MUTUAL FUNDS IN NEPALESE SECURITIES MARKET


INTRODUCTION

1.1 Background

A security market, or financial market, can be defined as a mechanism for bringing together buyers and sellers of financial assets in order to facilitate trading (Sharpe, Alexander & Bailey, p.47). It is recognized as an effective way of raising capital for commercial enterprises, and at the same time providing an investment opportunity for individuals and institutions. It provides mechanism to mobilize community savings for productive investment. The security market is a requisite for the sound development of an economy because it not only provides stable long-term capital for companies and an effective savings vehicle for the public, but also functions as an efficient tool for resource allocation.

Nepal being one of the least developed countries in the world has to make every possible endeavour to efficiently mobilize the available capital. The need for an efficient securities market is a must for the efficient allocation of capital within economies. Mass participation in country’s industrialization process is possible only through the efficient mechanism of securities market as it promotes efficient collection of small and scattered savings from the investors and provides returns to them in the form dividend (Adhikari, p.41). Moreover, the financial intermediaries which link savers at one end and users of capital at the other would be needed to make the mass participation possible and the securities market work more efficiently. These intermediaries have knowledge of the problems of investment and of opportunities of employing funds profitably which is denied to most individual investors. They can go farther afield geographically; they know the personal reputation of would-be borrowers; they command expert advice of the highest quality. In this manner they can secure a higher return on the savings of individuals owing to superior knowledge and bargaining power (Grant, A.T.K., p.183).

Mutual funds come right there. Mutual funds are simply a means of combining or pooling the funds of a large group of investors (Corrado & Jordan, p.88). Since they provide indirect access to financial markets for individuals, they are a form of financial intermediary. They represent a sensible and efficient vehicle for individual investors to participate in the market (Fisher & Jordan, p.654). Investing in mutual funds, the individual investor can in effect employ a team of investment professionals to manage his money under the direction of a portfolio or fund manager. These individuals work full-time on studying the markets, market trends, and individual stocks. Also, the fund allows the investor to purchase a very diversified portfolio of securities for a small investment. It is impossible to purchase a very diversified portfolio of individual securities with a modest investment outside of a mutual fund.

Thus, mutual funds could be an admirable institution for bridging the gap between the individual savers and the established businesses in Nepal. It could be the medium to attract small Nepalese investors to help them participate in the Nepalese securities market.

In fact, the work has been started. Following are the brief introduction of the mutual funds established in Nepal so far.

1.2 Concept of Mutual Fund

Basically, a company that pools funds obtained from individual investors and invests them in the securities market is called an investment company. In other words, an investment company is a business that specializes in managing financial assets for individual investors. All mutual funds are, in fact, investment companies, however, not all investment companies are mutual funds (Corrado & Jordan, p.89).

There are two primary forms of investment companies: open-end and closed-end companies.

With an open-end fund, the fund itself will sell new shares to anyone wishing to buy and will redeem (i.e., buy back) shares from anyone wishing to sell. When an investor wishes to buy open-end fund shares, the fund simply issues them and then invests the money received. When someone wishes to sell open-end fund shares, the fund sells some of its assets and uses the cash to redeem the shares. As a result, with an open-end fund, the number of shares outstanding fluctuates through time.

With a closed-end fund, the number of shares is fixed and never changes. If you want to buy shares, you must buy them from another investor. Similarly, if you wish to sell shares that you own, you must sell them to another investor.

Strictly speaking, the term “mutual fund” actually refers only to an open-end investment company. Nonetheless, particularly in recent years, the term “investment company” has all but disappeared from common use and investment companies are now generically called mutual funds (Ibid., p.90).

The mutual fund industry has grown tremendously in the developed economies, especially the U.S., where they are now the largest type of financial intermediary, followed by commercial banks and life insurance companies (Ibid., p.88). The U.S. mutual fund market is the largest in the world, accounting for half of the $16.2 trillion in mutual fund assets reported worldwide. In 2004, U.S. mutual fund assets reached a record $8.1 trillion, while the total U.S.-registered investment companies managed a record $8.6 trillion at year-end 2004 (ici.org/factbook).

In India, the origin of mutual fund industry is with the introduction of the concept of mutual fund by Unit Trust of India in the year 1963, by an Act of Parliament (amfiindia.com). As at the end of September, 2004, there were 29 funds, which managed assets of Rs. 153108 crores under 421 schemes.

Back in our country Nepal, the history of mutual funds started with the flotation of NCM First mutual fund 2050 by NIDC Capital Markets in 1993 (Shrestha, et. al., p.203). Currently, there are two mutual fund schemes: NCM Mutual fund 2059, managed by NIDC Capital Markets with NIDC as the trustee, and Citizen Unit Scheme managed by Citizen Investment Trust.

1.3 Mutual funds in Nepal

Until now, there are three mutual funds in Nepal. But the NCM First Mutual fund, 2050 has already been terminated. The NCM Mutual fund, 2059 and the Citizen Unit Scheme are the currently prevailing mutual funds in Nepal. Brief introductions of these schemes are given below:

1. NCM First Mutual Fund, 2050
With the objective of providing expert investment services, NCM First Mutual Fund, 2050 an open-end fund with a par value of Rs.10 per unit was issued in multiple of 100 units by NIDC Capital Markets in the year 1993. Its main features were (Hada, Rabin, 2004):
· The sale of this scheme was made in 17th Ashad 2050 to 11th Bhadra 2050.
· The allotment of this scheme was made in 11th Ashwin 2050.
· After the distribution of Unit Certificate, the buy and sales were made on the NAV of the First Mutual Fund.
· This scheme was listed according to Security Exchange Act 2040.
· The target was collection of capital will be 100 millions.
· This fund was just an investors’ saving scheme. The investors were the shareholders of the funds’ assets on the basis of the units the hold.
· The unit price of this fund was Rs.10 and the investors were required to hold a minimum of 100 units. Investors for wishing to subscribe in addition to above can hold any without limit.
· The custodian and the banker of the scheme was Nepal Arab Bank Ltd.
· The management company of the scheme was NIDC Capital Market Ltd.
· The expected return of the scheme was 19% annually.

After two years of the introduction, its buying and selling was stopped due to excessive selling pressure. In order to revive the fund and provide liquidity, by means of repurchase, Nepal Rastra Bank and Nepal Industrial Development Corporation injected an amount of Rs.45 million and Rs.15 million respectively in the 1995. The custodian and the trustee of the scheme was NCML. The fund manager of the scheme was NIDC Capital Market Ltd. Thereafter, the fund was converted to close-end fund and listed in the NEPSE. By the end of FY 1999/2000, the fund was in operation in the market with per unit NAV of Rs.22.15. The scheme was terminated by the end of fiscal year 2000/2001.

2. NCM mutual fund, 2059
During the termination of NCM First Mutual Fund, 2050, the fund holders were given option to refund or to participate in another new scheme called “NCM Mutual Fund, 2059”. All the assets and liabilities of NCM First Mutual Fund, 2050 was valued on 2058/06/29 and was transferred to NCM First Mutual Fund, 2059. SEBO approved this new mutual fund on August 9, 2002. Its basic features are as follows (Prospectus of NCM Mutual Fund, 2059):
· The scheme is limited to 1 crore units and shall be managed as close-end fund.
· The pare value of each unit shall be of Rs.10.
· The units issued under this scheme are listed in NEPSE in accordance to Securities Exchange Act, 2040.
· The scheme is managed by NCML and the trustee is NIDC.
· The management company and the trustee has bought 7.5% each, collectively 15% of the total issued units and has invested as seed capital in the fund.
· In order to revive the fund and provide liquidity NRB and NIDC injected an amount of Rs.45 million respectively in the 1995. After valuation of assets of NCM First Mutual Fund, 2050, NCML has returned the fund of NRB. While the funds provided by NIDC as kitty fund has been transferred to NCM Mutual Fund, 2059 and new units has been issued.

