrum, in Brazil, retail ownership was around 18 percent, in the case study countries, in some countries, such as Turkey, the and the rest was owned by a combination of institutional investors.3 mutual fund sector, at the end of 2012, was virtually 100 percent Similarly, in Morocco institutional investors owned 91 percent of retail owned.2 In Peru, at the time of the case study, the mutual assets under management in mutual funds. Clearly in these last fund sector was also almost 100 percent individual investor owned. two cases retail demand is relatively weaker than institutional demand. 54 | MUTUAL FUNDS in developing markets: addressing challenges to growth Box 3.1: Distinction between Retail and Institutional Demand In a retail transaction, the individual chooses which fund to buy (whether that choice is advised or not). The individual may buy the units or shares directly from the fund or within a wrapper such as a defined contribution pension scheme. In an institutional transaction, the manager of an institutional portfolio (insurance, pension, or another mutual fund) decides to invest in a fund, without reference to the wishes of the individual scheme member or policy holder. (See chapter 1 for more on this.) The differentiation between the two types of transactions is simple when dealing with mutual fund sales made to defined benefit pension schemes or insurance companies or to other mutual funds, which are clearly institutions. However, in practice this classification is not consistent or may not hold true in all markets. In some countries, such as Kenya, statistics on the mutual fund sector simply do not differentiate between institutional and retail sales. In some countries, sales classified as retail may be classified as institutional in other countries. For example, in the United States, sales made through defined contribution pension schemes are categorized as retail, whereas in France they are categorized as institutional. When demand for mutual funds derives from unit-linked insurance products, this may be treated statistically as deriving from an institution (the insurer) or from the individual who takes out the unit-linked plan. Of course, all demand eventually derives from individuals because it is individual money that contributes to pension schemes, pays for insurance policies, and takes ownership stakes in companies, including those companies that offer pension schemes and insurance policies. Institutional Demand In countries where institutional investors—pension schemes, Even if regulation allows pension schemes and insurance insurance schemes,4 and corporates—are not very well developed companies to invest into mutual funds, institutional demand or are divesting assets, demand for mutual funds can be low. for mutual funds may not develop unless mutual fund For instance, in Kenya, although no official figures were available, investment portfolios are aligned to the investment objectives institutional demand for mutual funds was thought to be low, of institutional investors. As noted, in both Peru and Turkey, partly because both the life insurance and pension sectors were not institutional investment in mutual funds was virtually nonexistent. well developed. Similarly, in Turkey, where institutional ownership In both countries, pension schemes could invest in mutual funds of mutual funds is low (1 percent in 2012),5 pension and insurance but mostly do not do so.10 In Peru, for instance, because domestic vehicles represented only around 1 percent and 3 percent of GDP, mutual funds invest predominantly in the local market, potential respectively, in 2011.6 In contrast, where institutional investors are buyers may not perceive them to offer any particular advantage more developed, such as in developed markets in Europe, there is to pension schemes and insurance companies who already have in potentially higher institutional ownership of mutual funds. For house expertise in domestic asset management. In Turkey, on the example, in Europe, more than 34 percent of mutual funds were other hand, mutual funds predominantly invested in short-term owned by insurance and pension vehicles at the end of 2011 and instruments (see figure 1.7 on asset exposure in chapter 1, where just over 8% were owned by nonfinancial corporations.7 In addition, Turkish mutual funds are shown to have only around 3 percent as in several developed markets, if pension funds are divesting exposure to equities) and may not have been able to meet the assets (for example, as “baby boomers” draw on their retirement), longer-term investment needs of Turkish pension funds. The most demand for mutual funds may decrease if they are the underlying popular Turkish mutual fund, the MMF, was predominantly sold by assets. For instance, in the United States, 10,000 baby boomers banks to retail clients rather than institutional clients. In countries will turn 65 every day until the year 2030,8 which may lead to sale where mutual funds are more commonly used for retirement of pension assets, including mutual funds. A similar phenomenon savings, these funds typically have much higher equity exposures, may arise in some emerging markets; for instance, it is anticipated such as 45 percent exposure to equity in the United States.11 in Morocco by 2026.9 In addition, institutional investors may not invest in domestic Where institutional investors are instead a significant presence mutual funds if such funds do not offer exposure to international and if such investors receive better fiscal treatment than mutual assets, either because of lack of capacity or regulatory funds, the mutual fund sector is likely to grow to the extent such constraints. Investing abroad via a collective investment scheme schemes are allowed to invest in mutual funds. As discussed in typically is attractive to institutional investors because it would chapter 2, if pension schemes or insurance companies’ products be more expensive for them to hire their own in-house team of benefit from better tax treatment than mutual funds, savings are experts in international investments than to invest through a likely to flow to those contractual savings schemes rather than to professionally managed mutual fund investing internationally. In mutual funds. Particularly if, in the case of pensions, contributions developed markets it is typical for such international diversification also are mandatory and represent a substantial proportion of to be offered to domestic institutional investors via domestically salaries, demand for mutual funds will likely be low if regulation based mutual funds rather than by foreign-based mutual funds. At does not permit or restricts pension schemes’ and insurance the time of the case studies, neither Peruvian nor Turkish domestic companies’ investment into mutual funds. mutual funds invested abroad to any great extent, perhaps because CHAPTER 3: Market Drivers and Impediments to Mutual Fund Development | 55 fund operators felt that they did not have established expertise in more expensive brand awareness building and promotional activity. such investment. However, in Peru, the 10 percent of funds under Institutional investors also tend to exert pressure on costs and management that pension schemes invested in mutual funds, at demand good performance to a greater extent than retail investors, the time of the case study, were made in foreign mutual funds that which may in turn make mutual funds more competitive. Ensuring invested outside Peru.12 This presented a missed opportunity for that institutional investors can use mutual funds as underlying domestic mutual funds. However, even if domestic mutual funds investments, and that mutual funds can invest abroad, is therefore are not barred from making foreign investments, other legal, important. regulatory, or tax barriers to foreign investment may exist (see chapter 2). Retail Demand Corporate demand for mutual funds, particularly for cash Mutual funds tend to be more successful in countries with a management, may help expand the mutual fund sector. larger number of smaller savers, that is, a larger middle class. Corporations are typically characterized as institutional investors. Mutual funds are essentially designed to diversify risk for smaller They use mutual funds, specifically MMFs, for cash management. savers who do not have enough money to achieve diversification In fact, MMFs are a large component of the mutual fund sector in themselves; thus, they tend to be a middle class savings vehicle. some developed markets, such as the United States, partly because An OECD study15 estimated that the global middle class totaled of this demand from corporates. In the United States, 20 percent 1.8 billion people in 2009, of which Europe had 664 million (or 36 of the cash assets of nonfinancial businesses were invested into percent) versus Sub-Saharan Africa with 32 million people (or 2 MMFs in 2012 (although this percentage had declined from its peak percent).16 Correspondingly, assets under management invested of 37 percent in 2008).13 In Brazil, 8 percent of collective investment in mutual funds in Europe at the end of 2012 were $6.2 trillion, schemes were owned by corporates.14 Nonfinancial companies whereas in Sub-Saharan Africa it was $69 billion. Although a range owned 26 percent of mutual funds in Morocco, where MMFs of other factors explored in this study may also have an impact also represented 26 percent of total funds under management. on availability of savings, essentially, other things being equal, High levels of ownership of MMFs by corporates can lead to very the greater the income of households in a country, the more likely large amounts of money flowing into and out of MMFs daily, in it is that the mutual fund sector will develop more strongly. This turn requiring highly liquid underlying investments that may be a tendency is shown to some extent in the sample of emerging problem in emerging markets (as discussed later in this chapter). markets shown in table 3.1, where some mutual fund markets that represent a larger proportion of GDP also tend to be in countries Overall, institutional demand has benefits for mutual funds in where the gross national income per capita is higher. A more general in that it can generate large inflows that can build assets detailed discussion of this relationship between fund use and per under management rapidly. Where it derives from long-term capita income can be found in a March 2014 ICI study.17 investors such as pension funds and insurance companies, these flows can be more stable and fund choices more discriminating Consumers who have higher levels of education, higher levels of because they are made by expert investors; where it relates to income, more disposable income, and reside in, or close to, urban corporate demand for MMFs, large daily inflows and outflows areas are more likely to invest in mutual funds or to be open to doing may be involved, which may be difficult to accommodate in less so. A 2011 study on household savings in India18 noted that savers with liquid markets. Institutional flows have the benefit that they are 11 or more years of education were more likely to invest in securities usually cheaper to attract than retail flows, which usually involve Table 3.1: Selected Emerging Markets Categorized by Gross National Income per Capita: Value of Mutual Funds as a Percentage of GDP, Year End 2011 Low Lower Middle Upper Middle High ($1,045 or less) ($1,046–4,125) ($4,126–12,745) ($12,426 or More) Country Mutual Funds Country Mutual Funds Country Mutual Funds Country Mutual Funds as % GDP as % GDP as % GDP as % GDP Kenya 0.80 India 4.61 Brazil 46.87 Korea 34.12 Indonesia 2.19 China 4.65 Russia 0.16 Morocco 26.92 Costa Rica 3.09 Saudi Arabia 4.50 Nigeria 0.20 Hungary 11.7 Slovenia 5.00 Pakistan 1.43 Malaysia 28.31 Mexico 8.00 Peru 2.79 South Africa 30.61 Turkey 2.33 Sources: IOSCO survey, World Bank, case studies. 56 | MUTUAL FUNDS in developing markets: addressing challenges to growth markets and mutual funds. People living near urban areas were more government awareness and understanding of mutual funds may likely to make such investments than those in rural areas. In fact, 87 mean that mutual funds do not receive attention in financial sector percent of mutual fund assets under management in India derived strategies or may suffer in comparative fiscal treatment with other from the top 15 cities by size, with the top five cities accounting for savings schemes. Regulators may also lack understanding and 74 percent of the value of the sector.19 The 2011 study in India further awareness of mutual funds, which may mean that they are less showed that those with higher income levels were less likely to be risk willing or able to participate in educating the public on the benefits averse and therefore more open to investing in securities and mutual that mutual funds can provide. As chapter 2 points out, this lack funds. The survey also found that one of the main reasons people did of understanding may also lead to funds being less effectively not invest in securities markets was inadequate financial resources. regulated and supervised, which in turn may damage the potential The lack of disposable income is a widespread barrier to savings. A for market development, because confidence in these funds is global survey on consumer attitudes to savings in the period 2004– less likely to develop. The vast majority of the public may also not 200820 showed that the largest barrier to saving was lack of disposable be familiar with mutual funds or understand how they function, income: Almost 50 percent of people did not save simply because they although this may be equally true in developed countries as well.23 could not afford to. Finally, low levels of participation in the formal In India, an income and savings survey24 indicated that fewer than 2 economy may reduce potential for mutual fund development because percent of the population invested in mutual funds and 90 percent those in the informal economy may not risk investing their money of savers were unaware of the existence of mutual funds. In fact, a where it may be noticed by the tax authorities. survey25 of Indian mutual fund operators showed that they thought the inadequacy of consumers’ knowledge of mutual funds was the However, consumers may also feel that they have sufficient greatest impediment to greater mutual fund market penetration. savings through contractual savings schemes and therefore do Similarly, in South Africa, which has the largest fund market in not need to invest in mutual funds, and cultural factors may Sub-Saharan Africa, and where mutual funds have been sold since dictate investor preference for other types of investments. As 1965, a survey on financial literacy26 showed that only 2 percent discussed in chapter 2, individuals who are required to make pension of the sample held mutual funds and only 33 percent had heard of contributions to a first and/or second pillar system by law, or by such funds. their employment contract, may feel that they have already made adequate savings. A global consumer attitudes survey21 found that In these markets, the lack of public and standardized information 12 to 15 percent of those participating in 13 of the emerging and on mutual funds and the lack of specialist independent data developed markets felt that they already saved enough. The survey providers may limit awareness and, therefore, demand for mutual also found that reliance on governments to provide an adequate funds. In developed markets, independent media cover mutual level of pension is higher in emerging versus developed markets; funds extensively. However, in early emerging markets, such media for instance, 49 percent of those surveyed in India thought that coverage is usually not present. For instance, in Kenya, national government would provide adequate pension, and the average newspapers generally do not have personal financial pages or across all survey countries (developed and emerging) was 24 supplements, and no websites or magazines feature comprehensive percent. In emerging markets retail investors also tend to prefer fund information on a regular basis.27 The scale of developed other investment choices such as gold or real estate. For example, markets can also sustain the cost of specialist independent fund Turkey’s Capital Markets Board undertook a study that showed information providers such as Lipper, Morningstar, and Standard & that retail investors preferred investing in gold, real estate, and Poor’s, who measure and compare factors such as fund investment bank deposits, in that order of preference.22 performance and cost.28 Some of these features of developed markets may, of course, also be prevalent in more developed Overall, retail demand also has benefits for mutual funds. Although emerging markets and help with building understanding and such flows tend to be smaller, take longer to build, and be more awareness on mutual funds. For example, in India and Malaysia, expensive to attract (because they involve building brand awareness coverage of mutual funds is similar to that seen in mature markets and promotional activity), they may be more remunerative because with well-developed statistical and information services from trade such clients may be less sensitive to cost and to periods of indifferent associations and specialist data providers. However, in smaller fund performance than institutional clients. However, retail investors may markets, independent data providers are uncommon, so sources be less familiar with the risks entailed in mutual fund investing and so of unbiased information about funds may be nonexistent, as in may redeem in large numbers if markets fall sharply (this tendency Kenya, or limited, as in Turkey. This lack of independent mutual should reduce over time as such risks become better understood). fund performance and cost data may also reduce competition Incentivization of retail saving through mutual funds needs to be pressures on the sector. In addition, developed fund markets have carefully considered, however; if it is overdone, too much money standardized requirements for disclosure of information about may flow into such funds that may not be able to be accommodated funds, which help investors effectively compare funds, as