MUTUAL FUNDS

BY
MUHAMMAD RASHID ZAFER, ACA
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WHAT IS MUTUAL FUND
An investment vehicle that pools money from
many investors and invest it according to
predetermined objective.
Each investor gets a share of the pool
proportionate to the initial investment.
Capital of the mutual fund is divided into
shares or units.
Mutual funds invest in bonds, stocks, money-
market instruments, real estate, commodities
or a combination of any of these.

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FLOW OF FUNDS
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HISTORY OF MUTUAL FUNDS
The first mutual fund was established in
Europe.
A Dutch merchant Adriaan van Ketwich
created the first mutual fund in 1774.
Eendragt Maakt Magt, which meant Unity
Creates Strength.
First mutual fund outside the Netherlands was
the Foreign & Colonial Government Trust,
which was established in London in 1868.
Mutual funds were introduced into the United
States in the 1890s. They became popular
during the 1920s.

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HISTORY OF MUTUAL FUNDS
In 1893, the first closed-end fund The Boston
Personal Property Trust was formed.
In year 1924, the first open-end fund
Massachusetts Investors Trust of Boston
was the formed.
In Pakistan NIT offered first open end fund in
1962.
ICP offered a series of closed end funds in
1966, these were later privatized in 2000.
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PROS AND CONS OF MUTUAL
FUNDS
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Diversification. Securities from hundreds or even
thousands of issuers it reduces the risk of loss.
Professional Management. Expertise to manage
and reinvest interest or dividend income, or to
investigate thousands of securities. Access to
extensive research, market information, and
skilled securities traders.
Liquidity. Mutual fund can be bought and sold on
any business day, so investors have easy access
to their money. Many individual securities can also
be bought and sold readily, others aren't widely
traded. (CE & IC)

PROS AND CONS OF MUTUAL
FUNDS
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Convenience. Mutual funds offer services that
make investing easier. Mail, telephone, or the
Internet. Automatic investments into a fund or
automatic transfers from a fund to your bank
account.
Tax Free Return The stock dividend from
mutual funds are exempt from tax. Cash
dividend taxable.

PROS AND CONS OF MUTUAL
FUNDS
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No Guarantees. Unlike bank deposits,
principal and returns are not guaranteed.
Diversification Penalty." Diversification
reduces the risk of loss, it also limits the
potential for making a killing in the market.
Diversification does not protect from a loss
caused by an overall decline in financial
markets.
MUTUAL FUNDS -
STRUCTURES
Open End continuously offer and redeem
their units to the investors.

Closed End one time issuance of
certificates and then are traded in the
secondary market.

Investment Company one time issuance of
shares and then are traded in the secondary
market.

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LEGAL STRUCTURE
Open end and closed end funds are established
through a trust deed as a trust under the trust act
1888.
Investment Company is established as a limited
liability company.
Operated by two parties i.e. fund manager and the
trustee or custodian.
CDC - largest trustee of mutual funds in Pakistan
with almost 90% of the market share.
SECP through NBFC Regulations 2008 regulates
the mutual fund industry.

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TERMINOLOGIES &
DOCUMENTS
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Net Asset Value
Trust Deed
Offering Documents
Sales Load


PARTIES TO MUTUAL FUND

Fund Manager
Manage the assets of the mutual fund.
Maintenance of financial and other records
and documents.
Maintenance of the record of unit or certificate
holders.
Receipt and processing of investment and
redemption applications.
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PARTIES TO MUTUAL FUND
Trustee
Hold all the property mutual fund for the unit or
certificate holder.
Settlement of transaction entered into by the fund
manager.
Ensure the methodology and procedures adopted
by the fund manager in calculating the value of units
are adequate.
Monitoring of the actions of fund manager in the
light of applicable law i.e. to act as front line
regulator.

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MUTUAL FUNDS - TYPES
Money Market Fund invest mainly in money
market instruments i.e. fixed income securities
with short maturity and high credit quality.
Bond Fund invest mainly in bonds having
longer maturity.
Equity Funds invest primarily in stocks.
Hybrid Funds invest in both bonds and
stocks.
Index Fund or Index Tracker aims to
replicate the movements of an index regardless
of market conditions.

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MUTUAL FUNDS TYPES -
PAKISTAN
Equity Fund
At least 70% of the net assets invested in listed
equity securities.
Remaining net assets invested in cash or near
cash instruments, treasury bills.
No exposure in CFS.
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MUTUAL FUNDS TYPES -
PAKISTAN
Balanced Fund
30% to 70 % invested in listed equity securities.
Remaining assets in money market instruments,
commercial paper, reverse repo, TFCs, sukuks, CFS,
spread, preference shares.
Rating of debt security not lower than A-.
Rating of bank not lower than AA-.
Weighted average time to maturity of non equity
assets should not exceed 2 years.
Investment in CFS and spread should not exceed
25%.
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MUTUAL FUNDS TYPES -
PAKISTAN
Asset Allocation Fund
May invest in any type of security at any time and
may diversify as per the offering document.
The offering document must specify the types of
securities and the rating criteria.
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MUTUAL FUNDS TYPES -
PAKISTAN
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Fund of Funds
Invest its assets in other funds only.
Remaining in bank accounts and treasury bills not
exceeding 90 days.
Must not invest in seed capital.
May be equity, income, money market etc.