Out of the total units, it distributed 1.5 million units to its management and trustee, 1.33 million to the unit holders of previous mutual fund scheme and the remaining 7.17 million units issued to the public. As published in the annual report 2061/2062 of SEBO, total investment of the fund reached to 156.49 million.

3. Citizen Unit Scheme, 2052
Citizen Unit Scheme, 2052 with a par value of Rs.100 came into operation in the year 1995. CIT has been managing this scheme. The scheme is in operation on income cum growth concept. It is an open-end scheme and provides regular income in the form of dividend to the unit holders. Its essential features are: (Prospectus of Citizen Unit Scheme, 2052):
· In order to sustain and increase the confidence of investors and to simplify the operation of the scheme, until and unless the fund of the scheme does not reach to a self sustained position, only a minimum amount of dividend shall be distributed.
· In order to maintain liquidity, the scheme itself has been maintaining the provision of repurchase. The repurchase price is based on NAV of the scheme. But until and unless the fund of the scheme does not reach to a self sustained position, the repurchase price will be equal to par value.
· Since it is a regular income scheme, while investing the funds, proper consideration has been taken regarding value added income and regular income.
· As for then, maximum of 30% of the investment shall be on organized institutions.
· Unless and until there are not sufficient instrument bearing fixed and regular income in the capital market, the funds allocated to invest on such instruments shall be mobilized towards advancing short-term loan. But such investment on advancing short-term loan shall not exceed the funds invested in the government securities.
· Most of the incomes earned from the Citizen Unit Scheme shall be distributed as dividends.
· For the calculation of income, the increase in the value of securities has been converted into income either by handing over or selling it.

As reported in the annual report 2061/2062 of SEBO, by the end of the FY 2061/62, it sold units amounting to Rs. 1215.62 million and repurchased the units amounting to Rs. 702.53 million. The total number of participants of the scheme has reached to 10,813 and it had declared to distribute 7% dividend to its unit holders.

The present study will attempt to explore the prospects and performances of these two.


1.4 Statement of the problem

The low involvement of institutional investors has been an accepted reality in Nepalese securities market. It has been also one of the major issues for the development of securities market in Nepal (Adhikari, 2005). Moreover, the participation of mutual funds as institutional investors is limited to only two- NCM mutual fund and Citizen Unit Scheme.

It has been studied that countries having developed securities market mechanism are developed and countries with poor securities market mechanism are underdeveloped (Dhungel, 2001). Likely, the part mutual funds can play in developing the market could be assumed from the fact that the developed securities market like that of U.S., has the mutual funds as its largest financial intermediary. So Nepal has the need to push up this industry.

General investors would be better off by investing in the shares of an investment company rather than making their own portfolio because of numerous reasons. The funds have a diversified portfolio, which means less risk to the investors. Skilled and experienced professionals manage the mutual funds. Because they are large professionally managed portfolios, mutual funds incur proportionally lower trading commissions than do individuals.

In spite of the recent growth in Nepalese securities market after the pro-democracy movement of 2062/63 and the various advantages of mutual funds, the success of mutual fund is not noticeable in the country. On the one hand, huge oversubscription of primary issues and the surging NEPSE index are being observed while the transaction of mutual funds is quite low in the market.


In this present context, the study attempts to deal with the followings:
· How do the mutual funds operate in Nepal?
· How have they been performing over the years?
· Are they performing better than the market? Better than naïve diversification?
· Which of the two funds is performing better in terms of returns to its investors?

1.5 Purpose of the Study

As already stated, the focus of the study is to assess the mutual fund industry of Nepalese Securities market. Currently, there are two players: NCM mutual fund is exactly a closed-end fund and the other Citizen Unit Scheme has the nature of open-end type. In this aspect, the study takes the basic purpose to examine the performances of the funds, compare them with each other, with market’s return as well as with a randomly diversified portfolio.

Specifically,
· To explore a brief history of Nepalese mutual funds and their operations.
· To examine the performances of the funds with respect to the returns provided to the investors.
· To evaluate the returns of the funds with respect to market (i.e., NEPSE) return and a randomly constructed portfolio.
· To compare the performances of the two funds in terms of the returns provided.

1.6 Significance of the Study

As the objectives set for the study is to examine the performances of the Nepalese mutual funds, the thesis would be an important paper to deal the prospects of Nepalese mutual funds.
Nepalese mutual have not really played a significant role in Nepalese security market as displayed by its minimum share in the market. Investors also seem to be less interested in these products as the trading at NEPSE indicates. So, in these perspectives, this study would have significance to the following stakeholders, to point out:
1. To mutual fund operators: The performances of the mutual funds have been analysed over the period of operation and the weaknesses of their operation could be indicated.
2. To general investors: It provides information about Nepalese mutual fund industry. The literature review would also be of help to general investors.
3. To regulators of security market: The underperformance of Nepalese funds could be pointed out from the study and the study would help to take the corrective measures.
4. To Academician and researchers: Nepalese mutual fund industry does not have that depth. The study is an attempt to provide some assistance in the continuous field of learning and researching.

1.7 Study Limitations

There could be a lot many issues to be considered in mutual fund industry of Nepal. However, the study is only focused on their performances in terms of the returns provided to investors. So, the study has its limitations.
· It will not examine the other variables of performances of the funds’ management. Only the rates of returns will be considered.
· The effect of the sample size may be present on the findings.
· Only the exploratory and descriptive research design will be taken. No attempts will be made to measure the relationship of the performances with the probable variables as asset size, liquidity, portfolio mix, etc.


LITERATURE REVIEW

2.1 Conceptual Framework

The concepts dealing with mutual fund and related are discussed here. Mutual funds are financial intermediaries that pool the financial resources of investors and invest those resources in (diversified) portfolio of assets (Saunders & Cornett, 2001, p.502).
By definition, Mutual fund is one type of investment company (Corrado & Jordan, p.88). At the most basic level, a company that pools funds obtained from individual investors and invests them is called an investment company (ibid, p.89). So let us first deal with the term “investment company.”

2.1.1 Investment Companies

Investment companies are a type of financial intermediary, who obtain money from investors and use that to purchase financial assets as stocks and bonds (Sharpe, Alexander & Bailey, p.699). In a way, it is a company that provides collective investment opportunities to individuals, businesses and other investors. It is the company which manages a portfolio of securities of various other companies through the funds generated from the public by the issue of shares.

Types
There are two fundamental types of investment companies: open-end and closed-end investment companies.

1. Open-end investment company
With an open-end fund, the fund itself will sell new shares to anyone wishing to buy and will redeem (i.e., buy back) shares from anyone wishing to sell. When an investor wishes to buy open-end fund shares, the fund simply issues them and then invests the money received. When someone wishes to sell open-end fund shares, the fund sells some of its assets and uses the cash to redeem the shares. As a result, with an open-end fund, the number of shares outstanding fluctuates through time.

Open-end investment companies are commonly known as mutual funds (Sharpe, Alexander & Bailey, p. 705). So, strictly speaking, the term “mutual fund” actually refers only to an open-end investment company. However, in the recent years, the term “investment company” has all but disappeared from common use and investment companies are now generically called mutual funds (Corrado & Jordan, p.90).

In our own country, NCM mutual fund is actually a closed-end investment company but is named as a mutual fund, so nowadays, the term “mutual fund” seems to have taken over. It is also likely as mutual funds or open-end investment companies are the most popular form of investment companies and accounts for nearly 95% of the total investment companies in U.S. as of 2004 data (ici.org/factbook).