discussed because of the level of capital market development. If it is underdone, in chapter 2. However, in several emerging markets, such as Peru mutual funds may fail to develop. and Kenya, mutual fund disclosure is nonstandardized, which can reduce demand because investors cannot rely on data being Lack of Awareness given on the same basis and therefore being comparable.29 This general lack of awareness and understanding of mutual funds is In emerging markets, both governments and individuals may also exacerbated because in countries where mutual funds are relatively lack awareness and understanding of mutual funds. The lack of CHAPTER 3: Market Drivers and Impediments to Mutual Fund Development | 57 small, their operators may not be able to fund the advertising and sensitive to inflation and to the possibility of future interest rate promotion that larger and more mainstream financial services, changes that could reduce the value of the capital invested in bond such as banking and insurance, can afford. Thus unless the mutual funds.33 They are thus reluctant to invest in financial instruments funds being sold are part of the range of services provided by a with long durations and/or fixed interest rates in case the capital major financial institution, such as a bank or insurer, the brand value of their investments plummets (see box 3.2). Investors in name of the mutual fund operator is unlikely to be widely known. some markets may also be more sensitive to loss of capital than to One solution may be for government or the regulator to finance the potential of making gains. For instance, in Turkey more than 60 and undertake financial literacy campaigns to educate people as to percent of those surveyed in a capital markets awareness study34 financial choices and their implications if the market cannot afford preferred a lower (but safer) or guaranteed rate of return, whereas to do this. only just more than 20 percent wanted best market performance or competitive rates. Emerging market retail investors also need sources of independent financial advice, and this is typically uncommon in such markets. In emerging markets, given people’s inexperience of dealing with Box 3.2: Brazilian Fund Market Response to Inves- investments such as mutual funds and the large number of funds tor Fear of Inflation and Interest Rate Volatility that may be available in many countries, a common need is for sources of information and advice as to which fund best suits a In Brazil where investors are worried about interest rate client’s needs. For example, in markets where there is a proliferation volatility, fund managers have effectively converted longer- of mutual funds, as in Brazil (around 11,500), investors who lack term “fixed-income” funds to MMFs. financial knowledge may find it difficult to decide which one to In Brazil, including the assets of multimercado35 funds and FAPI36 buy. Although standardized categorization of such funds can help, funds, fixed-income and money market instruments accounted investors may still be confronted by a choice of 50 to 100 funds of for 75 percent of total assets under management.37 Almost a similar type, and where there is a lack of comprehensive unbiased 70 percent of bonds held had a duration of three years or less. information in the marketplace, this can deter people from investing. However, even though the bonds held by such funds may not In emerging markets, the financial advisory industry, which covers mature for three or five years, the interest rate on 70 percent of a wide range of financial services and could assist in developing bonds held was indexed to a reference interest rate or floating retail demand for mutual funds, is typically not well developed. rate. Thus, when market interest rates change, the rates For instance, South African financial literacy research30 showed payable by the bonds held by funds change too, which implies that a source of independent advice, such as a broker, ranked far no impact on the capital value of the bonds concerned. Thus in Brazil such bonds are more like money market instruments below other sources of advice (4 percent, compared with almost whose capital value is not likely to fluctuate. Funds investing 80 percent of advice derived from family or friends), whereas this in these instruments can therefore offer a more stable capital is a more significant source of advice in the United Kingdom (14 value and less volatility to investors. percent).31 In general, sources of independent financial advice will tend to develop only once entrepreneurs perceive that a demand for such advice exists and that money can be made providing this service. Thus, the better the incentivization for investing in mutual funds, the greater the demand and the resulting need for advice. The availability of MMFs may improve investor confidence, but in some markets these may entail greater risks than are Lack of Confidence apparent. As discussed in chapter 1, MMFs are mutual funds Investors may simply lack confidence in the financial sector that invest primarily in short-term debt of corporates, banks, and/or mutual funds or be deterred by market volatility or and governments, such as commercial paper, treasury bills, and the potential loss of capital. In countries with long histories of certificates of deposit. The popularity of MMFs in many markets— financial crises, ordinary investors may lack confidence in the both developed and emerging—often derives from their net asset financial system in general. Economic and financial instability can value per unit being either constant, so there is no potential for either deter investors from investing or influence their investment loss of capital, or variable, but relatively little potential for loss of strategy. Mutual funds in emerging markets are also more likely capital (see box 3.3). These funds are also popular because they can to experience problems with buying or selling fund assets quickly access wholesale money market rates and therefore usually offer and easily because of illiquidity in the market (see discussion higher interest rates than investors receive with retail deposits. below). This can engender fear in investors who have experienced This difference in interest return was a key element in the genesis or witnessed the inability of others to withdraw their money from of such funds in France and the United States and, more recently, a mutual fund upon demand.32 As discussed in chapter 2, investors in China. However, in some emerging markets, there may be no may also lack confidence in mutual funds because of prior Ponzi definition of what a MMF is, and the investment may in fact be schemes. In addition, market volatility may also deter investors riskier for investors than would be typical. For instance, almost 50 because it implies uncertain investment outcomes. In Brazil, percent of Kenyan mutual fund assets under management were for instance, a history of economic turbulence, with periods of invested in what are referred to as “MMFs.” However, many of these high interest rates and high inflation, has made investors highly funds actually invest in bonds with a life of anywhere up to five 58 | MUTUAL FUNDS in developing markets: addressing challenges to growth Box 3.3: Money Market Funds and the Risks of Constant Value MMFs in Volatile Interest Rate Environments Money market funds are popular when they offer higher returns through their access to wholesale money market interest rates together with diversification of risk. In competing with bank deposits, these funds may also encourage banks to provide better rates of interest. Such funds can become systemically significant providers of finance to corporates. For instance, in the United States, MMFs at the time of the credit crunch were estimated to own around 40 percent of commercial paper in issue.38 However, a possible downside is that investors may be misled into investing into money market or other funds, thinking that their capital is safer than it is. If the funds underperform, disillusion could set in and confidence in funds may be damaged as a result. This is why brief, clear, comprehensible disclosure of risk is important. Constant value MMFs, in particular, may be inadvisable in environments with volatile interest rates.39 In Kenya, for example, Central Bank benchmark interest rates between 2000 and 2012 had abrupt movements with relative frequency, ranging roughly between 1 percent and 20 percent. Unless constant value MMFs hold very short-term paper, it is probable that such interest rate volatility would cause capital loss sooner or later, and such funds would “break the buck” and damage market confidence. years on acquisition, which would ordinarily be categorized as “fixed in Turkey, for instance, when loan spreads were higher than mutual income,”40 so their unit values are likely to be volatile (see chapter 2). fund–related fees, banks that controlled mutual funds had less incentive to promote mutual funds versus deposits. Similarly mutual Mixed asset class funds or fund of funds, which reduce volatility of fund demand declines when government savings instruments offer returns, may also improve confidence. However, in some countries high real rates of return43 to retail investors, with security of capital regulatory frameworks governing funds either do not envisage with which mutual funds cannot compete. In Pakistan, for instance, mixed asset class funds that can shift their asset allocation to in the early 2000s, national savings vehicles available only to retail equities, bonds, and cash over time, or do not envisage funds of investors provided interest rates of 15 percent; unsurprisingly, funds, which can shift asset allocation through their underlying mutual funds were crowded out. Similarly, at the time of the mutual funds. Where this is the case, fund managers will be less case study in Kenya, the Central Bank had reduced the minimum able to reduce volatility of returns and to offer “target absolute subscription for treasury bills to the equivalent approximately of return funds,” which are usually funds of funds that aim to give a $250, enabling direct retail participation. T-bills are a more secure positive return in every year. Although these types of fund may be investment, and so this could channel retail investor money away difficult to operate in newly developing capital markets, which lack from money market mutual funds. Last, investors may also simply the range of liquid investments needed to operate them, providing prefer to invest directly into equities or bonds instead of seeking for such funds to exist gives flexibility as markets develop. to diversify risk through mutual funds. For instance, in Kenya at the end of 2012, local individuals owned just more than 23 percent Impact of Competing Saving Methods on Demand of shares44 listed on the Nairobi Stock Exchange45 and accounted for nearly 19 percent of market turnover in the last quarter of that for Mutual Funds year.46 Similarly, in Turkey, direct equity investment appeared In general, mutual funds may be crowded out by other savings to be more popular than investing indirectly via equity mutual mechanisms in the market that are mandatory or offer funds: Borsa Istanbul held more than a million individual accounts, advantages such as ease of access, more competitive returns, although fewer than 10 percent were thought to be active.47 more security, or greater tax efficiency. As already mentioned, where retirement provision is mandatory, and contributions Conversely, when returns on other savings products are low, are high, people may see no further need to save. Other savings capped, or limited, or when the underlying investments in mechanisms may also crowd out mutual funds because of relative mutual funds perform well, mutual funds may flourish. When tax advantages as noted in chapter 2. As discussed in chapter interest rates on deposits (and MMFs) are low, as they have been 2, in Peru, for instance, mutual funds had to withhold tax when in many countries since the credit crunch, investors will tend to distributing income or gains to investors, but banks did not have look elsewhere to improve their returns. Demand for bond funds to do the same for deposits.41 This crowding-out effect may be and equity income funds typically increase in these circumstances. compounded if other long-term savings mechanisms are also easily Figure 3.1 illustrates this point. It shows the impact of interest rates accessed; that is, in some countries, retirement contributions can on inflow of savings into funds versus bank deposits in the United be withdrawn before retirement with relatively low, or no, penalties, Kingdom: Basically, as interest rates fall, net retail sales of funds which reduces the need to invest through mutual funds, which are increase. Mutual funds may also benefit from limits or caps placed valued for their liquidity (because they are obliged to redeem upon on other savings instruments. In Turkey, where current accounts did request).42 Mutual funds also compete with bank deposits. When not pay interest, banks offered MMFs to their clients with excess interest rates are high, ordinary investors will typically leave their cash in current accounts and in turn levied charges of 5.5 percent money on deposit in banks, where their capital is usually subject to per annum on the funds (until these charges became capped at 1.1 deposit guarantees, rather than take higher levels of risk in equity percent).48 More recently, Chinese MMFs have seen success mainly or bond mutual funds. In addition, as at the time of the case study because they could offer interest rates of around 6 percent whereas ordinary individuals could get only around 0.3 percent on demand CHAPTER 3: Market Drivers and Impediments to Mutual Fund Development | 59 Figure 3.1: Net Acquisition of Deposits and Currency and Net Retail Sales of Mutual Funds by U.K. Households versus Bank of England Base Rate, 2004–2013 U.K. Pounds, Millions Base Rate, Percent 120,000 7 100,000 6 5 80,000 4 60,000 3 40,000 2 20,000 1 0 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Currency and Deposits Retail Mutual Fund Sales Bank rate Source: Bank of England, Investment Management Association, and ONS. deposits, and the government capped one-year deposit rates at Domestic mutual funds may also be crowded out if foreign mutual 3.3 percent.49 Also, as mentioned in chapter 2, income distributed funds can be publicly offered and are more competitive than by Chinese MMFs was free of withholding tax, whereas interest on domestic funds. The development of a domestic mutual fund market deposits was not.50 The entry of MMFs can disadvantage banks such may be impeded if there are no exchange controls and authorities as in the United States in the 1970s, when Federal Reserve regulation permit foreign mutual funds that prove to be more competitive Q capped interest rates on bank deposit rates and MMFs were than domestic mutual funds to be sold into a country. Foreign funds able to offer investors access to market interest rates, which were may have advantages over domestic funds. For instance, they may higher. In France in the 1980s, government did not permit interest have lower charges because of economies of scale. Their managers payment on retail deposits,51 thus making MMFs more attractive. On may have wider and deeper investment knowledge of international the other hand, in the United Kingdom, bank savings deposit rates markets, well-established brands, and deeper pockets to pay for have habitually been competitive with wholesale money market promotion and commissions to distributors. They may therefore rates; thus MMFs have never developed to any great extent. Last, potentially be more attractive to domestic investors than domestic mutual fund demand may also be strongly influenced by the market funds. For example, a 2012 study53 of distribution of UCITS in Asia performance of their underlying investments; for example, figure 3.2 noted that in Hong Kong, China, offshore funds represented 94 illustrates that net sales of equity funds tends to correspond with percent of total market value. As discussed in chapter 2, some equity market performance. countries’ regulatory systems, such as the United States, make it Figure 3.2: Global Net Sales of Equity Funds versus Annual Return on Equities, 2002–201352 $, Billions Percent 600 60 500 50 400 40 300 30 200 20 100 10 0 0 -100 -10 -200 -20 -300 -30 -400 -40 -500 -50 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Global net sales of equity funds (left scale) Annual return on equities (right scale) a Sources: Bloomberg, ICI Global Perspective, March 2014, International Investment Funds Association, and Morgan Stanley Capital International. a. December to December percent change in MSCI All Country World Daily Total Return Index. 