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What is a mutual fund?

A mutual fund is a collective investment scheme, which specializes in investing a pool of

money collected from many investors for the purpose of investing in securities such as
stocks, bonds, money market instruments and similar assets. A fund's portfolio is structured
and maintained to match the investment objectives stated in its prospectus.

One of the main advantages of funds is that they give small investors access to professionally
managed, diversified portfolios of equities, bonds and other securities, which would be quite
difficult (if not impossible) to create with a small amount of capital. The income earned
through these investments and the capital appreciations realized are shared by its unit holders
in proportion to the number of units owned by them. Open-ended fund units are issued and
can typically be purchased or redeemed as needed at the fund's current net asset value (NAV)
per share whereas closed-end funds are listed on the stock exchanges and can be freely

Types of Mutual Funds (By Structure)

Funds can be open-ended funds or closed-end funds depending on their structure.
Open-ended Funds
These funds are in a continuous process of issuing shares/ units on demand and redeeming
shares/ units on demand. The shares/ units do not trade on a market. The number of shares/
units outstanding varies each time the net asset valuation calculation is carried out, which is
daily for most open-ended funds.

Closed-end Funds

Closed-end funds issue a specific number of shares. Their capitalization is fixed. The shares
are not redeemable, but are readily transferable and traded on either a stock exchange or the
over-the-counter market. The price of a closed-end fund share fluctuates based on investor
supply and demand. Closed-end funds are not required to redeem shares and have managed

Why Invest in a Mutual Fund?

1. Cost Efficiencies

The operating costs of a fund manager are lower due to the economies of scale of
managing large portfolios. Mutual fund management can save on accounting fees, research
costs, and brokerage fees, etc., due to the availability of a relatively large pool of resources.
For example, the cost of managing a single Rs.lOOmn portfolio is less than the cost of
managing 500 portfolios of Rs.200,000 each. Not only are costs lower, professional managers
are less likely to make bad investment decisions by investing too much in a single security.

2. Expert Management

Due to paucity of knowledge, an average investor does not feel confident enough to decide
which securities to invest in, a condition made worse as investment advisory services are not
available to most investors nor are they familiar with this concept. Mutual fund managers are
trained investment professionals whose knowledge can provide greater risk adjusted returns.
Successful timing and selection of stocks by mutual fund managers can maximise shareholder
returns which investors may not be able to achieve on their own. The method of stock
valuation and selection is a scientific process for which professionals use technical and
fundamental analysis to identify stocks that have the best prospect of value appreciation.

Technical analysis entails scrutinising the historical stock price and volume movements that
help in identifying price patterns to assist in the forecast of future prices. Fundamental
analysis, on the other hand, is based on the study of economic data such as earning prospects,
dividends, product risk, return on equity, profit margin, expected growth rate in earnings,
financial conditions, market share, patent protection etc., of a company to calculate its
intrinsic value. This intrinsic value is then compared with the current market value of the
stock to make buy, sell, or hold decisions. Usually, an average investor does not have the
time or the expertise, as opposed to fund managers, to keep abreast of all the micro and
macro changes affecting stock prices.

3. Risk Diversification

Investors are averse to huge fluctuations in stock prices. A mutual fund can stave off this
barrier by providing broad diversification through the pooling of resources, a possibility not
available to an individual investor. The portfolio theory suggests that as an investor spreads
his/her investment over a large number of stocks, the investment risk goes down. Stock prices
of various companies are less then perfectly correlated. Therefore, adding stocks that are not
highly correlated with each other results in a reduction of portfolio risk.

Investment risk arises from two sources - company risk and market risk. Company risk
purports that something ‘bad’ will happen to the company, therefore, its stock price will fall.
This may be due to poor management of the company, a natural disaster such as fire or storm,
human error, drop in demand of the product, etc. Company risk effects only one particular
firm or industry but not all the stocks in the market.