Types of Mutual Funds/ open-end investment companies:
Open-end investment companies can be subdivided into those that charge a sales fee (load funds) and those that do not (no-load funds). A load fund charges investors for the costs involved in selling the fund which generally involves brokerage, insurance expenses, etc. A no-load fund, on the other hand, sells its shares at a price equal to their NAV as it sells shares directly to the investors without the use of a sales organization.

Moreover, these-days mutual funds are generally divided into various categories based upon their stated investment objectives in their prospectuses. For example, the main types of objectives are growth, balanced income, and industry-specialized funds. Growth funds typically possess diversified portfolios of common stocks in the hope of achieving large capital gains for their shareholders. The balanced fund generally holds a portfolio of diversified common stocks, preferred stocks, and bonds with the hope of achieving capital gains and dividend and interest income, while at the same time conserving the principal. Income funds concentrate heavily on high-interest and high-dividend-yielding securities. Bond funds vary also in the average duration of its holdings. Portfolios with low durations are significantly less sensitive to changes in interest rates than those with high durations. The industry-specialized mutual fund obviously specializes in investing in portfolios of selected industries; such a fund appeals to investors who are extremely optimistic about the prospects for these few industries and are willing to assume the risks associated with such a concentration of their investment dollars. Families of funds have developed that allow investors to switch from a fund with one objective to a fund (in the same family) with a different objective for a modest fee. An investor might be motivated to do this as the stock market and interest rates go through various phases (Fisher & Jordan, p.653).

Likewise, the investment company institute identifies 22 groups of open-end mutual funds, according to the objectives outlined in the prospectus. They can be broadly aggregated into four groups: equity, bond and equity, bond, and money market. The ICI data exclude closed-end funds, unit investment trusts, variable annuities, and unregistered funds (such as hedge funds).
Equity funds Investing primarily in common stocks with the goal of long-term growth

Aggressive growth Maximum appreciation with no concern for current income
Growth Capital appreciation with some concern for current income
Growth and Income Capital appreciation and steady current income
Equity-International Capital appreciation from non-U.S. common stocks
Equity-Global Capital appreciation from both U.S. and non-U.S. stocks

Bond and Equity Funds Investing in a mix of common stocks and long-term debt with the goal of achieving both long-term growth and income
Equity-Income High income from common stocks with history continuous dividends
Flexible Portfolio Stocks, bonds, and liquid assets varying with market conditions
Balanced Capital appreciation, current income, and stability of principal
Income-Mixed High current income from both stocks and bonds

Bond Funds Investing in long-term bonds with the primary goal of income
National Municipal Municipal bonds issued by any or all states
State Municipal Municipal bonds issued by specific states
Income-Bond Mixture of corporate and government bonds
Government U.S. Treasury securities
GNMA Mortgage securities backed by Government National Mortgage Association
Global Bond Bonds of both U.S. and non-U.S. issuers
Corporate Bond Diversified portfolio of corporate bonds
High Yield Bond Maintain at least 2/3 of assets in non-investment-grade corporate bonds

Money Market Funds Investing in short-term, highly liquid securities
Tax-Exempt, National Short-term obligations of state and local governments
Tax-Exempt, State Short-term obligations of state and local governments within specific states
Taxable Short-term obligations of U.S. government and corporations

2. Closed-end investment companies

With a closed-end fund, the number of shares is fixed and never changes. If you want to buy shares, you must buy them from another investor. Similarly, if you wish to sell shares that you own, you must sell them to another investor.

Closed-end investment companies, unlike mutual funds, usually sell no additional shares of their own stock after the initial public offering. A closed-end investment company is more like a traditional, publicly traded corporation, with a fixed number of shares of common stock outstanding (Cheney & Moses, p. 120). Their shares are traded either on an organized exchange or in the over-the-counter market. Thus an investor who wants to buy or sell shares of a closed-end fund would simply place an order with a broker (Sharpe, Alexander & Bailey, p. 702).

A closed-end fund can operate as a diversified or a non-diversified fund. A diversified fund holds a large number of securities from different industries and thus provides the investor with diversification. In a non-diversified fund, the portfolio concentrates in specific industry segments such as petroleum resources or gold-mining issues. Some non-diversified funds also concentrate in specific types of securities as junk bonds, convertible bonds, municipal bonds, real estate investment trusts (REITS), or preferred stock (Cheney & Moses, p. 122).
There are three other types of closed-end investment companies (ibid, p.123):
1. Unit Trusts: This type of portfolio typically sells for $1,000 known as a “unit” and that represents a claim to a fixed portfolio of securities. The securities in the portfolio are purchased and the ratio is fixed before the units are offered to investors. Since the composition of the portfolio remains unchanged, no management committee is needed for the trust after the securities are acquired. Once the initial public offering is made, the “units” are traded in the OTC market. The number of ownership units remains fixed as in the case of a closed–end fund.

The portfolio of a unit trust generally consists of fixed-income securities such as tax-exempt municipal bonds, corporate bonds, or government securities. The trustee of the portfolio collects all the interest paid on the bonds and pays to the investors, usually on a monthly basis. When the bonds mature, the trustee distributes the principal, and the trust terminates.

2. Dual funds: Closed-end dual fund got its name “dual” since it has two types of shares, income and capital. The income shareholder has the right over all interest and dividends, and the capital shareholder receives all the capital gain distributions.
3. Primes and Scores: Beginning in the early 1980s, a no. of investment trusts were formed for the purpose of splitting blue-chip common stocks into conservative and speculative components. A separate trust is created for each common stock, and the trust creates three different securities: trust units, primes and scores. The prime (prescribed right to income and maximum equity) security entitles the holder to all the stock’s price appreciation above a specified price when the trust is liquidated.

2.1.2 Mutual Fund Operations

A Mutual fund is simply a corporation owned by its shareholders. The shareholders elect a board of directors; the board of directors is responsible for hiring a manager to oversee the fund’s operations. Although mutual funds often belong to larger “family” of funds, every fund is a separate company owned by its shareholders.

Most mutual funds are created by investment advisory firms, which are businesses that specialize in managing mutual funds. Investment advisory firms are also called mutual fund companies. Increasingly, such firms have additional operations such as discount brokerages and other financial services.

In U.S., the securities Act of 1933 requires the fund’s shares to be registered with the Securities and Exchange Commission prior to their sale. The Securities Exchange Act of 1934 regulates the purchase and sale of all types of securities, including mutual fund shares. The investment advisors act of 1940 regulates certain activities of the investment advisers to mutual funds. The investment company act of 1111984 is a highly detailed regulatory stature applying to the fund itself. This act contains numerous provision designed to prevent self-dealing and other conflicts of interest, provide for the safe keeping of fund assets, and prohibit the payment of excessive fees and charges by the fund and its shareholders (Woolfell, Charles J., 1994).

The National Association of Securities Dealers (NASD) imposed new rules on July 1, 1993 to suppress the unregulated growth of mutual fund sales charges. The new rules for charges on mutual funds limit 12b-1 fees to 0.75% a year plus a 0.25 % service fee. Limits are also placed on the total a fund can collect in sales charges to a specified percentage of new sales it makes. The rules allow a fund with no upfront sales charge and whose 12b-1 is not over 0.25%, to refer to itself as a no-load fund (Ibid).

A mutual fund is a fund established in the form of a trust to raise money through the sale of units to the public or a section of the public under one or more schemes for investing in securities, including money market instruments. The regulation of mutual funds operating in India falls under the purview of the authority of the Securities and Exchange Board of India (SEBI). Any person proposing to set up a mutual fund in India is required, under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 (Mutual fund Regulations), to be registered with the SEBI. The Mutual Fund Regulations lay down several criteria that need to be fulfilled in order to be granted registration as a mutual fund. Every mutual fund must be registered with SEBI and must be constituted in the form of a trust in accordance with the provisions of the Indian Trusts Act, 1882. The instrument of trust must be in the form of a deed between the sponsor and the trustees of the mutual fund duly registered under the provisions of the Indian Registration Act, 1908 (www.sebi.gov.in).