60 | MUTUAL FUNDS in developing markets: addressing challenges to growth Figure 3.3: Total Expense Ratios in Select Emerging and Developed Markets Percent 3 2.42% 2.15% I2.42% 1.89% 1.85% 2.42% T1.68% 1.76% 2 1.50% 1.85% 1.43% 1.05% 1.02% 42% 0.89% 0.82% 0.79% 0.79% 0.77% 0.71% 1 0.63% 0.59% .55% 0.43% I0.30% 0.23% 0.17% 0.17% , 0 Bond Fund Equity Fund Mixed Fund Money Market Fund Canada China India Korea South Africa Thailand United States Source: Morningstar Fund Research 2013. a complete deterrent because equity mutual funds constituted 30 illegal to offer a mutual fund unless it is a domestically based fund percent of assets under management in Kenyan mutual funds at approved by the regulator. However, other countries, such as Turkey, the time of the case study. have regimes that “recognize” foreign funds for public offer or allow foreign funds to be privately offered to professional or rich investors. But in Turkey, although numerous foreign funds have been approved Supply for offer, they have not been successful in attracting investors, One of the inherent contradictions of developing mutual funds in probably because their method of taxation is more cumbersome emerging markets is that the key requirement for mutual funds than for investors in domestic funds.54 to function is a sufficient range of adequately liquid, diversified investments that are easily valued and transferable; however, Although mutual fund-related costs in emerging markets are not emerging markets often do not fulfill this requirement. Little necessarily higher than those in developed markets, where these purpose is seen in introducing laws and regulations to facilitate the costs are high relative to direct investment, they may deter introduction of mutual funds if these funds are unable to function demand. A mutual fund’s total expense ratio is its total annual properly. As mentioned in chapter 1, mutual funds are typically operating expenses expressed as a ratio of its average net assets. an outcome, and not a cause, of capital markets development. Total operating expenses include the annual management charge It was only when capital markets in the United Kingdom and the paid to the fund operator as well as various charges, such as for United States became sufficiently liquid that these funds could legal, audit, and trustee, depositary, or custody services. Although start to function and thus came into existence. Mutual funds higher annual management charges may make the business need a sufficient range of investments to diversify risk. They also of operating funds more viable, they can also deter investors, need markets with adequate liquidity to invest new inflows to the especially in comparison with other competing investment fund promptly and to be able to sell assets to raise cash and meet products. In addition, when the total costs of a fund, as measured redemptions. Funds must also be able to accurately price their by the total annual operating expense ratio, are high, the return to portfolios of assets to accurately value fund shares or units for sale the investor is correspondingly lower. Figure 3.3 shows the range or redemption.57 In addition, for assets to be easily bought and sold of total expense ratios55 of mutual funds in a selection of emerging they usually need to be transferable58 and to be traded on a market and developed markets derived from a Morningstar study of global that functions frequently, reliably, and transparently. Without such investor experience.56 It shows the United States as one of the conditions, a strong possibility exists that one or more funds may lowest cost developed markets globally and Canada as one of the fail either to diversify risk, or to redeem upon request, which will most expensive, implying that such costs are not uniformly lower in damage confidence in such funds and possibly damage confidence developed markets versus emerging markets. In Kenya, for example, in wider capital markets. investing in equities via a fund resulted in annual charges of up to 3.5 percent (in addition to entry charges of up to 6 percent). This was clearly expensive compared with investing directly in equities Ability to Diversify Investments through a broker with as little as $1,000 and once-off brokerage If only a very limited range of investments—money market fees of 2 percent or less. However, this level of cost was clearly not instruments, equities, or bonds—is available, mutual funds CHAPTER 3: Market Drivers and Impediments to Mutual Fund Development | 61 cannot satisfy diversification requirements or differentiate their holding both equities and bonds, than if it is a “pure” equity fund performance from other funds in the market. In such cases, the (see box 3.4). legal framework should ideally enable mixed asset funds, which can invest in shares, bonds, and money market instruments. Mutual Emerging markets may also have limited supply of government funds typically are not allowed to invest more than 5 percent or bonds or a limited supply of government bonds of varying 10 percent of their value in any one issue of securities and cannot durations. In Saudi Arabia, where government borrowing needs are have more than 20 percent cumulative exposure to the deposits, minimal, no government bonds are available to buy; government money market instruments, and issuance of any one issuer (with issuance in other countries may be limited because of relative the exception of government).59 These limits ensure that a fund cost versus other forms of borrowing or other factors. In yet other provides diversification and that fund operators earn their charges countries, government bonds may have limited duration, which for portfolio selection and management (which they would not do leads to the absence of a yield curve against which to rate corporate if a fund had only two or three investments). In developed markets, issuance, which may in turn limit the supply of corporate bonds. mutual funds may have hundreds of different holdings, which is Similarly, the supply of money market instruments in emerging relatively easy to achieve in markets such as the London Stock markets may be insufficient, as fund managers in Kenya, Exchange (around 2,500 listed companies) or the New York Stock for instance, asserted. IOSCO’s recommendation64 is that a Exchange, which is part of the Intercontinental Exchange network conservative MMF’s portfolio should have a weighted average constituting 11 different exchanges trading 12,000 securities and maturity of up to 60 days and a weighted average life of 120 days, contracts globally. However, as a recent IOSCO survey60 found, which means a sufficient supply of such money market instruments even in emerging markets that are wider and deeper, such as South is needed for such funds to operate. Africa, achieving required levels of diversification could be difficult. Emerging markets generally have less developed stock markets, Need for Liquidity and countries with smaller stock market capitalization to GDP ratios tend to also have smaller mutual fund assets under In illiquid markets, where trading is infrequent and assets management to GDP ratios (see figure 3.4). Exposure to equities cannot be easily bought or sold, valuing mutual funds is difficult; is often low in emerging markets (for instance, 3 percent in Peru), moreover, new inflows may not be able to be invested promptly, often because supply of liquid equities is low.61 For instance, in and open-ended funds may not be able to promptly honor Peru, despite 241 issuers with a market capitalization of around investor redemption requests. Mutual funds ideally need to access $153 billion at the end of 2012, monthly stock market turnover in current prices for their investments daily to value fund assets and December 2012 was only $2.2 billion, indicating a lack of liquidity.62 calculate the price per share or unit at which investors can enter or Kenya had around 50 listed companies at the time of the study, exit the fund that day. This means that the prices of the underlying only 20 of which were reasonably liquid, and Morocco had around assets must be formed daily, which may not happen in emerging 77, with liquidity concentrated in the largest 15 companies. A markets where few transactions take place (moreover when prices mutual fund in such circumstances is more likely to be able to are formed, they may be volatile and easy to manipulate) and achieve effective diversification if it is permitted to be a mixed fund, where institutional investors such as pension funds tend to “buy Figure 3.4: 2012 Mutual Fund Assets/GDP versus Stock Market Capitalization/GDP63 Long-Term Mutual Fund Assets as a Percentage of GDP 100 90 Australia 80 70 United States 60 R² = 0.38 50 United Brazil Canada Kingdom 40 Switzerland France Sweden Denmark 30 South Africa Austria Korea 20 10 Netherlands Chile 0 Philippines 0 20 40 60 80 100 120 140 160 180 Stock Market Capitalization as a Percentage of GDP Sources: International Investment Funds Association and World Bank. Note: Total net asset data for Russia are as of 2011. Data is included for Argentina, Australia, Austria, Belgium, Brazil, Bulgaria, Canada,Chile, China, Costa Rica, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, India, Italy, Japan, Korea, Rep. of, Mexico, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, Romania, Russia, Slovakia, Slovenia, South Africa, Spain, Sweden, Switzerland, Trinidad and Tobago, Turkey, United Kingdom, and the United States. 62 | MUTUAL FUNDS in developing markets: addressing challenges to growth Box 3.4: Achieving Investment Diversification in Ugandan Equity Mutual Funds Uganda, which has had a mutual funds law since 2003,65 had underlying regulations requiring a fund to have a minimum of 16 holdings (four investments capped at 10 percent of fund value and 12 investments capped at 5 percent). However, the Ugandan Securities Exchange had only eight listed domestic securities and seven cross-listings. Turnover on the exchange was around $6 million in the last quarter of 2012. This made it virtually impossible for an equity mutual fund to operate effectively; simply not enough different equities were available for an equity fund to achieve the diversification required by the regulations. It was also very unlikely that an equity fund that raised $5 million could get invested within a three-month period. and hold” because assets are hard to come by. In Morocco, for they synthetically replicate the performance of an index using instance, given stock market illiquidity, historical prices disclosed swaps, but this is feasible only in markets where there are financial by the Casablanca Stock Exchange may not automatically reflect institutions able and willing to enter into such transactions. the actual value of shares or give a good indication of the price that would result from future transactions.66 In illiquid markets, mutual Closed-ended funds may be better suited to illiquid markets. fund inflows from investors therefore are also at risk of being In illiquid markets where the range of equities or bonds available kept in cash instead of being invested because assets are difficult is limited and these instruments are infrequently traded, the to buy. This means investors are not achieving the exposure to development of closed-ended funds should be encouraged before the asset classes and entities described in the fund’s investment open-ended funds. In countries where funds developed organically, policy and objectives. On the flip side, if mutual funds fail to meet closed-ended funds usually developed first, because they did not their fundamental obligation to investors to redeem upon request need liquid securities markets. Because such funds do not have because assets cannot be sold quickly to raise cash, then again to redeem their shares or units, the fund does not need liquid investors again are being deprived of their right as stated in the underlying assets. Thus these funds can also be used for investment fund’s prospectus. Another problem is that stock exchanges may in infrastructure, real estate, and venture capital–type companies not trade every day, so prices cannot be formed every day. In this (see box 2.7 for more on closed-end funds). case funds in emerging markets may be permitted by regulation to value and deal less frequently: only once every two weeks or Ability to Hedge Risks even once a month.67 This was the case in Uganda at the time the Collective Investment Schemes Act was passed in 2003. Trading In emerging markets, mutual funds may not have access to on the Uganda Securities Exchange was twice weekly for a few instruments to hedge risks. In markets such as Kenya or Morocco, hours (it subsequently started to trade five days a week and open because underlying assets (such as shares or bonds) are not for normal business hours). In this case, prices could be formed only typically well developed, derivatives (contracts whose value depends twice weekly also, so daily valuation and pricing of funds could not on the value of an underlying asset) are correspondingly not well be required. Infrequent trading of bonds is also a problem in many developed or available. This means that derivatives cannot be used emerging (and developed) markets. In Brazil, where bond funds are in such countries (as they are in others) to reduce risk. In addition, more like MMFs (see discussion above), a wide range of government mutual funds investing in foreign assets might wish to hedge the bonds are found (with fixed, floating, and index-linked rates of currency risk involved, but this will not be possible if currency interest). However, illiquidity is still a problem because secondary forward contracts or swaps are not available, as is generally the markets in bonds are very limited. In Brazil this is because if the case in early emerging markets. It is very important, therefore, to interest rate on a bond floats or moves with an interest rate index, recognize that developing mutual funds and developing capital the market value of the bond held does not change, and therefore markets are interdependent; mutual funds can function effectively there is no need to sell the bond if bonds with higher rates come only where capital markets provide sufficient diversification and onto the market. In countries with no exchange controls, such as liquidity. Peru, illiquidity may drive investors in search of liquid assets toward foreign assets. Market Structure and Infrastructure Indexed funds may also not be able to operate in illiquid markets. Market structure impediments can restrict competition between Index funds aim to replicate the performance of a stated index (less mutual fund operators, create barriers to entry, and limit product management charges) by using inflows to buy the components of development. the relevant equity or bond index in the same proportions as the constituents of the index. However, if an index fund cannot buy and Dominance of Bank Ownership of Fund Operators sell the underlying assets every day as money enters and leaves the fund, it will diverge from the performance of the index. Many Banks and insurers dominate ownership of fund operators in exchange-traded funds operate in this way, although in some cases many emerging and developed markets, both in terms of number CHAPTER 3: Market Drivers and Impediments to Mutual Fund Development | 63 of operators and by value of assets under management in funds. operate funds, whereas in Morocco, Peru, and Turkey (since 2013), Figure 3.5 shows this domination of bank ownership in terms of a specifically licensed fund management company is required to number of operators in the case study countries. However, bank operate funds. Although these fund management companies dominance is even stronger in the same countries when analyzed may often be a subsidiary of a bank, insurance company, or in terms of assets under management. In Brazil, 17 of the top 20 other financial sector business, their focus is exclusively fund operators (accounting for 85 percent of assets under management) management, and they are invested in the success of the mutual were bank owned. Similarly, in Morocco, seven of the top eight asset fund business and the development of the sector. Banks and insurer management companies were owned by banks and controlled 87 domination may also reduce competition in the mutual fund sector. percent of assets under management, and in Peru banks controlled In Peru, for example, to buy units in a fund operated by a bank- 95 percent of assets under management. In Kenya, the top eight controlled fund operator, the client would have to open an account operators in terms of assets under management were banks and with the bank that owned that operator. Subscription into the fund insurers and controlled 50 percent of the market. In Turkey only 30 was then made through this account, and investment proceeds percent of assets under management were controlled by banks.68 were also received through this account. This potentially deterred bank clients from investing in funds offered by other operators, Although mutual fund operators owned by a larger financial thus reducing competition between operators. services firm may have certain advantages, this type of ownership also leads to less exclusive focus on developing the Bank or insurer domination may also influence the type of mutual mutual fund management business and may deter growth and fund products developed in the market. Fund operators dominated competition within the sector. If a dedicated firm operates funds, by banks and insurers will tend to create the product range that can the firm would focus exclusively on developing and growing the be sold most effectively by their parent organization to its client mutual fund business. However, when banks are the fund operators, base. It is possible, therefore, that the relatively low percentage of or dominantly own mutual fund operators, the business priority assets under management invested into equities in many emerging may not always be mutual fund sector growth (the same will also be markets (as shown in chapter 1), in markets where banks dominate true of insurance ownership). For instance, in Kenya and in Turkey ownership of operators, may also be related to these banks being (until the end of 2012), the operator of the fund, which created the more able to sell money market and fixed-income products to their mutual fund and was legally responsible for its operation, did not client base rather than equities. Banks would be more incentivized have to hold a fund management license. Instead, an operator to offer MMFs because these funds have less volatile returns, could simply appoint an investment management company to therefore being more acceptable to clients and presenting less manage the assets of the fund. Thus entities that covered a broad reputational risk to banks. For example, the domination of MMFs range of financial services, such as investment banks in Kenya and in Turkey could possibly have resulted from banks seeking to retain banks in Turkey, could create and operate funds. In this case, fund their clients through an interest-bearing investment at a time when operation is simply one activity within a wider-ranging business current accounts paid no interest and term deposits locked clients whose commercial priorities will vary over time. In contrast, in in for periods when interest rates were likely to fluctuate. Thus the Brazil, regulation required a specialist administrator company to bank’s clients received interest and quick access to their money, Figure 3.5: Bank Domination of Mutual Fund Operators by Number of Operators Percent 100 7 5 90 19 80 30 70 57 31 60 60 5 85 50 20 6 40 30 7 44 7 43 20 40 10 20 15 0 Brazila Kenya Morocco Peru Turkeyb Independent Broker Insurer Bank/ Investment Bank Other Source: World Bank case studies. a. In Brazil, the figure refers to the top 20 administrators/managers of funds in Brazil only, but there are 92 administrators. b. In Turkey, the figure refers to ownership of portfolio management companies (only entities permitted to create funds at year end 2012). 