Why are mutual funds lagging behind?

All over the world, small and large investors pool their money into mutual funds in the expectation of high returns resulting from the sound decisions and expertise of the fund managers. However, in Bangladesh most mutual funds – there are 34 close-end and 61 open-end mutual funds listed by the BSEC – are failing to perform efficiently and profitably. While some funds offer low dividends, others are sold at a discount having institutional investors offloading their stakes.

Mutual funds gained substantial popularity and demand in the 2010s which caused their net asset values (NAVs) to rise sharply and prompted many new entrants into a bull market without having expertise and professionalism. This created a subsequent bubble leading many investors to lose a lot of money when it finally burst and caused a market crash. In the aftermath of such a collapse, many mutual funds have been struggling to recover.

While investigating the predicament of the mutual funds, a couple of fundamental problems come to mind. Firstly, the type of investors in the market significantly impact the demand for mutual funds. Most of the investors in the capital market are stock traders who seek quick returns by buying small shares and selling them at a higher price. They have little interest in stable long-term investments that give dividends. In fact, most traders are likely to be engaged in rumour-based trading instead of carrying out the technical and quantitative analysis to invest in reliable, profit-making companies.

The underlying problem in the capital market itself is the high degree of volatility and market manipulation (pump and dump or ramping) that benefits a small number of traders at the cost of many others. This is illustrated with the price spikes of junk bonds, and stocks of small and unreliable companies whereas large profitable companies struggle to attract sufficient capital (as they tend to be more expensive and offer long term dividends for which most traders do not have the patience). This contradicts the purpose of stock markets to efficiently allocate capital to the most profitable and high-performing firms.

This sort of market culture discourages professional investing and influences the behaviour of institutional investors by making them hesitant to invest in sound and long-term investment vehicles like mutual funds. It is no surprise that many mutual funds are trading at a discount as their trading to NAV ratio is low.

Secondly, mutual funds have struggled because of their inability to secure investors' confidence in their management capabilities. This is because investors would only feel confident if they believe that the fund managers would invest their money wisely and earn higher returns than they could have done by themselves.

However, low dividends and returns by the mutual funds have discouraged investment. Erosion of confidence is resulted from ineffective management, and lack of expertise and professionalism by the mutual fund managers. There is also evidence that many mutual funds are offering dividends despite incurring losses which erode the capital base of the funds and foreshadow a greater crisis.

Finally, in order to address the problems that plague this sector, regulatory oversight needs to be overhauled bringing policy consistency. For example, close-end funds should not be allowed to take in more capital beyond their time limit to check the disparity between trading price and NAV. Moreover, the regulator has to fix its policies on whether it should allow mutual funds to offer dividends which creates uncertainty for investors. The lack of policy consistency is bad for any sector, especially the one for mutual funds. The issue that the publicly-owned ICB mutual funds are dominating the market and crowding out other mutual funds also needs to be addressed.

Overall, policymakers should look into how they can improve the management practices and regulatory oversight of the mutual funds. Simultaneously ensuring consistent policies and cracking down on market manipulation are a must as it is the public's money that is at stake. As market for mutual funds being classified as a frontier market, there is a lot of room for it to develop.

The author is a former chairman of the Bangladesh Securities and Exchange Commission (BSEC).

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.