Investment vehicles like mutual and unit funds cater to the needs of small savers and also provide opportunity to gain from investment in the diversified portfolio of securities. In the context of Nepal, the securities market had tested a case of mutual fund with the floatation of NCM Mutual fund, 2050, a closed ended fund with an amount of 100 million managed by NIDC Capital Markets Ltd. The SEBO/N accommodated the floatation after making the issue prospectus more transparent. It had also prescribed for inclusion and acceptance of investor friendly provisions which include the autonomy of the fund, the fund manager and the custodian with their clearly defined roles and transparency in the valuation of assets. Besides the fund should be an earnings cum growth (not growth scheme alone) and that sponsor should bring in at least 15% corpus to the fund. However, clear mandate to regulate such a fund was not available to the SEBO/N and existing legal frameworks too were not sufficient.

Later on, SEBO/N got involved in restructuring of the fund when the fund could not cope with the liquidity pressure generated by the fund holders, SEBO/N cooperated to the efforts to rescue the fund and approved amended prospectus that restructured the fund. The fund size was tuned to Rs. 52.3 million that was to be retired on July 15, 2001.

The experience encouraged the enactment of Securities Investment Trust Act, 1997 and SEBO/N got involved in drafting the act. SEBO/N observed the necessity of drafting an Investment Trust Act to enable the establishment and operation of trust funds. With a view to give a sound legal footing and to protect the interest of the investors, the legislation has provisions regarding the fund management companies and the trustee. The act enhances transparency and brings the trust fund within the regulatory domain of SEBO/N (SEBO Nepal –A Five Year Performance (1993-1998).

NCM Mutual Fund is in operation in accordance to the rules and guidelines as in its prospectus, while the Citizen Unit Scheme is administered with reference to Citizen Investment Act, 2047, its bye-laws and “Nagarik Akanka Yojana Sanchalan Karyabidihi Niyamharu, 2052”.

NCM Mutual Fund is a closed-end fund and the units issued under it are listed in NEPSE in accordance to Securities Exchange Act, 2040. The prospectus or the rule book of Citizen Unit Scheme does not mention whether it is open-end or closed-end. But, looking at its operation it is an open-end fund. However, its rule number 15 suggests that its unit shall be listed NEPSE in accordance to Securities Exchange Act, 2040.

The share price of the mutual fund is based on Net Asset Value (NAV Calculation) per, which is found by subtracting from the market value of the portfolio the mutual fund’s liabilities and then dividing by the number of mutual fund shares issued. The sources of income of the funds are dividends, interests, fees, capital gain distribution and change in the price of the fund. In case of NCM Mutual Fund, it calculates its NAV each month considering the average price of shares of its portfolio during the month. The buying and selling of shares is done in NEPSE. In such circumstances, when there is high selling pressure, or there is undue effect on its price, or where there is no regular transactions, the manager and the trustee is vested with the power to take part in its buying and selling up to 25% to regularize the transactions in the market. In case of Citizen Unit Scheme, as per rule number 20, 21, 22, shares shall be bought and sold at NAV, but the fund also can itself determine the buying and selling price to regularize its functioning. Therefore, currently, the fund determined its repurchase price at Rs. 100 plus interest 7%.

NCM Mutual Fund guarantees at least 5% dividend to its shareholders. If the income of the particular year is insufficient to distribute 5% dividend, retaining earning will be utilized. In case of absence of retained earning, 5% dividend will be provided adjusting it at the end of its maturity. Rule number 18 of “Nagarik Akanka Yojana Sanchalan Karyabidhi Niyamharu, 2052” assures 8% dividend to its unit holders for the first three years of its operation. As per the provision of rule number 26, Nepal government has fully exempted tax on the returns earned on investment by the scheme. Further, the unit holders are tax freed up to the investment of Rs. 10000 in the scheme. Instead of distributing dividends, the fund is providing interest to the unit holders to take benefit of the rule number 26, which further exempts tax on the interest provided to its unit holders.

NCM Mutual Fund is a close-end scheme having a life-time of ten years from its date of issue. In case of arousal of critical situation leading to its end, the management company can terminate its activities with the consent of the concerned authorities. Such information will be published at least in three daily newspapers. In case of liquidation, within three months of its termination, the money of the investor will be return either by converting its assets into cash or by issuing certificate of new scheme of distributing its securities.

The open-end fund, Citizen Unit Scheme is a perpetual scheme. It shall come to end on such situation when there is a repurchase of more than 75% of the outstanding units. The remaining units shall be purchased back at the price determined on the basis of valuation of its assets.

In case of amendment of rules and regulations regarding the schemes, NCM Mutual Fund should take the prior approval of SEBO and publish it in the paper. While, there is a provision in the Citizen Unit Scheme that the trust is vested with the power to change its rules and regulation that are hindering its performance as per rule numbers 27 and 28 and such changes will be reported through the newspapers.

2.1.3 Performance Measurement

The present study takes the basic purpose of evaluating the performances of current Nepalese mutual funds. So, related to the portfolio performance measurement, some terms and concepts are presented next:

(i) Net asset value: Net asset value (NAV) is simply the total market value of the securities owned, less any liabilities, divided by the number of shares outstanding (Cheney & Moses, p. 122). For example, an investment company that holds various stocks traded on a stock exchange (say NEPSE) could easily find out what the closing prices of those stocks were at the end of the day and then simply multiply these prices by the number of shares that it owns. After adding up these figures, the investment company would subtract any liabilities that it had outstanding. Dividing the resulting difference by the number of outstanding shares of the investment company produces its net asset value.

Equivalently, an investment company’s net asset value at the end of day t, NAVt, can be determined by using the following equation:
where,
MVAt = market value of investment company’s assets
LIABt = amount of investment company’s liabilities
NSOt = no. of shares the investment company has outstanding

(ii) Investor’s return from investing in investment companies:
a. Investor’s return from mutual fund investing:
The investors generally obtain three types of return as a result of owing shares (units) of a mutual fund:
· Cash dividend or interest disbursements
· Capital gains disbursement
· Change in the fund’s net asset value(NAV) per share
The one period rate of return for a mutual fund share is defined in following equation:
where,
HPR = Holding period return
NAV = Net assets value
CG = Capital gains
DIV = Dividends

b. Investor’s return from closed-end fund:
Closed –end funds are essentially marketable shares of common stocks. As a result, their one-period rates of return are calculated like common stock returns shown by the following equation:

where,
HPR = holding period return
P = price of the fund
CR = cash receipts

(iii) Performance Measurement:
The main idea behind performance measurement is to compare the returns obtained by the investment manager through active management with the returns that could have been obtained for the client if one or more appropriate alternative portfolios had been chosen for investment. The reason for this comparison is straightforward performance should be evaluated on a relative basis, not on an absolute basis. In the foregoing topic, we talked about absolute basis, to get a clear idea about performance we need to compare with some other portfolio. Such comparison portfolios are often referred as ‘benchmark portfolio’. Such benchmark portfolios are usually the stock exchanges. In our case we have taken up the stock exchange as the benchmark portfolio risk and return. Although return is a key aspect of performance, some way must be found out to account for the portfolio’s exposure to risk. Having identified the return it is also essential to figure out whether the returns were superior or inferior. This could be done when we estimate the portfolios risk level during the period. The total risk of a portfolio can be divided in tow parts: the systematic (market) risk and the unsystematic risk, i.e.,

Total risk = Systematic risk + Unsystematic risk

The first part, systematic risk, is due to risk factors that affect the overall market- such as changes in the nation’s economy, tax reforms by the government, or a change in the world energy situation, etc. These are the risks that affect securities overall and consequently, cannot be diversified away. In other words, even an investor who holds a well-diversified portfolio will be exposed to this type of risk.