64 | MUTUAL FUNDS in developing markets: addressing challenges to growth and the banks got 5.5 percent annual charges (until the regulator sales. From the perspective of the banks or insurance companies, limited these). In addition, banks that own mutual fund operators such a link helps derive another revenue stream from an existing may also not necessarily market mutual funds on an ongoing basis, cost base. because other activities may be more profitable. For instance, as referred to earlier, in Turkey, banks were incentivized to offer MMFs Banks and insurance companies have a large existing client when they could charge 5.5 percent annual charges on such funds; base to distribute funds, but if they dominate retail distribution, however, when charges were capped at 1.1 percent, it made more they can restrict independent fund operators from entering the sense to channel such clients to deposits instead, thus contracting market (if institutional investors are not significant owners of assets under management in such funds. Turkish MMF assets mutual funds). Enabling “funds of funds” can help independent declined from 78 percent of total assets at the end of 2011 to 58 fund managers to enter the market in such circumstances. Mutual percent by the end of 2012. funds, like other financial products, tend to be sold rather than bought. Banks and insurers have sales networks that have existing In sum, bank or insurance domination of ownership of fund customers who are already in the formal financial sector. Thus, operators has both positive and negative effects. Banks and as shown in chapter 1, banks in particular often play a dominant insurance companies are typically well placed to develop such role in distributing mutual funds in both developed and emerging business because they have known brand names, established markets. Where banks or insurers dominate fund distribution, distribution networks, large client bases and are generally able to they are unlikely to recommend or distribute products offered by finance such businesses and can take a long-term view of their competing fund operators. The typical entry route for a new fund development. These institutions do not need to achieve early market entrant that is not owned by a major financial institution is profitability, unlike independent operators who are likely to come to first attract institutional clients (which do not require distribution under more pressure to make early profits and, therefore, may not networks), establish a reputation for performance, build assets enter the business in small nascent markets. However, as noted under management and fee revenue, and then expand into retail above, from the sector development perspective, such institutions markets. Thus, if as in Peru there is little institutional mutual may give lower priority to developing a mutual fund business if it is fund business, bank domination of retail distribution may make only one business activity among many and if it is not as profitable it difficult for nonbank entrants to distribute their funds and build as some other activities (as would generally be expected in the early mutual fund businesses. In Brazil, bank domination of distribution stages of mutual fund development). has been offset partly because institutional investors are a significant presence (as in Morocco), but also because independent fund management companies can sell their funds to bank clients Ability to Access Distribution through “funds of funds” offered by the bank.70 However, in some Access to distribution channels can have a major effect on the regulatory regimes, such as Kenya at the time of the case study, fund operator’s profitability and ability to conduct business; it is not possible to operate funds of funds, because the rules do it can also impact household penetration of mutual funds. If a not allow a fund to invest 100 percent in other funds. This may fund operator cannot sell units in its funds directly to investors shut off one route through which independent fund management (for example, through its own website), this may both limit the companies can enter the market. It may also reduce the potential operator’s ability to develop their business and reduce potential for creating funds of funds that invest abroad, which is typically distribution channels. In Turkey, for instance, until 2012, if a fund a cost-effective way for ordinary individuals and institutional management firm was the operator of a mutual fund, it could sell investors to invest abroad. units in its funds only through intermediary institutions (banks and brokerages). Thus such firms were captive to distribution Developing a wider range of distribution channels, including channels over which they had no control. Fund operators may also financial advisers (which are generally absent in early emerging in effect be forced to use particular distribution channels because markets) and Internet-based platforms to sell funds, may of regulatory requirements for minimum fund sizes. For example, increase household penetration of mutual funds and help new fund in China circa 2006, mutual funds could be licensed to operate operators enter the market, thus supporting sector development. only if they attained a certain minimum size (approximating to Some emerging markets have a wider range of distribution $26 million). The only way to gather this level of investment at the channels, which reduces bank and insurance domination of fund time was to distribute the fund through one of the four banks that sales and enables independent fund operators to build alternative dominated 80 percent of mutual fund distribution:69 If this could distribution channels. In most countries stockbrokers or private not be achieved, the fund could not be formed. wealth management divisions of banks may offer advisory services, although private wealth management tends to focus on higher- Fund operators’ ability to build their own distribution channels is net-worth individuals. In developed markets, financial advisors often limited. If mutual fund operators were to incur the expense may distribute mutual funds and other financial products. These of building their own “captive” distribution, such as a sales force advisers may be remunerated by commissions agreed by them with or branch network, this would likely increase the costs of mutual mutual fund operators and therefore act as agent of that operator.71 funds and in turn make them less attractive to investors. Thus Independent financial advisers, on the other hand, are increasingly mutual fund operators linked to or owned by entities that already being required to act as the agent of the client and be remunerated have substantial distribution networks may be best placed to make only as agreed between the client and the adviser. In either case, if CHAPTER 3: Market Drivers and Impediments to Mutual Fund Development | 65 the operator of the mutual fund pays a commission, they do so only Incentivizing Distribution when a sale is made. This is less of a financial burden than hiring a Where banks dominate fund operation and distribution, their salesforce, or creating a branch or agency network, and therefore charging structures may also make it difficult for independent, offers a better opportunity for independent fund operators to nonbank affiliated players to enter the market and hence enter the sector. However, financial advisers are largely absent in potentially restrict competition. When mutual funds operated by early emerging markets, although they are developing in countries bank or insurance subsidiaries are offered through their own branch such as Brazil and India. This is almost certainly because, in early or agency networks, the distribution costs incurred are internal to emerging markets, demand is insufficient for such advice to make a the bank or insurance company, which may choose to pass these pure financial advisory business sustainable; where such businesses on by applying entry or exit charges or may choose to absorb them. do exist they are likely to be adjuncts of and complementary to an But entrants that do not have access to such a distribution channel existing business such as banking or private banking or sometimes will need to incur costs to provide commissions to intermediaries legal and accountancy firms (see box 3.5). In India, a recent study and to recover these by levying entry or exit charges on their clients. concluded that the presence of financial advisors had the highest This may make funds of these players uncompetitive with those correlation to penetration of mutual funds in Indian districts, bank or insurance offerings that have no entry or exit charges. Thus indicating the importanc e of this distribution channel for Indian any such new entrant is likely to need sufficient initial capital to mutual fund operators.72 In addition, Internet-based platforms sustain some years of up-front costs as they build up distribution. may target distributors of mutual funds (“business to business”), A new independent start-up fund operator will find this a barrier to offering a wide range of mutual funds, and often other products, entering the market. from different providers. They also allow the distributor to deal online for all their clients. Other such platforms may offer a similar The relative attractiveness of mutual funds compared with other service directly to members of the public (“business to consumer”). products, and the limits placed on mutual fund charges and Such a service may be provided in several countries; one fund commissions, may also place mutual funds at a disadvantage supermarket, for instance, operates in Hong Kong, China; India; compared with other savings products being distributed. Sales Malaysia; and Singapore. Again, this is a relatively low cost way of persons who deal with competing savings products are naturally a mutual fund operator to access a wide variety of potential clients influenced by the relative incentives these products offer their through a single outlet, with commissions payable only when a sale customers and themselves. Simply put, sales persons will tend to is made.73 sell the most attractive product to the client, because that is the easiest sell and therefore most remunerative to the distributor. For In many developed and emerging markets, the competence of example, in Turkey, mutual fund distribution was noncompetitive distributors—whether in banks, financial advisory firms, or compared to pension savings because of a couple of factors: elsewhere—and the ability to adequately explain mutual funds First, the government added 25 units to every 100 units of value to their clients can also affect mutual fund penetration. In India, contributed to the individual pension system, making mutual funds for example, nearly 62 percent of mutual fund operators reported less attractive in comparison; second, pensions salespersons were that the quality of mutual fund distributors was a key impediment paid commissions up front, amounting to up to a total of seven to improving mutual fund penetration.74 Internationally there has years of the applicable annual charges (compared with much lower been a trend to professionalize financial advice; regulators are annual commissions paid for mutual funds sales). Kenya provides increasingly requiring advisers to have certain qualifications or a a similar example. Commission for a life insurance policy was 40 required level of experience as discussed in chapter 2 (for example, percent of the first year’s premiums, falling to 10 percent in each of see box 3.5). the next two years. By comparison, the maximum commission for a unit trust was up to 6 percent of the value of the initial charge. Most regulatory regimes also limit the charges that can be made to funds and require that these are clearly disclosed (see chapter Box 3.5: Nontraditional Distribution Channels for Mutual Funds in India Almost three-quarters of mutual fund assets under management in India is derived from the four big metropolitan areas—Chennai, Delhi, Kolkata, and Mumbai—and the top 35 metropolitan cities accounted for around 90 percent of assets under management as at year end September 2013.75 The Indian government has been focused on the need to expand the distribution of mutual funds beyond the major cities. It has sought to expand distribution channels for funds by allowing sales through independent financial advisers remunerated by fees from their clients. The government has also allowed “simple and performing” mutual fund schemes to be sold through postal agents (India Post has branches all across India), retired government and semigovernment officials, retired bank officers with service of at least 10 years, and other similar persons such as bank correspondents and persons who sell other financial products. In response to this expansion in permitted distributors, the mutual funds trade association has developed a special Mutual Fund Foundation Certification and one-day Mutual Fund Foundation Certification training program for these groups. 66 | MUTUAL FUNDS in developing markets: addressing challenges to growth 2). For example, in many countries the operator cannot charge it may be useful to additionally encourage retail demand to counter the cost of marketing and selling a fund to the fund; instead the some of these effects. operator has to pay this out of the entry, annual or exit charges. In comparison, bank, pension, and insurance products may not face such requirements and can therefore pay higher commissions than Supply of Service Providers mutual funds can, which again incentivizes the distributor to sell In the early phases of market development, because of the lack competing products rather than mutual funds. of economies of scale, the mutual fund sector may be dominated by a few service providers, thus concentrating risk. As discussed in chapter 2, mutual funds need service providers other than Charges as a Barrier to Entry and a Basis of the operator to operate effectively. This includes trustees or Competition (versus Performance) depositaries responsible for safekeeping assets and supervising Charges are typically one of the factors driving competition in fund operation or custodians responsible for safekeeping fund the mutual fund sector; however, in some markets, charges can assets.78 Most commonly, this role is taken by banks or their be the primary basis of competition rather than performance. subsidiaries. However, in nascent markets, few entities may be The fund prospectus usually establishes the nature and scale prepared to take on the custodian, trustee, or depositary role. of charges, which may be limited by regulation (as in the case in This may be because the sector is too small to provide acceptable Morocco and in Turkey). In some countries, although entry charges revenues for a diverse range of providers and, in turn, may lead are allowed, fund management companies choose not to levy them to small numbers of service providers who dominate the market (exit charges are generally rare). This, in turn, may enable fund and thus concentrate risk. In Kenya, for instance, the mutual fund operators (or their parent companies) with more capital to deter less market had 16 mutual fund operators and only two trustees (both well-financed competitors from entering the market.76 Funds with banks), with one trustee being the predominant provider of such lower charges are also more likely to provide better performance services. New service providers may be encouraged to enter this because charges reduce returns; this may also give fund operators business as the scale of their other key business (for example, as with deeper pockets an advantage. In such cases, it would be key custodians to pension fund assets) expands. for independent fund operators to differentiate themselves by their performance; this will most likely be assisted by developing wider Where there is a lack of custodians or depositaries, central and deeper capital markets as well as public awareness of funds. securities depositories may provide these services. In some countries, such as Brazil and Turkey, the central securities depository When institutional investors, which typically pay lower annual provides custody services to funds, although another entity – such management fees, predominate, new mutual fund operators as the fund’s administrator in Brazil or the fund’s founder in Turkey may find that these low charges make it difficult to enter the —would supervise fund operation. In other countries, such as ­ market or to create viable businesses. Internationally, annual Lebanon, the central securities depositary may also supervise fund management charges levied on institutional investment into operation. This has the advantage of creating economies of scale mutual funds are generally lower than the charges made on retail that could result in lower costs to funds; however, it can also result investment, partly because the cost of attracting and servicing in a monopoly position. The central securities depository can play a large numbers of small transactions in the retail market is much useful role where legal frameworks require that the depositary to a higher than the cost of attracting and servicing small numbers of fund must be legally and functionally independent of the operator. large transactions in the institutional market. Also, to attract retail However, many developed and emerging countries permit the business, the operator typically has to pay promotional costs and depositary of a fund to be part of the same parent group as the commissions to distributors, or fees to platforms, out of annual fund operator, provided that the depositary and the fund operator management charges. In Morocco competition for institutional are functionally independent. business at the time of the study was such that mutual funds sold to institutional clients (who have large capital and higher Third-party administrators that offer