MUTUAL FUNDS TYPES -
PAKISTAN
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Capital Protected / Guaranteed Fund
Make investments in such manner that the
original capital is protected while yielding positive
returns.
Normally capital protection is achieved by placing
the capital in term deposits with bank.
Rating of the bank should not be lower than AA-.
MUTUAL FUNDS TYPES -
PAKISTAN
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Index Fund
Strive to remain fully invested in accordance with
the stated index.
Under no circumstances investment fall below
85% of the assets in securities covered in the
index.
Any remaining asset must be kept in bank
account or treasury bills not exceeding 90 days.
Efficient Market Hypothesis
MUTUAL FUNDS TYPES -
PAKISTAN
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Money Market Fund
Invest in cash and near cash instruments i.e.
treasury bills, money market instruments,
commercial papers, reverse repo etc.
No exposure in equities, CFS, spread transaction.
Rating of any security should not be lower than
AA.
Maturity time of any asset should not exceed six
months.
Weighted average time to maturity should not
exceed 90 days.
MUTUAL FUNDS TYPES -
PAKISTAN
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Income Fund
Invest in government securities, TDRs,
commercial papers, reverse repo, TFCs/sukuks,
CFS, spread transactions.
Rating of any security should not be lower than
investment grade.
No restriction regarding time to maturity of any
single assets in the portfolio.
Weighted average time to maturity of assets shall
not exceed 4 years.
MUTUAL FUNDS TYPES -
PAKISTAN
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Aggressive Fixed Income Fund
Invest in government securities, TDRs, cmmercial
papers, reverse repo, TFCs/sukuks, CFS, spread
transaction.
Both rated and unrated security are eligible for
investment.
No restriction regarding time to maturity of any
single assets in the portfolio.
Weighted average time to maturity of assets shall
not exceed 5 years.



MUTUAL FUNDS TYPES -
PAKISTAN
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Islamic Funds
May be categorized as income, money market,
fund of funds, equity, balanced or index tracker.
All the investments must be Shariah compliant.
Investment avenues includes Shariah compliant
stocks, sukuks, deposit with Islamic banks,
spread transactions etc.
SCREENING CRITERAIA FOR
ISLAMIC EQUITY FUNDS
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Criteria 1 Business of the Investee
Company
The business of the investee company should
be Halal.
Criteria 2 Illiquid Assets Must be 20% of
the Total Assets
Illiquid assets means plant and machinery,
inventory etc.
Criteria 3 Market Price Per Share > Net
Liquid Assets Per Share
Net Liquid Assets = TA-ILA-TL


SCREENING CRITERAIA FOR
ISLAMIC FUNDS
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Criteria 4 Non-Compliant Income < 5% of
Gross Revenue
Non Compliant Income includes interest, income
from gambling, gains on derivatives.
Criteria 5 Non-Shariah Compliant
Investments < 33% of Total Assets
Non-Shariah Compliant Investments include
investments in money market funds, money
market instruments, bonds, PIBs, CoIs, CoDs,
TFCs, DSCs, derivatives etc.
SCREENING CRITERAIA FOR
ISLAMIC FUNDS
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Criteria 6 Interest Bearing Debt < 40% of
Total Assets
Interest bearing debt includes bonds, TFCs,
conventional bank loans, finance lease, and
preference shares etc.


DEBT VERSUS EQUITY
FINANCING
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Debt financing is a double edged sword.
Leveraged companies can magnify their returns
in booms, but in slumps, they lose the edge and
can even go bankrupt.
Debt financing results in a zero-sum game in
which at least one stakeholder i.e. shareholders
or creditors suffer.
Equity financing ensures normal returns in
booms and survival in slumps. Therefore, the
company will not be squeezed of liquidity as
interest expense as an autonomous expense
will not feature as a significant portion of total
operating expenses.

A SIMPLIFIED ECONOMIC
MODEL
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Non Leverage Company
Assets Rs. Equity + Liability Rs.
Fixed Assets 60 Debt 0
Current Assets 40 Equity 100
Total 100 Total 100
A SIMPLIFIED ECONOMIC
MODEL
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Economic Boom
Income Statement
Economic Recession
Income Statement
Non Leveraged Company Rs. Non Leveraged Company

Rs.
Net Sales 100 Net Sales 60
Cost of Goods Sold 70 Cost of Goods Sold (70%) 42
Gross Profit 30 Gross Profit 18
Operating Expenses 10 Operating Expenses 10
PBIT 20 PBIT 8
Interest Expense 0 Interest Expense 0
PBT 20 PBT 8
Tax Expense (20%) 4 Tax Expense 1.6
Net Income 16 Net Income 6.4
ROE 16% ROE 6.4%
A SIMPLIFIED ECONOMIC
MODEL
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Leveraged Company
Assets Rs. Equity + Liability Rs.
Fixed Assets 60 Debt 60
Current Assets 40 Equity 40
Total 100 Total 100
A SIMPLIFIED ECONOMIC
MODEL
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Economic Boom
Income Statement
Economic Recession
Income Statement
Leveraged Company

Rs. Leveraged Company

Rs.

Net Sales 100 Net Sales 60
Cost of Goods Sold 70 Cost of Goods Sold 42
Gross Profit 30 Gross Profit 18
Operating Expenses 10 Operating Expenses 10
PBIT 20 PBIT 8
Interest Expense (12%) 7.2 Interest Expense 7.2
PBT 12.8 PBT 0.8
Tax Expense (20%) 2.56 Tax Expense 0.16
Net Income 10.24 Net Income 0.64
ROE 25.6% ROE 1.6%
TAX STRUCTURE
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Income Tax Ordinance, 2001
Income of mutual fund is exempt subject to
distribution of ninety percent of accounting income
reduced by capital gains realized or unrealized.
Mutual funds are also exempt from withholding tax
and capital gains tax.
Investor will be taxed on cash dividend @ 10% stock
dividend exempt.
Investors have to pay capital gains tax if units,
certificates or shares are redeemed/sold before one
year.
Investors also get rebate on income tax on their
investment in mutual funds.
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THANK YOU!
rashidzafer@yahoo.com