The second component, unsystematic risk, is unique to a particular company or industry; it is independent of economic, political, and other factors that affect all securities in a systematic manner. A wildcat strike may affect only one company; a new competitor may begin to produce essentially the same product; or a technological breakthrough can make an existing product obsolete. For most stocks, unsystematic risk accounts for 60% to 75% of the stock’s total risk or standard deviation. However, by diversification this kind of risk can be reduced or even eliminated if diversification is efficient. Therefore, not all of the risk involved is relevant since part of the risk can be diversified away. The important risk is the unavoidable or systematic risk (Van Horne & Wachowicz, 2000, p.98)

(iv) Capital Asset Pricing Model (CAPM)
In market equilibrium, a security is supposed to provide an expected return commensurate with its systematic risk-the risk that cannot be avoided by diversification. The greater the systematic risk of a security, the greater the return the investors will expect from the security. The relationship between expected return and the systematic risk, and the valuation of securities that follows, is the essence of William Sharpe’s capital asset pricing model (CAPM). This model was developed in the 1960s, and it has had important implication for finance ever since. The major assumptions of this model are:
· The markets are efficient. The capital market efficiency implies the share prices reflect all available information.
· Investors are risk averse. They prefer the highest expected return for a given level of risk.
· All the investors have homogenous expectations about the expected returns and risks of securities.
· All investors' decisions are based on single time period.
· All investors can lend and borrow at a risk free rate of interest.
CAPM provides a framework for measuring the systematic risk of an individual security and relate it to the systematic risk of a well-diversified portfolio. In the context of CAPM, the risk of an individual security is defined as the volatility of the securities return vis-à-vis the return of the market portfolio. The risk (volatility) of individual securities is measured by beta (β). Beta is a measure of a security's risk relative to the market portfolio. Since diversifiable risk does not matter, beta is, thus, a measure of the systematic risk of a security. The market portfolio is the reference for measuring the volatility of individual risky security. The graphical representation of the CAPM is called the security market line (SML). The equation for the SML is:

where,
E(Rj) = the expected return on security j
Rf = the risk free rate
E(Rm) = the expected return on the market portfolio
βj = the un-diversifiable risk of security j

2.1.4 Models of Performance Measurement

The performance evaluation is mainly concentrated to comparison with the scheme return with benchmark portfolio and risk free return. The returns are calculated on the basis of month end NAV announced by the mutual funds. Evaluation can be made on the basis of market prices also. The returns have been calculated taking month end net asset values since their commencement to redemption and in the case of the schemes which are still in operation.

Standard deviation of such monthly returns is to be taken as risk. In order to obtain the systemic risk of the portfolio CAPM version of market model is applied. Higher value of Beta indicates a high sensitivity of fund returns against market returns the lower value indicates a low sensitivity. Diversification of the portfolio is also one of the major advantages of mutual fund. Risk can be measured by regressing fund returns with the market returns. The value of coefficient of determination indicates the degree of diversification.

The measures that can help to evaluate the performance of portfolio are as follows:
1. Sharpe Measure
2. Treynor Measure
3. Jensen Alpha
4. Fama Model
5. Appraisal Ratio
6. Fama-French three-factor model alpha
7. CAPM market-timing alpha and gamma
8. Modigliani Measure
9. Morning Star Ratings
10. Carhart 4-factor model
The finance profession has used the first four performance measures for many years. The Jensen alpha, the Treynor measure and the appraisal ratio are all rooted in the Sharpe-Linter CAPM, whereas the Fama-French three-factor alpha is the equivalent of the CAPM-based Jensen alpha in a multi-factor setting that includes size and book-to-market factors along with the market factors.

1. Sharpe Measure
William Sharpe has attempted to get a summary measure of portfolio performance (William F. Sharpe, 1966). The Sharpe Index of desirability, known as the reward to variability ratio can be used for comparing portfolios in different risk classes. The Sharpe Index is given by:
where,
Si = Sharpe Index
ri bar =Average Return from Portfolio i
σi = Standard deviation of returns for portfolio i
R = Risk-free rate of interest

Sharpe ratio composite measure of portfolio performance follows closely from the author’s earlier work on Capital Asset Pricing Model (CAPM). His procedure involves first subtracting from each portfolio’s net average return, an estimate of the risk-free rate over the evaluation period. This difference can be viewed as a risk premium or reward for investing in assets with more than zero risk. Then each portfolio’s risk premium is divided by its standard deviation of annual returns, a measure of the portfolio’s total risk or variability, estimated over the evaluation period.

2. Treynor Measure
The Treynor measure is similar to Sharpe Measure except that it defines reward (average excess return) as a ratio of CAPM beta risk. Treynor suggests measuring a portfolio’s return relative to its systematic risk rather than relative to its total risk, as does the Sharpe measure. This index is given by the following equation:

where,
Ti = Treynor Index
ri bar = Average return on portfolio i
R =Risk free rate of interest
bi = Beta Coefficient of portfolio i

A key to understanding Treynor’s portfolio-performance measure is the concept of a characteristic line. The slope of the characteristic line is the beta coefficient, a measure of the portfolio’s systematic risk. Some people view systematic risk as a type of volatility measure. Thus, by comparing the slopes of characteristic lines, the investor gets an indication of the fund’s volatility. The steeper the line, the more systematic risk or volatility the fund possesses. Treynor has proposed incorporating these various concepts into a single index to measure portfolio performance more accurately.

3. Jensen Alpha
The Treynor and Sharpe Indexes provide measures for ranking the relative performances of various portfolios, on a risk-adjusted basis. Jensen attempts to construct a measure of absolute performance on a risk-adjusted basis –that is, a definite standard against which performances of various funds can be measured. This standard is based on measuring the “portfolio manager’s predictive ability –that is, his ability to earn returns through successful prediction of security prices which are higher than those which we would expect given the level of riskiness of his portfolio.” Dr. Jensen has modified the characteristic line to make it useful as a one parameter investment performance measure.

A simplified version of his basic model is given by:

where,
Rit = Average return on portfolio i
Rft = Risk-free rate of interest for period t
αi = Intercept that measures the forecasting ability of the portfolio manager
βi = A measure of systematic risk
Rmt = Average return of a market portfolio for period t

Higher alpha represents superior performance of the fund and vice versa. Limitation of this model is that it considers only systematic risk not the entire risk associated with the fund and an ordinary investor cannot mitigate unsystematic risk, as his knowledge of market is primitive.

4. Fama Model
The Eugene Fama model is an extension of Jensen model. This model compares the performance, measured in terms of returns, of a fund with the required return commensurate with the total risk associated with it. The difference between these two is taken as a measure of the performance of the fund and is called net selectivity.

The net selectivity represents the stock selection skill of the fund manager, as it is the excess return over and above the return required to compensate for the total risk taken by the fund manager. Higher value of which indicates that fund manger has earned returns well above the return commensurate with the level of risk taken by him. Required return can be calculated as:

where,
Sm = standard deviation of market returns
Rm = Actual return of the fund
Rf = The net selectivity is then calculated by subtracting this required return from the actual return of the fund.