specialized services to negotiation power) levied very low annual management charges. mutual fund operators can be valuable for fund operators trying Some firms indicated as low as between one and five basis points, to enter the market. These administrators may offer a number of whereas charges on retail investors were in the range of roughly 150 services, such as registering holders, servicing investors, and fund to 190 basis points.77 Although established mutual fund operators accounting and valuation. As discussed in chapter 2, to enable may be able to sustain these lower charging levels because they third-party administration, mutual fund legislation or regulation have larger pools of assets under management on which to levy must specify that operators can delegate activities to other parties. such charges, new entrants may not be able to build their business IOSCO principles require that the responsibility for the activity on such charging levels, particularly if they are not part of a larger still lies with the operator, and both the operator and regulator organization (such as a bank) that may be able to subsidize costs can oversee the delegate effectively. If the fund operator cannot for some years. This potentially could impede new independent delegate to a third party, new mutual fund operators entering the fund operators from entering the market and developing a viable market would have to buy or develop the systems and expertise business. In addition, given the lack of liquidity and depth in the needed to administer its mutual funds. This would make entering securities markets, and the resulting constraint on differentiation the market more expensive. Specialized third-party administrators and performance, Moroccan funds thus competed heavily on fees who service a number of clients can also lead to economies of scale rather than performance. Where institutional demand is dominant, that could reduce mutual fund costs. Although the other case study CHAPTER 3: Market Drivers and Impediments to Mutual Fund Development | 67 countries did not have third-party administrators, Brazil’s slightly to buy and sell fund assets or trade fund shares or units, central unusual market structure offered similar benefits to the ability to depositories to maintain records of securities ownership, and delegate to a third party (although the legal responsibilities were clearing and settlement organizations to clear and settle securities somewhat different). In Brazil, an administrator was responsible markets transactions (see box 3.6). In early emerging markets, such for operating a mutual fund but could appoint an external and infrastructure will be nascent; their scale and nature will tend to independent fund manager to manage the fund’s assets. In effect adjust over time as market needs evolve. Of course, all institutional a fund manager could enter the market at relatively low cost as investors in a particular market will deal on the same exchange long as it could find an administrator to provide services to it to and experience the same registration and clearing and settlement establish and service its funds. In turn, this could assist increase procedures, so the mutual fund sector will not suffer a greater or the number of independent fund managers and competition in the lesser impediment than other institutional investors in that market. market. Early markets present several challenges to operating mutual In nascent mutual fund markets, it may be hard to find domestic funds; namely, these markets often have limited listings, legal and audit firms with experience in mutual funds. A solution infrequent trading, slow and unreliable settlement systems, and in such cases is to draw on expertise available from neighboring slow registration of ownership of securities. As discussed earlier countries (within the same language group) that have more in this chapter, an early emerging stock market is likely to have a advanced mutual fund sectors. For instance, Kenyan lawyers and limited number of listings and more sporadic trading. This would accountants have worked with mutual funds for some years and make it difficult to develop stock or bond market indices against so could provide expertise to other countries in the East African which fund performance can be measured or to use such indices Community as they develop their markets. In addition, the quality of as the basis for developing passively managed index funds. In auditors and their oversight of audits may not meet the standards addition, in some countries stock markets may operate only on of “internationally acceptable quality” required by IOSCO. Given two or three days a week for limited periods, so it would not be that bank regulation often requires a specified standard for bank possible for mutual funds to buy and sell underlying assets daily. audits, one option is for regulation to require that only auditors that Mutual funds also need reliable trade and settlement cycles80 so are eligible to undertake bank audits may undertake mutual fund that investments can be bought and sold with daily inflow and audits. outflows of money. In nascent stock markets, counterparties for guaranteed settlement may not be available, so funds in emerging markets are more likely to be at risk of failed trades. In addition, if Market Infrastructure company shares are registered by individual corporate registrars In early emerging markets, market infrastructure to facilitate a (as in Uganda in 2003), once the transaction has been executed mutual fund sector may be only starting to develop, which can on the exchange, the change in ownership of company shares will impede the mutual fund’s ability to operate. Market infrastructure need to be confirmed through a company’s registrar, which may typically refers to stock exchanges or trading platforms on which take weeks and can impede fund operations as well as the ability to exercise shareholder rights (through voting shares owned by the fund) and to sell assets. Similarly, if dividends are payable by Box 3.6: Market Infrastructure Supporting check, it may be necessary to physically collect the check and bank Mutual Funds it, which will take time and possibly delay receipt of income by a fund. These problems are usually eliminated with the entry of an Historically, such market infrastructure consisted of physical electronic central securities depository with links to clearing and trading floors where securities were bought and sold.79 This settlement systems. However, more unique challenges may also included paper-based systems for confirming and undertaking exist in certain markets. For instance, in Vietnam in 2007, a fund transactions. Registers of ownership of holdings and processing operator was permitted to have only a single trading account to of settlement of transactions (delivery of securities or of undertake any trading on behalf of clients including funds and the payment for them) were also paper based, taking several weeks and conducted through checks. firm’s own account trading. This also meant that a fund operator could deal only through the one brokerage with which it held the Securities (and fund shares or units) were either in bearer form single trading account, restricting the operator’s ability to choose (a document of ownership of a holding that gives details of different brokers for different transactions. the holding but does not state the name of the owner) or in registered form (a document of ownership where the name and Other challenges may also exist to impede mutual fund address of the holder are given as well as details of the holding). operations, such as slow, costly, or unreliable communications Selling such securities meant renouncing ownership of them, and money transmission. Funds need prompt online, electronic again via a paper-based system. price feeds81 from exchanges or data providers to value fund Most securities markets today display information and holdings and price fund shares or units, but these may not be undertake trades electronically and confirm, clear, and settle available in nascent markets. Historically fund regulatory systems transactions electronically. Registers are “dematerialized” and required communications, such as confirmations of transactions are also electronic and frequently held by central securities and annual and semiannual reports, to be sent to all investors by depositories. post. However, in many emerging markets postal systems have poor 68 | MUTUAL FUNDS in developing markets: addressing challenges to growth national coverage and sometimes are insufficiently reliable, and stages of market development, demand may not be sufficient couriers would generally be prohibitively expensive. The alternative for such services to make them viable. would be for the regulator to allow summaries of reports in national newspapers (potentially expensive also), with information included 3. Banks are always likely to play a major part in mutual on how to get the full report. Another alternative is for regulation fund markets, either as operators, administrators, and/ to permit such communication to be electronic, although this is or distributors of funds, and/or as trustees, depositaries, feasible only where Internet access is reasonably widespread and and custodians. To allow independent operators to thrive and services reasonably reliable. In some emerging markets money increase competition, bank dominance of distribution should transmission may be slow and expensive across different bank be offset by enabling other forms of distribution to develop networks and across regions, which would add to the cost of and encouraging a third-party administrator to provide investing in a mutual fund, particularly if contributions are small.82 basic services to independent investment managers (as in Also, the longer the money transfer takes, the greater delay in Australia and Brazil). A central securities depository that can getting the money into the fund and invested, possibly missing out play custodian or depositary may help address the lack of on market rises. Distributing fund income and/or gains to investors custody, depositary, and trustee services in emerging markets. would also be affected by money transmission costs, especially Alternately, regulation may permit a functionally separate where the cost is high relative to the value of the payment. In this custody/depositary subsidiary of a bank to provide services to case, enabling the “rolling up” or reinvestment of these dividends a fund operator subsidiary. can provide a solution, with the investor selling the required value of 4. There is no one “right” way of sequencing mutual fund sector shares or units where needed. development. Mutual funds develop only if a conjunction of factors is found: a reasonably sized and liquid capital In Summary market, clear but not excessive regulation, strong institutional 1. Ideally both institutional (including corporate) and retail investment notably from pension funds, availability of operators demand for mutual funds should be actively developed. and service providers, tax neutrality or incentivization, and a Institutional investors can contribute strongly to expanding the middle class with disposable income to save. Without some or mutual fund sector if they are permitted to use mutual funds all of those in place, attempts to grow a mutual fund sector may as underlying assets. Pension fund–related demand can grow prove fruitless. In general, mutual funds will be most successful if contributions to pension schemes that can invest in mutual where they exploit particular advantages, which may be an funds are mandatory and/or tax or otherwise incentivized. unintentional consequence of government policy in other areas. Institutional demand for mutual funds will also grow if mutual In some countries, MMFs have such advantages and are earliest funds offer an advantage such as cost-effective investment in to develop; in others it may be fixed-income funds or equity foreign assets without adverse tax consequences, or if MMFs funds. offer institutional, corporate, and retail customers competitive 5. Encouraging mutual fund demand is inadvisable if the supply returns because they have access to wholesale market rates. of liquid tradable securities and money market instruments 2. Retail demand is strongly influenced by interest rate policy is insufficient to enable mutual funds to accommodate and taxation as well as economic cycles. Experience from this demand. Capital markets development therefore needs developed markets indicates that participant-directed defined to be considered in parallel with mutual fund development. contribution pension systems (which can invest in mutual funds) A strong mutual fund industry can not only mobilize savings can contribute greatly to demand for domestic mutual funds. cost effectively and offer investors a wide range of choices Awareness and education programs to develop retail demand are for worldwide investment in a variety of short- or long-term a long-term and expensive exercise, which a nascent sector may instruments but also contribute to further growth in an not be able to undertake, so government or regulatory support existing capital market. In capital markets that are likely to may be needed. In the early stages of market development, remain illiquid for some time, policy makers should encourage awareness programs are more likely to be most effective if and actively focus on developing closed-ended funds and the targeted at relatively well-educated and affluent populations domestic capital markets instead of mutual funds. in major population centers (mass market advertising, on the 6. To kick-start a mutual fund sector, government could possibly other hand, is unlikely to be effective). In nascent markets, a create a publicly offered fund (e.g., the Unit Trust of India and single, well-publicized source, such as a trade association or Unit Trust of Tanzania) into which some government holdings regulator, for free, comprehensive, consistent, and factual are allocated. Although this concept has the advantage of information on funds is likely to be very useful. Developing a familiarizing investors with mutual funds and mobilizing savings, financial advisory sector may also help develop retail demand and providing a training ground for employees in the sector, it for mutual funds, because many people prefer to get face-to may also have disadvantages. Investors may perceive such face-financial guidance. However, this is a complex area to funds to have an implicit government guarantee and such funds develop and regulate, because such advice should cover a wider may succeed only where they offer incentives that nonstate- range of financial services than mutual funds, and in the early CHAPTER 3: Market Drivers and Impediments to Mutual Fund Development | 69 sponsored funds cannot offer, which may disadvantage private 11. Worldwide Mutual Fund Market Data, Investment Company sector entrants to the market. An alternative is for state-owned Institute, year end 2012. banks or insurers to take the lead in developing the mutual fund 12. Mutual funds based in foreign countries, often in Ireland or business. Luxembourg. 7. Market infrastructure in emerging markets is more likely to 13. Investment Company Institute, “2014 Investment Company Fact present challenges to the operation of mutual funds than in Book,” http://www.ici.org/pdf/2014_factbook.pdf. developed markets. When designing fund frameworks, policy 14. ANBIMA. These schemes invest predominantly in money market makers must take into account the practical implications of instruments or bonds that have floating rates or whose rates operating funds in a domestic market and, where necessary, are indexed, making them in effect money market instruments disapply international practices where they are not practicable. because their interest rates move in line with current market This requires knowledge both of how mutual funds typically rates. work and of how the domestic market functions. 15. Homi Kharas, “The Emerging Middle Class in Developing Countries,” OECD Development Centre Working Paper No. 285, 8. The lack of independent information providers in nascent http://www.oecd.org/dev/44457738.pdf. markets may be offset by the regulator requiring standardized disclosure of information on a central website and, if 16. The study defined the middle class as households with daily necessary, hosting such a website. This information could expenditures of between $10 and $100 per person in purchasing also be disclosed through a trade association, or alternatively power parity terms. through the websites of a stock exchange or a central securities 17. L. Christopher Plantier. “Globalisation and the Global Growth depository which provides services to all mutual funds. of Long-Term Mutual Funds,” ICI Research Report (March) (Washington, DC: Investment Company Institute, 2014). Endnotes 18. “How Households Save and Invest: Evidence from NCAER,” NCAER, July 2011, http://www.ncaer.org/publication_details. 1. Corporate entities quite often invest in mutual funds for php?pID=165. treasury management purposes and may be included within the 19. “Penetration of Mutual Funds in India: Opportunities and institutional investor category in data in some countries Challenges,” 2014. 2. European Fund and Asset Management Association, “Asset 20. “Understanding Consumer Attitudes to Saving,” Aviva, 2004–8. Management in Europe,” June 2014. This study surveyed more than 100,000 people in 25 countries 3. Associação Brasileira das Entidades dos Mercados Financeiro e around half of which were emerging markets. de Capitais (ANBIMA). 