5. Appraisal Ratio
The appraisal ratio is a transformation of the Jensen’s alpha (Treynor and Black, 1973). It is the ratio of Jensen’s alpha to the standard deviation of the portfolio’s non-market risk (i.e., unsystematic risk) as estimated below:
where,
αp = Jensen’s alpha
σ(εp) = standard deviation of the portfolio’s non-market risk

6. Fama-French three-factor model alpha
The Fama-French three-factor model alpha (Fama & French, 1993) is estimated from the following expanded form of the CAPM regression:



where,
Rpt = Average return on portfolio at time t
Rft = Risk free rate of interest for period t
αp = intercept that measures the forecasting ability of the portfolio manager
β = A measure of systematic risk
HMLt = high-minus-low book-to-market portfolio return in month t
SMBt = small-minus-big size portfolio return in month t

7. CAPM market-timing alpha and gamma
Henriksson and Merton (1981) model and the quadratic regression of Treynor and Mazuy (1966) model measure the market timing ability of a mutual fund manager. The Henriksson-Merton market-timing measure allows for the beta risk to be different in ex-post up and down markets. Specifically, the market timing alpha and gamma are given by,

where,
D = Dummy variable that equals 1 for (Rmt –Rft) >0 and zero otherwise.
αp and γp = The market timing alpha and gamma

Under the null hypothesis of no market timing, both alpha p and gamma p are expected to be zero, whereas a successful market timer’s mutual fund exhibit positive values of αp and γp.


8. Modigliani Measure
Modigliani and Modigliani (1997) express a fund’s performance relative to the market in percentage terms and they believe that the average investor would find the measure easier to understand. The Modigliani measure can be expressed as follows:

Modigliani and Modigliani propose to use the standard deviation of a broad-based market index, such as the S&P 500 as the benchmark for risk comparison, but presumably other benchmarks could be used. In essence, for a fund with any given risk and return, the Modigliani measure is equivalent to the return, the fund would have achieved if it had the same risk as the market index. Thus, the fund with the highest Modigliani measure, like the fund with the highest Sharpe ratio, would have the highest return for any level of risk. Since their measure is expressed in percentage points, Modigliani and Modigliani believe that it can be more easily understood by average investors.

9. Morning Star Ratings
Morningstar incorporated calculates its own measures of risk-adjusted performance that form the basis of its popular star ratings. Star ratings are well known among individual investors. One study found that 90 percent of new money invested in equity funds in 1995 flowed to funds rated 4 or 5 stars by Morning-star (Damato, 1996).

For the purpose of its star ratings, Morningstar divides all mutual funds into four asset classes –domestic stock funds, international stock funds, taxable bond funds, and municipal bond funds. First, Morningstar calculates an excess return measure for each fund by adjusting for sales loads and subtracting the 90-day Treasury Bill rate. These load-adjusted excess returns are then divided by the average excess return for the fund’s asset class. This can be summarized as follows:


Second, Morningstar calculates a measure of down-side risk by counting the number of months in which the fund’s excess return was negative, summing up all the negative excess returns and dividing the sum by the total number of months in the measurement period. The same calculation of average monthly under-performance is then done for the fund’s asset class as a whole. Their ratio constitutes Morningstar risk:


Third, Morningstar calculates its raw rating by subtracting the Morningstar risk score from the Morning-star return score. Finally, all funds are ranked by their raw rating within their asset class and assigned stars as follows: top 10 percent -5 stars; next 22.5 percent -4stars; middle 35 percent -3 stars; next 22.5 percent -2 stars; and bottom 10 percent -1 star. Stars are calculated for three-, five-, and 10-year periods and then combined into an overall rating. Funds with a track record of less than three years are not rated. In addition to its star ratings, Morningstar also calculates category ratings for each fund. The main difference between stars and category ratings is that category ratings are not based on four asset classes but on more narrowly defined categories, with each fund assigned to one (and only one) category among 44 altogether: 20 domestic stock categories, 9 international stock categories, 10 taxable bond categories, and 5 municipal bond categories. In addition, category ratings are not adjusted for sales load and are calculated only for a three-year period.

10. Carhart 4-factor model with time-varying betas
It is well known that biases can arise if managers trade on publicly available information, in other words if dynamic strategies are employed. Average alphas calculated using a fixed beta estimate for the entire performance period is highly unreliable if expected returns and risks vary over time. Therefore, Carhart 4-factor model with time-varying betas comes to rescue. It is given by
where, Zt-1 is a vector of lagged pre-determined instruments. Assuming that the beta for a fund varies over time, and that this variation can be captured by a linear relation to the conditional instruments, then beta it =beta i0 + B ‘i Zt-1, where B ‘i is a vector of response coefficients of the conditional beta with respect to the instruments in Zt-1.

Among the above performance measures, two models namely, Treynor measure and Jensen model use systematic risk based on the premise that the unsystematic risk is diversifiable. These models are suitable for large investors like institutional investors with high risk taking capacities as they do not face paucity of funds and can invest in a number of options to dilute some risks. For them, a portfolio can be spread across a number of stocks and sectors. However, Sharpe measure and Fama model that consider the entire risk associated with fund are suitable for small investors, as the ordinary investor lacks the necessary skills and resources to diversify. Moreover, the selection of the fund on the basis of superior stock selection ability of the fund manager will also help in safeguarding the money invested to a great extent. The investment in funds that have generated big returns at higher levels of risks leaves the money all the prone to risks of all kinds that may exceed the individual investors’ risk appetite.

The finance professionals have used the Sharpe measure, Jensen alpha, Treynor measure and appraisal ratio performance measures for many years. The Jensen alpha, the Treynor measure and the appraisal ratio are all rooted in the Sharpe-Linter CAPM, whereas Fama-French three-factor alpha is the equivalent of the CAPM-based Jensen alpha in a multiple-factor setting that includes size and book-to-market factors along with the market factor. To evaluate market timing, CAPM-based market-timing alpha and gamma and Fama-French three-factor model-based timing alpha and gamma are used (Kothari and Warner, 2001).




2.2 Review of past studies:

Review of past studies is important to gain knowledge on the status of the field of the study. It helps to discover what other research in the areas of the study has uncovered. The following section tries to present the most important research works that have been carried out in the area of investment companies:

The first empirical analysis of mutual funds performance is provided by Friend, Brown, Herman & Vickers in 1962. Because of the growing importance of investment companies in the United States, the Securities and Exchange Commission (SEC) engaged the Wharton School of Finance and Commerce to conduct a study of mutual funds (Fisher & Jordan, p. 672)

The investigation found no relationship between the performance of mutual funds studied and sales charges that these funds levied. “The fact that the analysis does not reveal a significant relation between management fees and performance indicates, in other words, that investors cannot assume the existence of higher management fees implies that superior management ability is thereby being purchased by the funds (Ibid).”
Next, the studies conducted on various dates have been presented chronologically:

Treynor’s study (1965)

In 1965, Jack Treynor presented a paper in the Harvard Business Review titled “How to rate management of investment funds” (Treynor, 1965, p.63-65). He made a comprehensive study on the performance of mutual funds. He devised an index in order to rank the performance of funds. To do so, he used the systematic risk, measured by the beta of the fund, rather than the total risk. Thus, Treynor’s index, Tp, is equal to:
where,
Excess Return (Risk premium) = Average Return – Risk less rate
He found out from his study that the funds were not as superior performer as the market portfolio.

Sharpe Study (1966)

In order to measure the performance of mutual funds William Sharpe devised an index of portfolio performance, denoted St, that is defined in equation below for portfolio i (Sharpe, 1966, p. 125.).
Sharpe gathered data on the risk and return of 34 mutual funds for a decade and ranked their performance. The Dow Jones Industrial Average (DJIA) was used as a standard of comparison in evaluation of the performance of the funds. Out of the 34 funds, 12 had risk-premium to risk ratios above the 0.667 of the DJIA. The average of the 34 mutual funds ratio was 0.633 which was below the DJIA’s 0.667. Sharpe concluded that DJIA was more efficient portfolio than the average mutual fund in the sample.