21. “Understanding Consumer Attitudes to Saving,” Aviva, 2004– 4. In Kenya demand from unit-linked insurance products was 2008. thought to be the main impetus for mutual fund sales, but it 22. Capital Markets Awareness and Knowledge Survey 2011. was not regarded as a significant factor in the other case study 23. Mutual funds have existed in the United Kingdom since 1931, but countries, possibly because such products may not be very in a survey conducted in 2006 (“Levels of Financial Literacy in developed in those markets. the UK: Results of a Baseline Survey” by the Financial Services 5. European Fund and Asset Management Association, “Asset Authority), 16 percent of those who owned mutual funds in the Management in Europe,” 2014 (exhibit 25 for reference), https:// sample thought that they entailed no risk and 82 percent only www.efama.org/Pages/EFAMA-Published-its-6th-Annual- low to moderate risk, even though mutual funds in the United Review---Asset-Management-in-Europe---Facts-and-Figures. Kingdom invest predominantly in equities and bonds. aspx. This is very low when compared to France (69 percent) 24. Invest India Incomes and Savings Survey 2007. or Germany (54 percent) where workplace pensions and special investment funds for institutional investors are significant 25. Rajesh Chakrabarti, Sarat Malik, Sudhakar Khairnar, and Aadhaar owners of mutual funds, and even in comparison with Hungary Verma, “Penetration of Mutual Funds in India: Opportunities and (6 percent) and Romania (4 percent). These figures derived from Challenges,” http://www.sebi.gov.in/cms/sebi_data/DRG_Study/ the same report. OpportunitiesChallenges.pdf. 6. World Bank Financial Sector Indicators. 26. Financial Services Board, “Financial Literacy in South Africa: Results of a National Baseline Survey” (2012), https://www. 7. EFAMA Annual Report 2012, http://www.efama.org/Publications/ fsb.co.za/Departments/communications/Documents/FSB%20 Public/Annual%20Reports/AnnualReport_2012.pdf. Annual%20Report%202013.pdf. 8. Pew Research Center. 27. The regulator in Kenya identifies those funds which are licensed 9. Morocco case study. on its site. 10. In Turkey although there was a limit (20 percent) on how much 28. These providers can advertise and promote their services and pension schemes could invest in mutual funds, it appeared that operate on a global scale. this permission was rarely used. 70 | MUTUAL FUNDS in developing markets: addressing challenges to growth 29. Nonstandardization of application forms was also cited as a 41. Recently the process of deducting such tax has been made much deterrent to investors in the study on the penetration of mutual simpler, which is a step in the right direction. funds in India; see Chakrabarti et al., “Penetration of Mutual 42. This is discussed in chapter 2. For instance, in Turkey the average Funds in India: Opportunities and Challenges.” holding period in a pension scheme at the time of the study 30. Financial Services Board, “Financial Literacy in South Africa: was only three years (admittedly the pension system has been Results of a National Baseline Survey” (2012). operating only since 2003). 31. Financial Services Authority, “Levels of Financial Literacy in the 43. That is, returns above inflation, so buying power is preserved. UK: Results of a Baseline Survey” (2006). 44. Capital Markets Authority Statistical Bulletin, Q4 2012. 32. A “run” on a fund, when investors flock to redeem their units and 45. Worth $3.25 billion, mutual funds having a total value of $270 the fund has difficulty in raising cash to meet this, is what every million. fund operator and regulator dreads; such loss of confidence 46. In Kenya 840,000 retail investor accounts in the central can be contagious and lead to a run across a sector, as nearly depositary owned 23 percent of shares held in the system. occurred with U.S. MMFs after the Federal Reserve Primary Fund “broke the buck” (became unable to pay back the $1 invested) in 47. However, the average duration of a domestic investment in equity September 2008 following the bankruptcy of Lehman Brothers. was 36 days in 2011, suggesting that such investment is typically The government stepped in to offer a temporary guarantee that speculative, in turn implying that mutual funds would be unsuited stemmed the flow. See http://www.sec.gov/News/Testimony/ to such investors’ needs. Detail/Testimony/1365171489510#.VD-ubPldWoM. 48. Turkey case study. At some points in the last 15 years interest 33. This contrasts with what generally happens with bond prices rates in Turkey were over 50 percent. Despite the Capital Markets in liquid bond markets. Bonds are issued in standard blocks of Board bringing in a charging limit of 1.1 percent on such funds, value (for example, in the United Kingdom of £100 of nominal MMFs still represented 77 percent of mutual fund assets under value or 100 percent), so if interest rates rise to 6 percent from 5 management at the end of 2011; however, the figures for 2012 percent, the price of an existing £100 bond with five years left to showed a drop to 58 percent of assets, with bond funds becoming maturity paying 5 percent will fall to £83.30 (100×5/6); paying more popular, rising from 7 percent of assets in 2011 to nearly 26 this will give the investor the 6 percent they would otherwise get percent of assets in 2012. See Investment Company Institute, for buying the new bond with a five-year maturity at £100. “Worldwide Mutual Fund Assets and Flows,” www.ici.org. 34. European Union and Capital Markets Board of Turkey, “Capital 49. Financial Times, March 10, 2014. Markets Awareness and Knowledge Survey 2011,” http://www. 50. This is an outcome of giving a tax advantage to dividends paid cmb.gov.tr/duyurugoster.aspx?aid=2012118&subid=1&ct=f. out by mutual funds in China, to mobilize savings to increase 35. The multimercado fund is often described as a Brazilian domestic availability of financing for companies and government. This hedge fund. Certainly the regulations permit a very wide range together with the fact that funds can offer returns much higher of investment powers for this kind of fund, which can borrow, go than bank savings accounts by investing in privately placed short, and make extensive use of derivatives both to leverage and instruments has accounted for the explosion in MMFs in China. reduce risk. The degree to which this freedom is used will vary 51. Treasury Management International, “Money Market Funds: A greatly from fund to fund, but extremes are rare, with most funds Global Story” (2011), http://www.treasury-management.com/ using their freedom to try to enhance returns while minimising article/4/216/1867/money-market-funds-a-global-story.html. risk. The increasing popularity of such funds may be due to their 52. The authors have received permission from ICI to use this graph, better recent record in delivering higher real returns to their which was printed in the March 2014 ICI Global Perspective investors at a time when real returns on other types of fund are authored by L. Christopher Plantier. “Globalisation and the Global falling. Growth of Long-Term Mutual Funds,” ICI Research Report (March) 36. Fundo de Aposentadoria Programada Individual (FAPI), which are (Washington, DC: Investment Company Institute, 2014). defined as investment funds into which individuals may invest 53. BNP Paribas, “Distribution of UCITS in Asia” (2012), http:// and exclusive funds that are held by open pension funds. securities.bnpparibas.com/quintessence/hot-topics/ucits-iv/ 37. Only about 12 percent of assets under management in Brazilian distribution-of-ucits-in-asia.html#.VWCi3flViko. mutual funds were invested in equities. 54. Whereas domestic investors in domestic funds suffer an 38. h t t p : // w w w . s e c . g o v / N e w s / Te s t i m o n y / D e t a i l / automatic 10 percent withholding tax, which is a final tax, Testimony/1365171489510#.VD-ubPldWoM. investors in foreign funds have to declare tax payable, which 39. It also would not align with IOSCO recommendations; see chapter is due at their marginal rate, which is typically higher than 10 2. percent, so investing in foreign funds is less tax efficient and more administratively burdensome. 40. In general, the maximum permitted maturity or residual maturity of instruments held by MMFs is around one year. This helps 55. Annual cost of operating a fund, which includes annual maintain the constant value of the unit. Assets of a short-term management charges but excludes portfolio transaction costs MMF would be expected to have an average weighted life of six and taxes. months or less. Some are restricted to an average weighted 56. Morningstar Fund Research, “Global Fund Investor Experience maturity of 90 days. 2013.” CHAPTER 3: Market Drivers and Impediments to Mutual Fund Development | 71 57. Otherwise incoming or outgoing investors may pay, or be paid, 69. This resulted in sales staff in the bank branches concerned too much or too little, and ongoing investors will experience being incentivized to sell the new fund to attain sales targets, concentration (increase in the value of their shares or units) or but as soon as another new fund came along, branch staff were dilution (decrease in value of the same). incentivized to sell that instead. In such circumstances, funds 58. That is, the consent of a third party is not required before they may not be recommended because they met client needs, or can be bought or sold. because they are a good investment, but because sales targets had to be met; as a consequence, fund investors firstly could lose 59. Deposits with any one deposit taker are also limited typically to money either through being churned from one fund to another or 10 percent or 20 percent of fund value. In more sophisticated from poor performance of their fund as attention switched from emerging markets, exposures to a counterparty through the old to the new fund. derivatives contracts are usually limited to 5 percent or 10 percent. Funds are typically permitted to have higher exposures 70. This is what is known as a “best of breed” sale through the bank to domestic government bonds because these are the lowest risk distribution channel: That is, instead of offering only mutual domestic investments. Even then, a fund should not invest more funds operated by the bank’s affiliated fund manager, the than 30 percent of its value in any one government issue. affiliated fund manager creates a “fund of funds” that invests in the leading funds of other managers (the best of the rest of 60. IOSCO/World Bank Survey. the market). This may achieve more sales, because the investor 61. But this is not necessarily the case in all countries. In Turkey, is being offered something different, but with the reassurance of exposure to equities is also low (3 percent), but there is more the bank brand attached to it. liquidity in the Turkish stock market. Borsa Istanbul had 395 listed 71. Financial advisers are generally required to have a license or companies with a market capitalization of around $307 billion register with a regulator or a trade association. For example, the and daily trade volume of around $385 million in 2012. See http:// Association of Mutual Funds of India registers both corporate www.borsaistanbul.com/docs/default-source/yay%C4%B1nlar/ and individual distributors. borsa-istanbul-2012-annual-report.pdf?sfvrsn=4. 72. See Chakrabarti et al., “Penetration of Mutual Funds in India: 62. MILA News, January 2013, No. 15 Opportunities and Challenges.” Other factors were levels of 63. The authors have received permission from ICI to use this graph, literacy, levels of savings, use of bank branches, which was printed in the March 2014 ICI Global Perspective 73. The mutual fund operator (or the mutual fund) may have to pay authored by L. Christopher Plantier. “Globalisation and the Global a fee to be on the platform concerned; commonly an annual Growth of Long-Term Mutual Funds,” ICI Research Report (March) commission will be paid by the operator to the platform that is a (Washington, DC: Investment Company Institute, 2014).. percentage of the value of the amount invested in that operator’s 64. IOSCO, “Policy Recommendations for Money Market Funds,” fund on that platform. October 2012. 74. Chakrabarti et al., “Penetration of Mutual Funds in India: 65. Technically the Collective Investment Schemes Act of 2003. Opportunities and Challenges.” 66. In some cases valuation by reference may be possible. This 75. KMPG, “Indian Mutual Fund Industry: Distribution Continuum: Key entails using the price movement of another share (in another oil to Success,” http://www.kpmg.com/IN/en/IssuesAndInsights/ company, for instance) or the price movement of another bond ArticlesPublications/Documents/Indian-Mutual-Fund-Industry. that has the same duration and credit rating as a proxy. However, pdf. the latter may also be difficult if there is no credit rating of bonds 76. Because these entrants would need entry charges to survive (to ensure relevant comparisons) and no standardized approach financially. to pricing of bonds of different maturities, as is also the case in Morocco and elsewhere. 77. Morocco case study. 67. Whether monthly redemption can truly qualify a fund as open 78. Depending on the legal structure of the fund and regulatory ended is a matter for debate; a minimum redemption period of requirements. once every two weeks is the European standard. 79. The New York Stock Exchange still has this form of trading, 68. The figures relate to those entities permitted to found funds and although electronic trading is also undertaken. responsible for their operation at the time of the case studies. 80. Expressed typically as T + x, where T is the trade day and x the In Brazil, Kenya, and Turkey at the time of the case studies the number of days within which settlement must be achieved. operator commonly contracted out investment management 81. Or if necessary through data given on storage sticks/flash drives. to an external fund management company. In the case of both 82. For example, in Vietnam in 2007, the difference was between Kenya and Turkey the numbers and levels of bank dominance of same day transfer and a cost of around $35 cents within the ownership of these were similar to that given for fund operators same bank and a transfer taking up to three days and costing above. However, in the case of Brazil, there were some 470 up to $3.50 with another bank. If investors are making only small investment managers, and although the top 20 of these manage contributions to funds, for example, $100, this cost, on top of around 85 percent of total assets under management and many an entry charge of 5 percent, might reduce the $100 invested were bank owned, there are a further 449 managers, some of to $91.5. which were independently owned, that managed the remaining 15 percent, worth around $150 billion. 72 | MUTUAL FUNDS in developing markets: addressing challenges to growth Appendix 1: Country Case Studies* Brazil History Legal Structures The first investment fund in Brazil was created in 1957; by 1970 The only fund structure provided for in law and used is the only 11 such funds were in existence. Regulation was originally by condominium, in either open-ended or closed-ended form. the Banco Central do Brasil. From the early 1990s responsibility Although the legal structure of Brazilian investment funds, as for regulation of funds moved across to the Comissão de Valores condominiums, is unusual, its governance meets best international Mobiliários (CVM), the capital markets regulator. After several standards. crises in the fund sector in the 1990s and early 2000s, the CVM issued Instrução 409 in 2004, covering all types of investment Size of MF Industry funds, which remains applicable today. Brazil’s investment funds market is the fourth largest domestic funds market in the world (after Australia, France, and the United Legal Environment States), worth $1.07 trillion at the end of 2012. It has an unusually In 1959 the Ministry of Finance issued the first official document large number of funds, totaling around 7,500 (only three other to address mutual funds, Portaria no. 309. In 1970 the Banco domestic markets worldwide have more than 5,000 funds). It also Central do Brasil issued Resolution no. 145, which was the first has a large number of firms that manage fund assets, around 450. government regulation to establish broad guidelines regarding the constitution, functioning, and management of mutual funds MF Categories/Product Offerings in Brazil. The government instituted new regulations (Resolutions 1787 in 1991, and 1912 in 1992), which created the Fundo de Types of Equity Bond Money Hybrid Other Aplicação Financeira (FAF), the Fundo de Renda Fixa (FRF), the Fund Funds Funds Market Funds Fundo de Renda Fixa-Curto Prazo (FRF-CP), and the Fundo de AUM in 104,255 600,507 44,403 234,101 87,731 Commodities, all of which absorbed the Fixed Income Fund and 2012 $, the Short Term Investment Fund that had been created in 1984 millions and 1986. These resolutions also transferred the supervision and regulation of equity funds from the BCB to the CVM. In November Founders/Promoters 1997 the Central Bank forced the separation of asset management activity from financial institutions’ banking activities by Resolution In Brazil, investment funds are created by administrators, 2451. which are major financial institutions such as banks, which are responsible for the operation of the fund and are responsible to the regulator for compliance. At the time of the study there Regulation were 92 administrators: the top 10 administrators account for The regulatory body is the Comissão de Valores Mobiliários 75 percent of assets under management. The administrator (CVM). The CVM was established by Law no. 6.385 of December 7, may manage its own funds, but it may also create funds at the 1976. At the time of the study the CVM had specific responsibility for request of independent investment managers if it considers the the licensing, regulation, and supervision of investment funds and investment manager to be fit and proper. Investment managers their administrators, fund managers, custodians, and distributors. number 469. The administrator remains primarily responsible for The Associação Brasileira das Entidades dos Mercados Financeiro compliance even if it subcontracts an independent investment e de Capitais (ANBIMA), the trade association of funds (and other manager to manage the investments. The administrator appoints securities activities), acts as a self-regulatory organization that both the custodian and the investment manager. These may or publishes voluntary codes and standards for its members. Although may not be part of the same financial group as the administrator. ANBIMA is not a statutory regulator, its contract with its members It is not unusual for all these functions to be carried out within the allows it to discipline