Jensen's Study (1968)

Dr. Michael C. Jensen modified the characteristic regression line to make it useful as a one-parameter investment performance measure. ( Jensen, “The performance of Mutual Funds in the period 1945-1964”, Journal of Business, May 1968, vol. XXIII, No. 2, p. 386-416.). Unlike Treynor & Sharpe, who provided relative performance measures, Jensen constructed a measure of absolute performance on a risk-adjusted basis, i.e., a definite standard against which performance of various funds can be measured.
The basic random variables in Jensen’s model are risk premium, as shown in the equation below:
rpi,t = ri,t - Rt
where,
rpi,t = Risk premium for asset i in period t
ri,t = one period rate of return from asset i in period
Rt = risk less rate observed in period t.

Jensen concluded that the funds in his study were on average not able to predict security prices well enough to outperform a buy-the-market and hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance. Jensen found that the funds earned (net expenses) about 11% less per year (compounded continuously) than they should earn given their level of systematic risk.

McDonald’s Study (1974)

Using 120 monthly rates of return from a decade, John G. McDonald analyzed the performance of 123 mutual funds. The Sharpe & Treynor performance measure were used but in the slightly reformulated manner. Dr. McDonald used monthly observations of the 30 days commercial paper rate as a surrogate for the risk less rate. These monthly observations of Rt were subtracted from each portfolio monthly rates to obtain monthly risk premium, denoted rpi,t - Rt. Then the average risk premium, denoted E (rpi,t - Rt), over the 120 months was divided by the appropriate risk measure to compare the portfolios performance.

McDonald found that, on average the funds with more aggressive objectives took more risk and earned higher return. Concerning the investment performance of 123 mutual funds, McDonald’s study reported that slightly over half the 123 mutual funds (i.e., 67 out of 123 had values for Treynor’s performance index that exceeded the stock market average. Use of Sharpe’s performance measure showed that about 31.7% of the funds outperformed the stock market average. Thus, using a slightly different specification of the Sharpe & Treynor’s portfolio performances measures and a different sample didn’t yield any significant differently conclusion. The study concluded that on average mutual funds performed about as well as a naïve buy-and-hold strategy.

Guy’s Study (1978)

James R. F. Guy conducted the performance of the British investment trust industry (Guy, 1978, p. 443-455.). The paper investigates a sample of 47 British closed-end investment trusts over the interval 1960-1970. Using the traditional performance measure of Jensen, Treynor & Sharpe, it was found that no trust in any of the intervals studied had performance measure that was significantly different from zero. Guy stated that it either meant that the test was not powerful enough to identify any superior performance if it existed, or that no trust significantly outperformed London Stock Exchange, which was the benchmark portfolio used.

The study also investigated two other performances measure: the first involved an empirically estimated security market line and the second the zero beta form of the capital asset pricing model. In both cases some significant measures of performance were obtained. On investigating whether the performance measures abstracted form beta, it was found that whereas the new measures were related to beta the effect in the case of the tradition measures was insignificant.

Hendricks, Jayendu and Zeckhauser’s Study (1993)

One of the important recent studies made on mutual fund performance is the one made by Hendricks, Jayendu and Zeckhauser (Hendricks, Patel & Zechkauser, 1993). The research was supported by grants from the Bradley Foundation & the Decision, Risk & Management Science Program of the National Science Foundation.

The study carefully examined the quarterly excess returns of 165 mutual funds from 1974 through 1988 in order to see whether funds with relatively high returns in one period tended to have primarily in common stocks with the objectives of growth, growth and income, or income and aggressive growth.

In the study each fund was placed in one of the eight groups based on the excess returns over the first quarter of 1974. Then the excess return of each group was measured for the second quarter of 1974 by averaging the excess returns of the funds in that group. The process was then repeated, except that the funds was assigned to one of the eight groups based on their quarterly excess returns for the second quarter of 1974, and then the average fund excess return was for each group was calculated for the third quarter of 1974. This process was repeated through the fourth quarter of 1988, re3sulting in a set of quarterly excess return for each group ranging from the second quarterly returns for the eight groups were calculated over the entire period.
The study found out that mutual funds that did better in one quarter were likely to do better in the next quarter. The study also suggested that investors should be concerned with short-term relative performance based on the funds return over the past four quarter. Similar results were obtained when various risk-adjusted measures of performance, such as ex-post Alphas, were used.

Malkiel’s Study (1995)

The performance of equity mutual funds was analyzed by Burton G. Malkiel. (Malkiel, 1995, p.549-72). The study takes a new look at mutual funds returns during the 1971 to 1991 period and utilizes a data set that includes the returns from all mutual funds in existence in each year of the period. Most data sets included all mutual funds that were in existence and thereby excluded funds that had terminated their operations. The study utilized two market indexes as benchmark portfolio: one was Standard & Poor’s 500 index and the other was Wilshire 5000.

The study utilized the CAPM model to have a measure of the funds performance shown as below:
Rfd –Rf =α+ β(Rmkt –Rf ) + Efd
where,
Rfd = Funds returns
Rmkt = Market return
Rf = Risk-free return
α is an intercept and β is beta which measures the risk. Positive α implies positive risk adjusted return.

The calculation used quarterly returns for the funds and for the market benchmark. The risk free rate taken was three-month Treasury bill rate reported by Ibbotson Associates. The study also took up an important issue: Survivorship Bias. It states that significant biases can be created in a study by including funds that no longer exits. Therefore the study tried to reduce their biasness by including funds that were in existence. The study found out that mutual funds tended to under perform the market, not only after management expenses have been deducted, but also gross of all reported expenses except load fees.

The study found out, by utilizing simulation of variety of feasible investment strategies based on the persistence phenomenon, that above average returns were produced during the 1970’s. During the 1980’s, however, the study found no evidence that investors could earn extraordinary returns following a strategy based on persistence.

In conclusion, the study stated that, it did not find any reason to abandon a belief that securities market is remarkably efficient. It suggested that most investors would be considerable better off by purchasing a low expense index fund, than by trying to select an active fund, than by trying to select an active fund manager who appears to process a hot hard. Since active management generally fails to provide excess returns and tends to generate greater tax burdens for investors the advantage of passive management holds a fortiori.

The findings, among others, were:
· In an aggregate, funds have underperformed benchmark portfolios both after management expenses and even gross expenses.
· The average alpha is negative when net returns are used and positive when gross returns were used, but neither is significantly different from zero.
· While considerable performance persistence existed during the 1970s, there was no consistency in fund during the 1980s.
· Funds betas and returns were not related as the CAPM suggest.

Likewise, Brown and Goetzmann (1995) analyzed the performance of mutual funds in USA in terms of returns, number of mutual funds established, and their total capitalization. They compared the returns of mutual funds with the returns of S&P 500. Their findings, among others, were that the mean returns on mutual funds during 1976 to 1988 were 14.5% which was higher than that of S&P 500 during same period. The capitalization of the funds increased from $37,218 million in 1976 to $166,474 million in 1988. The number of funds also increased from 372 to 829 during period. They, at the end, concluded that relative risk adjusted performance of mutual funds persists.

Mark M. Carhart (1997) in his article “On Persistence in Mutual Fund Performance” in the Journal of Finance took the objective of studying the persistence of mutual fund performance. Two models of performance measurement were used. The first was CAPM as described by Sharpe and Lintner; the other was his own Carhart 4-factor model. The mutual fund database covered diversified equity funds monthly from Jan. 1962 to Dec. 1993. The data are free of survivor bias, since they include all known equity funds over this period. Using the sample free of survivor bias, he demonstrated that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds’ mean and risk-adjusted returns. The results did not support the existence of skilled or informed mutual fund portfolio managers.