and even fine its members. same financial group. These entities are usually parts of banking conglomerates that also act as distributors of fund shares or units * N  ote that these country case studies were conducted mostly in 2012, and although to their own customer bases. the discussion is in the present tense, the information is as of the time of the case studies and therefore may not be the most current. Appendix 1: Country Case Studies | 73 Ownership Taxation Retail investors represent only 18 percent of ownership of In general, investment funds, as legal entities, are not subject to Brazilian investment funds. A further 15 percent is categorized as taxation in Brazil. They are considered fiscally transparent (“see- “privately” owned, which includes individuals with high net worth. through”) entities for tax purposes. That means that investment Public authorities corporate and other own 8 percent each. Five funds are not subject to taxation on income and capital gains arising percent is owned by foreign entities and 32 percent by pension funds. from their own transactions (at the portfolio level). The investors in the funds pay from 15 to 22.5 percent tax on the increase in the unit value in the six-month taxable period, which may derive from income Custodial Services and Depositaries or from realized or unrealized gains, with the level of tax payable A custodian must be appointed to a fund by the administrator. It depending on maturity of the portfolio and on the type of assets the has a fiduciary duty to supervise the operation of the fund by the fund holds, unless they are exempt from paying tax, for instance, if administrator and to safekeep and record fund of assets. they are domestic pension funds. For corporate investors, income from fund is treated as taxable profit for corporate tax but allowed to offset tax already paid. For individuals, accumulated tax already Distribution paid can be deducted from final tax due at the time of redemption. Distribution in the retail market in Brazil is largely in the hands The tax is payable by redemption of a matching value of units for of banks, which are also usually administrators and managers the amount of tax due and is known as come cotas or “eating units.” of the funds they offer. Thus their revenues arise from annual administration charges, there being no need to remunerate sales outlets with initial commissions. Independent distributors of funds Trade Association in Brazil are remunerated instead by means of a share in the ongoing The Associação Brasileira das Entidades dos Mercados Financeiro annual administration charge, sometimes called a “trail” commission. e de Capitais (ANBIMA) is the trade association of funds and other capital markets participants. Fees Subscription fees Not levied Redemption fees Not levied Annual management fees 0.25–4% Accounting Standards Investment funds are required to prepare annual financial statements, tables, and supplementary statements, standardized in accordance with the models established by the rules in force including the chart of accounts established in the Accounting Plan for Investment Funds (COFI) established by CVM Instruction 438 and 489 and the CVM rules. There are model accounts for guidance including notes to the financial statements. The administrator is responsible for preparing the financial statements. All funds should have their financial statements audited by an independent auditor registered at the CVM. They must include the notes required by the legal and regulatory statutes in force. 74 | MUTUAL FUNDS in developing markets: addressing challenges to growth Kenya History Founders/Promoters The first law that defined collective investment schemes in Kenya In Kenya, at the time of the case study, unit trusts had to be was the Unit Trusts Act of 1965; this remained applicable until 2000. formed by a “promoter” of which 16 were registered with the It was not until the late 1990s that the first unit trusts were created. regulator, the Capital Markets Authority of Kenya. A “promoter” must have either a license as a fund manager or as a stockbroker or as an investment bank. The promoter typically distributes Legal Environment the fund and appoints service providers to the fund, such as the The Capital Markets Act of 2000 and underlying Capital Markets fund manager, where the promoter is not itself a fund manager. (Collective Investment Schemes) Regulation 2001 constituted the The Capital Markets Act requires that unit trust assets may be main law and regulation governing collective investment schemes in managed only by an entity holding a fund manager license Kenya at the time of the case study. Ownership Regulation No statistics are published on ownership of unit trusts in Kenya. The Capital Markets Act empowered the Capital Markets Authority, Anecdotal indications are that the bulk of the money invested into which regulates unit trusts, fund managers, CIS promoters, unit unit trusts is from retail investors. trust trustees, and custodians. Custodial Services and Depositaries Legal Structures The Capital Markets Act requires that a corporate trustee must The only form of open-ended fund that was publicly offered at the be appointed to a unit trust and that the trustee must ensure time of the case study was the unit trust, although the current that a custodian is appointed to hold fund assets. Trustee Capital Markets Act and Collective Investment Scheme Regulations and custodian activity is undertaken by banks. Unusually, the also permit collective investment schemes to take the form of open trustee and the fund manager to a unit trust are not required to ended companies (referred to as “mutual funds” in the act, which be completely independent of each other; 10 percent common are investment companies with variable capital) or closed-ended ownership is permitted. companies (referred to as “investment companies” or “registered venture capital companies” in the act, which are investment Distribution companies of fixed capital). Although no statistics on this are published, sales of unit trusts are made mainly through insurance companies with fund managers, Size of MF Industry as well as through investment advisers, stockbrokers, banks, and Fifty-eight funds had a total value of KSh 24 billion or approximately insurance brokers and agents. $275 million at the end of June 2012. Fees MF Categories/Product Offerings Average fees across all funds Bond Money Types of Equity Subscription fees 0–6% (Debt) Market Hybrid Other Total Funds Funds Funds Funds Redemption fees Not levied Number of 13 11 15 14 5 58 Annual management fees 1–3.5% funds 2012 AUM in 82.84 10.76 130.47 39.67 11.58 275.3 2012 $, millions Appendix 1: Country Case Studies | 75 Accounting Standards Trade Association Annual audited reports and accounts are required. No accounting There are two trade associations: the Fund Managers Association standard is applicable to unit trusts or other collective investment and the Association of Collective Investment Schemes. Neither of schemes in Kenya. A sample review of reports and accounts these is formally a self-regulatory body, although some elements of indicates that they seek to comply with International Financial voluntary self-regulation were undertaken. Reporting Standards. Although the regulations require certain information to be stated, they do not establish an accounting basis or state that any particular standard should apply. Taxation Under the Income Tax Act, unit trusts may be registered or unregistered. Only unit trusts registered with the regulator can be publicly offered. Registered unit trusts are not tax disadvantaged for exempt investors (such as pension funds) and are tax neutral for nonexempt investors to the degree that they pay no more tax than if they had invested directly into bonds, equity, or cash. 76 | MUTUAL FUNDS in developing markets: addressing challenges to growth Morocco History Size of MF Industry The Moroccan mutual funds market was born in the mid- 333 mutual funds with DH 230 billion (~$26.65 billion) of assets 1990s in the context of privatizations and global reform of under management at the end of 2011. the capital market. Morocco designed a privatization program in the early 1990s, following the implementation of a structural MF Categories/Product Offerings adjustment program. In parallel, and as from 1993, the Casablanca Stock Exchange (CSE) was computerized to allow electronic Bond Money Types of Equity trading, a central depository company was created, and the (Debt) Market Other Total Funds Funds Conseil Déontologique des Valeurs Mobilières (CDVM) was set Funds Funds up to supervise and regulate the market. In this context, a legal Number of 79 153 40 61 333 framework was set up in 1993 to allow the creation of open-ended funds 2011 mutual funds, in the form of collective investments vehicles to be AUM in 2012 2.58 15.77 7.04 1.26 26.65 managed by finance professionals. $, billions Note: Exchange-traded funds and real-estate investment funds are not available yet Legal Environment in Morocco. The main law governing Moroccan mutual funds is law no. 1-93- 213 dated September 21, 1993, dealing with undertakings of Founders/Promoters collective investments in transferable securities (OPCVM). In Collective investment funds must be founded jointly by an asset addition, law no. 1-93-212 of September 21, 1993, concerning the management firm and a depository bank. However, the market is CDVM and the information required from entities offering securities promoted by approximately 65 institutions, most of which belong to the public contains a number of provisions concerning mutual to the financial sector. By virtue of the law, mutual funds must be funds. These provisions deal with (1) the control of mutual funds, founded jointly by an asset management company and a depository asset management companies, and mutual fund custodians by bank. However, the notion of founder does not reflect the reality of the CDVM, (2) the inclusion of mutual funds in the list of qualified the genesis of funds in Morocco, and professionals therefore make investors, (3) the appointment of new auditors by the commercial a distinction between the legal founders of a fund and its initiator, court upon request of the CDVM, and (4) the payment of usually referred to as its promoters. The vast majority of Moroccan commissions to the CDVM by mutual funds. Finally, mutual funds mutual funds have been initiated by a single promoter, most of the organized as Société d’Investissement à Capital Variable (SICAV), time by the asset management company itself, a commercial or that is investment companies, are subject to the provisions of the investment bank, or an insurance company. law on corporations. In case of conflict, the provisions of law no. 1-93-213 should prevail. Ownership The Moroccan mutual funds industry is dominated by Moroccan Regulation institutional investors, which own more than 90 percent of total The mutual fund industry is mainly regulated by the CDVM and, assets under management. The number of dedicated funds has to a lesser degree, by the Ministry of Finance. As is generally the surged during the last decade, and they now represent more than case for subsectors of the Moroccan financial market, the mutual 40 percent total assets under management. Fewer than 20,000 fund sector is under the dual supervision of the Ministry of Finance retail investors own shares or units of mutual funds, and these and of a separate regulatory agency, the CDVM. investors have recently been leavingthe market. Foreign investors are almost absent. Legal Structures It is contractual and corporate both by law and in practice. The Custodial Services and Depositaries number of mutual funds in activity has more than doubled during The activity of mutual funds custody is reserved by law to the last decade. Although mutual funds are initially created in the banks and is therefore highly concentrated. In practice, only nine form of investment companies (SICAV) and can still be set up under custodians are found in Morocco. All leading asset management this form, market participants have since then overwhelmingly companies are using their parent company for the custody of the elected for collective investment funds (FCP) because of the funds they have under management. flexibility they provide. Appendix 1: Country Case Studies | 77 Distribution Taxation In the absence of any specific legislation on financial solicitation, Moroccan mutual funds are in principle tax transparent. This the sale of shares or units of mutual funds by means of publicity means that funds as such are not subject to any tax but that holders or solicitation or through a brokerage firm, a bank, or other of shares or units of mutual funds are subject to tax depending on the establishment whose purpose is the placing of securities, capital gains (or loss) or the revenues resulting from their investment management, or advising in financial matters falls under the in mutual funds. However, the introduction of a special contribution legislation applicable to securities offerings. In practice, the to a social fund called the Fonds de Cohésion Social in 2011 resulted distribution of mutual funds is carried out by banks and asset in the direct taxation of several Moroccan mutual funds in 2012, for management companies. More marginally, the distribution is the first time since the creation of the industry. This provision was carried out by brokerage firms. apparently renewed in 2012, and some mutual funds will have to pay this contribution in 2013. This has been corrected in the 2013 budget law, which excluded mutual funds from contributing to the Fonds Fees de Cohésion Social, but the principle of tax transparency of mutual Fees are shown for all types of mutual funds as weighted average funds should be reinstated and guaranteed in the future. by net asset value of funds (as of December 31, 2011). Trade Association Subscription fees 1.39% Redemption fees 0.68% Association des Sociétés de gestion et des Fonds d’Investissement Marocains (ASFIM)—Association of Management Companies and Annual management fees 1.47% Investment Funds of Morocco. Accounting Standards Because of inconsistencies in Moroccan generally accepted accounting principles (GAAP), some large institutional investors make arbitrage between direct investments in fixed-income securities and indirect investments in the same class of assets through dedicated funds for accounting or tax purposes. The valuation of securities in the balance sheet of Moroccan companies differs between Moroccan GAAP and international financial reporting standards (IFRS). In particular, debt securities are valued at their nominal value under Moroccan GAAP, whereas shares or units of fixed income funds are valued at their net value (mark to market) as calculated and published weekly (or daily) by asset management companies. In this context, some institutional investors such as insurance companies can monitor their taxable income for a given year depending on how they invest their technical provisions, either directly in fixed income securities or indirectly through dedicated fixed income funds. Accounting standards—and tax rules—should therefore be reviewed to converge toward IFRS and prevent such arbitrages. 78 | MUTUAL FUNDS in developing markets: addressing challenges to growth Peru History Ownership The mutual funds industry began its establishment in 1995 Around 118,000 mutual fund accounts were in existence at the and grew substantially from assets under management of $5 million time of study. Although no publicly available research on this is in 1995 to $6,771 million in 2012, with volatility during the financial available, it is thought that ownership of Peruvian mutual funds is crisis. predominantly retail. Legal Environment Custodial Services and Depositaries Fondos Mutuos are enabled by the Ley de Mercado de Valores Decreto In Peru at the time of the study a fund management company was Legislativo no. 861 of 1996 as amended, but more specifically in required to appoint a custodian to a fund to safekeep its assets; detail by the Reglamento de Fondos Mutuos de Inversión en Valores however, the custodian carries out “bare” custodial duties and y sus Sociedades Administradoras Resolución CONASEV no. 0068- has no supervisory role other than refusing to undertake portfolio 2010. This was quite extensively amended and updated in 2010. transactions that are not permitted or illegal. The custodian may be a part of the same group as the fund management company. Regulation Distribution The Superintendencia de Mercado de Valores (SMV) (formerly CONASEV) supervises securities markets and mutual funds and Banks also control distribution of funds. Because they distribute their fund management companies and custodians. to their own customers through their own branches, there is no initial charge (front-end load) and no commission payable to sales agents. Legal Structures Peruvian law permits only the operation of investment funds Fees in contractual form. Fondos mutuos are open-ended funds of the contractual type, similar to those found in Spain and other Subscription fees Not levied European countries. The fondo mutuo is the principal form of Redemption fees 0–3% collective investment scheme available to the general public in Peru, although wealthier investors can find advisory services that Annual management fees 0.3–5% lead them to be able to invest in a wide range of foreign investment Source: IOSCO Survey Data. funds. Fondos de Inversión, which are also contractual funds but of an interval type that may be privately offered or publicly offered, Accounting Standards are enabled under a different law, no. 18.815 of 1989. Annex L to the regulations contains a description of the minimum content of the annual report of a mutual fund that must be Size of MF Industry audited by an approved auditor and signed by the duly authorized As at 2012 Q3 Peru had 61 mutual funds with AUM of $6.1 billion. representative of the management company. MF Categories/Product Offerings Taxation Until 2013 the fund management company had to calculate Bond Money Hybrid Types of Equity what tax should be payable by each investor on gains made in (Debt) Market Funds Total Funds Funds a fund, with rates of tax due varying between individuals and Funds Funds (Balanced) companies. This was complex and expensive. Since 2013 taxation AUM in 2012 0.15 3.27 2.14 0.53 6.1 has been much simpler: fund management companies in effect $, billions have to withhold 5 percent tax from the profit made on redemption of fund units. This is favorable by international standards but higher Founders/Promoters than tax payable on returns from bank deposits. Profits taken from Fondos mutuos are founded by fund management companies, investment in foreign funds will under the new system remain which must be licensed by the SMV. Ninety-six percent of assets taxable at 30 percent, which is less attractive than domestic funds, under management in fondos mutuos are managed by fund but such profits may be undeclared or may be made offshore. management companies owned by banks. Trade Association An Association of Mutual Funds was dormant at the time of the study. Appendix 1: Country Case Studies | 79 Turkey Regulation The CMB is the regulator of capital markets, including funds, History their founders, and custodians. Articles 88–135 of the Law 6362 Investment funds in Turkey have developed since the introduction set out the principal duties and functions of the board, which of the Capital Markets Law in 1981. The regulator of capital include determining the principles of establishment, operation, markets (including funds), the Capital Markets Board (CMB) of liquidation, and termination of capital markets institutions and Turkey, was created in 1982. This was followed by the establishment their supervision and the power to issue regulatory procedures. of the Istanbul Stock Exchange (ISE) in 1985. It was not until 1987 Under Law 6362 it is mandatory for all institutions authorized to perform investment services or activities to join the Capital Markets that the first fund defined as a “mutual fund” in Turkey was created. Association, a self-regulatory organization, whose objectives under the law include “to establish professional rules aimed at providing Legal Environment that the members of the Association work in solidarity with due care and discipline required by the capital markets, take necessary At the time of the case study, investment funds were governed measures in order to prevent unfair competition; made regulations by Capital Markets Law 2499. Two distinct legal structures of on issues assigned to it by legislation and determined by the Board, investment fund envisaged in this law: “investment companies” execute and supervise them; impose disciplinary penalties on with fixed capital (closed-ended corporate funds) in Articles 35 and behalf of member institutions.” At the end of 2011 the association 36 on “investment companies” and contractual funds (known as had 143 members: 101 brokerage firms, one derivatives exchange, “mutual funds”) in Articles 37 and 38. CMB Communiques set out and 41 banks. more detailed requirements for both types of funds. A new Capital Markets Law No 6362 was adopted in December 2012. This law envisaged investment companies with fixed capital and introduced Legal Structures investment companies with variable capital (open-ended corporate Law 6362 enables funds as investment companies with fixed funds) and enabled contractual funds as before. In addition to these, capital and investment companies with variable capital and the new law brought significant changes in the legal environment of contractual open-ended funds. Both investment companies with funds such that investment funds can be founded only by portfolio fixed capital and open-ended contractual funds were in operation management companies that are licensed by CMB, and portfolio at the time of the study, but regulations governing investment management companies are obliged to appoint a depositary for companies with variable capital had not been issued so this type of funds. fund was not functioning. MF Categories/Product Offerings Types of Bond (Debt) Money Market Equity Funds Mixed Fund Variable Fund Other Total Funds Funds Funds Number of 54 53 49 22 132 282 592 funds 2012 AUM, in 2012 $ 316,652 1,245,975 10,025,029 235,100 1,427,256 3,628,143 16,878,154 thousands Source: ICI. a. Dollar values converted from historical data at www.oanda.com. 80 | MUTUAL FUNDS in developing markets: addressing challenges to growth Founders/Promoters Fees Under the Capital Markets Law 6362 only an entity holding At the time of the study in 2012, the CMB had capped total a license from the Capital Markets Board as a portfolio expense ratios of funds to 1.28 percent for money market funds, management company is permitted to found a contractual 2.19 percent for short-term bond funds, gold and other precious fund (previously such funds could be founded only by a bank, metal funds, index funds, capital protected and guaranteed insurance company, brokerage firm, pension, or charitable fund). funds, 4.38 percent for funds of funds, and 3.65 percent for The portfolio management company is responsible for operating other types of funds (equity funds, bond funds, etc.). Subscription and distributing the fund and for appointing a depositary. and redemption fees are permitted but are not usually charged. Range for total expense ratios 1.28–4.38% Ownership Ninety-nine percent of assets under management in mutual funds Accounting Standards in Turkey is thought to be retail. Mutual funds were required by the CMB to have an independent Custodial Services and Depositaries auditor and to have annual financial reports and accounts that are audited and semiannual reports that are unaudited. An Under Law 6362 the portfolio management company of a fund internal audit function is also required. must appoint a depositary that has both safekeeping and supervisory duties. Previously the founder was responsible for safekeeping fund assets, although it may appoint a custodian to Taxation do this, and therefore no provision is in place for an oversight role Mutual funds are exempt from corporation tax and income tax, to be undertaken by the custodian. Takasbank, the depositary so income and profits received by the fund are not taxable at the and clearing and settlement institution to Borsa Istanbul, is the fund level. A 10 percent withholding tax is levied on any increase custodian to all funds. in the value of a unit (which may result from capital gain or from income, which is not distributed) over its purchase price when the Distribution unit is redeemed, unless the recipient is not taxable (for instance, a pension fund); this is a final tax (corporate investors can offset Historically only intermediary institutions have been permitted this against their corporation tax liability). If a fund is “equity to distribute mutual funds in Turkey, which are banks and intensive,” it invests more than 75 percent in equities (the required brokerage firms; portfolio management companies are also equity investment level increased to 80 percent with the secondary enabled to do so under Law 6362. One hundred other intermediary legislation under Law 6362). Investors are not subject to this institutions are brokerages: Banks own 27 brokerage firms and withholding tax upon redemption because otherwise funds would dominate fund distribution. Turkey has 44 banks, which have nearly suffer a disadvantage relative to direct equity investment, which is 10,000 branches. On the other hand, as a recent development, not subject to such a withholding tax. the units of all mutual funds (with the exclusion of specific types of mutual funds) operating in Turkish capital markets are being traded through an electronic trading platform called the “Turkey Trade Association Electronic Fund Distribution Platform” (TEFAS) since September 1, A trade association of portfolio managers, the Turkish 2015, which was established with the authorization of CMB and is Institutional Investment Managers Association (TKYD), has been operated by Takasbank. All banks, intermediary institutions, and in existence since 2000. At the end of 2011 it had 25 corporate and portfolio management companies are members of this platform. 30 individual members. It provides investors with access to all funds operating in Turkish capital markets (with the exclusion of specific types of mutual funds) through a single investment account. Appendix 1: Country Case Studies | 81 Appendix 2: Glossary Administrator—In Brazil, the operator of a mutual fund that is Custodian—In respect of an investment fund, a service provider legally responsible for creating and operating the mutual fund and that undertakes safekeeping of fund assets and securities appointing a fund manager to manage the fund’s assets; fund administration services (such as receipt of dividends or interest assets are held by a custodian (this is different from a “third-party and dealing with exercising rights of ownership of securities such administrator” [see below] but similar to a “responsible entity” in as voting at general meetings); it does not have a supervisory role Australia [see below]). (see “depositary” and “trustee”). Annual management charge—The charge payable to the fund Defined benefit pension scheme—A pension scheme whose operator per annum for the operation and management of a fund, sponsor (usually the employer but sometimes an insurance usually expressed as a percentage of the value of the fund. company) in effect underwrites the payment to a member of the scheme (provided they have met their contractual obligations) of a Capital gain (or loss)—The profit (or loss) made upon the sale of pension usually expressed as a percentage of salary that is payable an asset (including a fund share or unit) when it is sold for a price irrespective of the performance of the investments of the scheme. higher (or lower) than its cost of acquisition. Defined contribution pension scheme—A pension scheme whereby Capital growth—In relation to a fund, increase in the value of fund the value held by the account holder in their account at the date shares or units resulting from an increase in the value of the assets of retirement to pay a pension is the sum of the contributions held by the fund. made to the scheme and any gains and income earned by those contributions. Central securities depository—A specialist financial organization that holds and administers securities and processes securities Depositary—With respect to a mutual fund, a company that transactions and may also clear and settle securities transactions. is responsible for safekeeping of fund assets and supervision of operation of the fund and its compliance with regulation and the Closed-ended fund—A fund that has no obligation to redeem its founding document and prospectus of the fund. It may sometimes shares or units from holders and that therefore has a fixed number also provide third-party administration. of shares or units in issue (also known as a fund with fixed capital). Entry charge—Charge payable by an investor when they buy shares Collective investment scheme—A generic legal description of a or units in a fund, which is payable to the fund operator; usually vehicle that attracts money from a range of investors into a single expressed as a percentage of net asset value per share or unit. pool and professionally manages that pool: In some countries the term refers only to open-ended funds, and in others it refers to both Exchange-traded fund (ETF)—Marketable security that tracks an open-ended funds and closed-ended funds. In IOSCO terminology, index of shares, commodities, bonds, or a basket of assets such as “collective investment scheme” generally refers to open-ended an index fund. Unlike mutual funds, an ETF trades like a security on funds but may sometimes cover closed-ended funds also. a stock exchange. Contractual fund—Fund formed under the law of contract. Exit charge—Charge payable by an investor when they sell shares or units in a fund, which is payable to the fund operator, usually Contractual savings—Savings that must be made as required expressed as a percentage of net asset value per share or unit. under a contract, for instance, the contract between a sponsor of a defined benefit pension scheme (employer) and a member of the Externally managed fund—A fund that is managed and operated scheme (employee). by another entity, typically a fund management company, which is remunerated by an annual management charge paid out of the fund Corporate fund—Fund formed under company law (see also that is based on a percentage of the value of the assets of the fund. “investment company”). Fixed capital—See “closed-ended fund.” 82 | MUTUAL FUNDS in developing markets: addressing challenges to growth Fund management company—In many but not all countries, Mutual fund—An open-ended publicly offered investment fund; the entity that is legally responsible for creating and operating a the name is used generically as a convenient description of all such mutual fund, usually responsible for managing its portfolio and funds but has no legal significance. administering and marketing the fund. “No-load” fund or share or unit class—A fund or share or unit class Fund manager—An entity that manages the assets of mutual in a fund that has no entry charge and no exit charge. funds but does not operate mutual funds. Open-ended fund—A fund that is required to redeem its shares or Hedge fund—A type of fund that does not meet legal and regulatory units from holders typically on any business day upon their request requirements for publicly offered funds whose investment and and that therefore has a variable number of shares or units in issue borrowing powers are limited only by its founding documents; (also known as a fund with variable capital). usually such funds may be offered only to expert or professional investors. Also known as an alternative fund or sometimes an Operator—In relation to a mutual fund, the term is used in this alternative investment fund. study for the entity that is legally responsible for creating and operating the fund (IOSCO uses the same term in the same way). Income—Revenue earned by fund assets usually interest on bonds Different legislative frameworks may permit or require different or on deposits, dividends from equities, and sometimes rental from entities to do this, typically a licensed fund management company real estate. (Morocco and Peru), a licensed administrator (Brazil), a licensed responsible entity (Australia), a licensed founder (which is a bank, Index fund—A fund whose portfolio replicates a named index, either broker, insurance company, pension, or charitable fund; Turkey), physically (by investing in the relevant securities) or synthetically or a promoter (which is an investment bank, fund management (usually by means of swaps). Also known as a “passively managed” company, or broker; Kenya), or in the case of a corporate fund this fund because investments simply track an index and are not sometimes may be the board of the fund. actively selected. Passively managed—See “index fund.” Institutional investors—Vehicles that pool capital from a number of investors and invest it on their behalf: typically pension schemes, Responsible entity—In Australia, the firm that is responsible both insurance companies, and investment funds and sometimes for acting as the operator of the mutual fund (which takes the form corporates. of a trust) and as the trustee of the mutual fund; fund assets may be held by a custodian. Internally managed fund—A fund that employs its own staff that operate the fund within policy set by the fund’s board and therefore Share—An equal proportionate holding in a corporate fund that has bears the full cost of its operation. an equal proportionate right to income and capital gains generated by that fund. Investment company—A fund formed under corporate law, whether in open- or closed-ended form. An American fund formed Settlement bank—A bank that is responsible for financial under the Investment Company Act 1940 is colloquially known as settlement of transactions in the securities markets. a “mutual fund.” Third-party administrator—A firm that is appointed by the Investment fund—Used generally in this study to mean an open- operator of the fund to administer the fund (broadly, operate the or closed-ended fund of any legal structure. register, service shareholders, and undertake fund accounting; sometimes also undertake valuation and pricing). The operator Money market fund—Very generally a fund that invests in money delegates this activity to the third-party administrator but remains market instruments that have a duration of a year or less; this responsible for the activity. may be a constant value (or conservative) money market fund that seeks to maintain the value of the $1 invested and pay interest, or a variable value money market fund where the value of the $1 invested may fluctuate. Appendix 2: Glossary | 83 Trustee—In respect of a fund formed as a trust, a company (or Unit—An equal proportionate holding in a unit trust or contractual more rarely a board of individual trustees) that is responsible to fund that has an equal proportionate right to income and capital the beneficiaries of the trust (the owners of fund units) for the gains generated by that fund. safekeeping of fund assets and supervision of operation of the fund by the fund management company, which is also party to the deed Unit trust—Fund formed under trust law or precedent. that is the formation document for the fund. Variable capital—See “open-ended fund.” Undertaking for Collective Investment in Transferable Securities Wrapper—Term for a tax-privileged account belonging to a named (UCITS)—An open-ended publicly offered fund created in a individual within which certain permitted assets such as shares or European Economic Area country that invests in conformity with units in mutual funds can be held. the UCITS Directive and is therefore able to be offered across borders within that area. 84 | MUTUAL FUNDS in developing markets: addressing challenges to growth References Bogdan, Michael, and Daniel Schrass. 2014. “Profile of Mutual Khorana, A., H. Servaes, and P. Tufano, 2005. “Explaining the Size Fund Shareholders, 2013.” ICI Research Report, February. of the Mutual Fund Industry around the World.” Journal of Washington, DC: Investment Company Institute. Financial Economics 78: 145–85. 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