He had also provided three important rules-of –thumb for investors: 1.Avoid funds with persistently poor performance. 2. Funds with higher returns last year have higher-than-average expected returns next year, but not in years thereafter. 3. The investment costs of expense ratios, transaction costs, and load fees all have a direct, negative impact on performance (Carhart, 1997, p. 57-82)

Mark Grinblatt and Sheridan Titman in their article “The Persistence of mutual fund performance” (1992) have analyzed how mutual performance relates to past performance. The tests were based on a multiple portfolio benchmark that was formed on the basis of securities characteristics. The evidence found was that differences in performance between funds persist over time and that the persistence was consistent with the ability of fund managers to earn abnormal returns.

They used the mutual fund data, consisting of monthly cash-distribution adjusted returns and investment goals for 279 funds that existed from Dec.31, 1974 to Dec. 31, 1984. The results indicated that there was positive persistence in mutual fund performance. The persistence cannot be explained by inefficiencies in the benchmark that are related to firm size, dividend yield, past returns, skew-ness, interest rate sensitivity, or CAPM beta. They asserted that the past performance of investors who are considering an investment in mutual funds.

Similarly, Kothari, S. P. and J. Warner (2001), in their article, “Evaluating mutual fund performance”, have studied standard mutual fund performance measures, using simulation procedures combined with random and random-stratified samples of NYSE and AMEX securities. They have tracked simulated fund portfolios over time. These portfolios’ performance is ordinary and well-specified performance measures should not indicate abnormal performance. The main result is that the performance measures are badly mis-specified. Regardless of the performance measure, there were indications of abnormal fund performance, including market timing ability, when none exists.

They had constructed a 50-stock mutual fund portfolio each month from January 1964 through December 1991 and have tracked these 336 simulated mutual fund portfolios’ performance over three-year periods (months 1 through 36) using a number of performance measures, namely, Sharpe measure, Jensen Alpha, Treynor measure, and the appraisal ratio, and Fama-French Three factor model alpha.

From the simulations, the main message that had been derived was that standard mutual fund performances were unreliable and could result in false inferences. In particular, it was easy to detect abnormal performance and market-timing ability when none exists. The results showed that the range of measured performance is quite large even when true performance was ordinary. It provides a benchmark to gauge mutual fund performance. Comparisons of the numerical results with those reported in actual mutual fund studies raises the possibility that reported results are due to misspecification, rather that abnormal performance.

Finally, the results have indicated that procedures based on the Fama-French 3-factor model are somewhat better than CAPM based measures. This is not surprising, and indicates that “style” analysis is useful in benchmarking fund returns. The misspecification even for Fama-French suggests at least two possibilities. One is that size and book-to-market do not completely describe the characteristics relevant for expected returns. The second is related to the estimation process, and that sampling distributions of the performance measures differ from those assumed under null hypothesis, for example because expected returns change overtime. Further investigation of the latter possibility could be particularly fruitful in explaining why the tests using simulated portfolios often show market timing when none is present.

Kurian, A.P. (2004) provides an insight on Indian Mutual Fund Industry through his article entitled, “On a Growth Trajectory”, in the “Analyst”, vol. X, issue-7. Mutual funds industry is undoubtedly one of the fastest growing industries particularly in the financial sector. Looking at the last ten years, the compounded annual growth rate is around 10% and similarly in the last 11 years it is about 11-12% per annum. This reflects how consistently they are growing and this will be further accelerated as they go ahead.

Back to our own country, Suman Neupane (2001), in his dissertation entitled, “A Study of Mutual Funds Performance in Nepal”, dealt with the following problems:
· Why were the investors shying away from investing in mutual funds?
· What was the performance of the mutual funds in the country in terms of risk-adjusted return?
· Were the mutual funds generating returns in excess of market returns?
· Was there a need of a mutual fund (or investment company) in country like ours?
· Which of the funds generated higher returns?
With due consideration to the problems, the objectives of his study was set as follows:
· To find out the performance of the mutual funds currently operating in the country in terms of risk-adjusted returns.
· To figure out whether the funds have been able to outperform the market portfolio in terms of risk-adjusted returns.
· To find out as to which of the two funds performed better during the period studied in terms of risk-adjusted returns.

His study resulted that the NCM Mutual Fund was not as efficient as the Market Portfolio. CIT seems to be a better performing fund than the NCM mutual fund on the basis of the annual rates of return. In addition, he came up with several deficiencies in the practice of mutual funds in Nepal. The deficiencies range from passive investment strategy adopted by funds managers to the repurchase of units at par value rather than at NAV.

In the same year, Braja Mohan Adhikari conducted a research in mutual funds and the results are presented in his dissertation “A financial study of mutual fund companies in Nepal: A comparative study of Citizen Investment Trust and NIDC Capital Markets Ltd.”. He took the following objectives of exploring the profitability condition of CIT and NCM fund, the condition of their investment portfolio, the condition of their expenditure portfolio and the financial strengths and weaknesses. The methodologies taken were the financial analysis, Student’s t-test, correlation analysis and the trend analysis. His findings, among others, were:
· Analyzing the schemes of the two companies, the unit trust scheme of CIT was giving high yield, low risk and more liquidity than that of the NCM.
· EPS of both were fluctuating, however, the profitability condition was satisfactory.
However, the thesis was not devoted at finding out the performances aspect of the funds with regard to the performance evaluation tools.

Mahato, Srijana (2002), in her dissertation, “Risk and Return Analysis of investing in Mutual Fund” had laid following objectives:
· General idea and practice of mutual funds in Nepal.
· Performance of the mutual funds in current status.
· To find out whether investing in share is better or in fund.
· To know why people are not showing interest towards mutual funds.
With regard to above objectives, following research questions were set:
· Why investors are shying away from mutual funds?
· Why it had not been as successful as its counterparts in India or in developed country?
Her study had revealed that condition of Mutual Fund was not very good. One of the major reasons for it was the inadequate knowledge about the features and operations of the mutual funds. NCM Mutual fund was risky than the market and was not as efficient as the market portfolio. Investors were shying away from the because of less return and high risk in comparison to the market. So, she concluded, investing in share was better than in the fund.

Hada, Rabin (2004) in his dissertation, “Mutual fund: An Emerging Trend in Nepalese Financial Market” had set following objectives:
· To examine the need and significance of mutual fund for Nepalese economy.
· To examine the steps taken by government to introduce mutual funds in Nepalese stock market.
· To explore the current problems being faced by the mutual funds and the performances in Nepalese market.
Above objectives were set on the ground of the following problems:
· Why was mutual fund needed especially in Nepalese market?
· What are the advantages and disadvantages of mutual fund?
· How mutual funds make investment less risky?
· What are the current problems of mutual fund?
· Does mutual fund help to increase the habit of investment of people?
· How far it is relevant in the Nepalese financial market?
His study revealed that the lack of financial knowledge, proper government policy and efficient management had led to poor popularity of the concept of mutual fund among general public.

Sthapit, Anubrata (2004) in her dissertation “Mutual funds and Securities Markets in Nepal” had set the following objectives:
· To examine the role of mutual funds in the securities market of Nepal.
· To evaluate the performance of mutual funds.
· To find out the reasons affecting the performances of mutual funds in the securities market.
With the help of both primary and secondary data, she concluded that the existence of Mutual fund in the Nepalese security market was very nominal, as the market capitalization was very low. Citizen Unit Scheme had concentrated its investment in government securities while NCM Mutual fund had focused on shares. So, the change in market prices of the shares had more effect on it than the CIT and likewise, it seemed more risky than Citizen Unit Scheme and the market. Through the primary data analysis, Sthapit concluded that the management was alleged by the public for the poor performances of NCM fund and similarly, the study showed that since people considered risk and return as the main factors in making investment choice, Citizen Unit Scheme had been favoured to NCM mutual fund, as the former was less risky than the latter.