Examples of company risk are Taj Company and Mohib Textiles where companies failed
because of poor management resulting in huge losses to investors. Another example is that of
Union Carbide, whose plant exploded in India in 1984, leaving thousands of people dead and
disabled. Yet another example is the oil spill in Alaska where Exxon ended up paying billions
of dollars to clean up the mess. Stock prices did not fall drastically in the case of Union
Carbide or Exxon as both companies had huge reserves to safeguard against such accidents.

Company risk can be reduced or even eliminated by owning a large number of stocks in the
portfolio. If an investor holds a large number of stocks in the portfolio, and some of these
companies do not perform well, it will not affect the overall returns significantly. Financial
analysts suggest that company risk can be reduced drastically if an investor holds about 40
stocks in his/her portfolio. Since it is difficult for an average investor with limited resources
to own and keep track of so many different stocks, investors can reduce investing in a mutual

Market risk affects the entire range of stocks through such variables as interest rates,
inflation, budget deficits, government regulations, taxes, political and economic situation of
the country, war, recession etc., but some companies tend to suffer more than others. For
example, during a recession companies that deal in consumer goods such as cars get more
affected than those that deal in necessities. This is because during a recession people may
postpone buying durables like a washing machine or a car but they do not postpone eating
food or taking medicine. Mutual fund managers hold stocks that they feel have less market
risk when they expect a recession or a downfall in the stork market- for some reason.
Types of Mutual Funds (By Objective)

Open-ended or closed-end funds can be of several types; however the most basic
classifications are stock funds, income funds, hybrid funds or specialty funds. Further
classifications evolve as each fund pursues diverse investment strategies for instance: Islamic
Equity Funds, Sector Funds, Global Equity Funds, High Yield Debt Funds, Aggressive
Equity Funds, Income Funds and so on.

• Stock Funds

• Income and Money Market Funds

• Hybrid Funds

• Pension Funds

• Islamic Funds

• Specialty Funds

Stock Funds

Stock funds invest primarily in stocks. A share of stock represents a unit of ownership in a
company. When companies profit, the stock may increase in value, or the company can pass
its profits to shareholders in the form of dividends. However, stock funds expose the
shareholder to greater risk as returns are not fixed.

By buying shares of a stock mutual fund, the investor becomes a part owner of each of the
securities in his fund’s portfolio. Where stock investments have historically been a great
source for increasing individual wealth, even the most successful companies may experience
periodic declines in value. However, stocks have historically performed better than other
investments in securities, such as bonds and money market instruments.

Stock funds are generally:

• Aggressive growth funds invest in undervalued stocks with potential for capital

• Emerging market equity funds invest primarily in equity securities of companies

based in less-developed regions of the world.

• Global equity funds invest primarily in worldwide equity securities, including those of
U.S. companies.

• Growth funds invest primarily in common stocks of well-established companies with

the potential for capital appreciation. These funds’ primary aim is to increase the
value of their investments (capital gain) rather than generate a flow of dividends.
• Income equity funds seek income by investing primarily in equity securities of
companies with good dividends.
• Regional equity funds invest in equity securities of companies based in specific world
regions, such as Europe, Latin America, the Pacific Region, or individual countries.
• Sector equity funds seek capital appreciation by investing in companies in related
fields or specific industries, such as financial services, health care, natural resources,
technology, or utilities.

• Islamic stock funds seek shariah compliant equity securities.

Income and Money Market Funds

Income funds invest in portfolios consisting of debt securities, money market instruments,
CFS, spread transactions, ready future, direct deposits, etc. Money market funds make
investments in short term debt securities of a minimum investment grade and which have a
maximum average duration of 90 days. Debt securities are issued when money is lent to the
company, municipality, or government agency that issues the debt. In exchange for the use of
this money, the issuer promises to repay the amount loaned (the principal; also known as the
face value of the bond) on a specific maturity date. In addition, the issuer typically promises
to make periodic interest payments over the life of the loan.

Income funds that invest in debt securities are generally less volatile than stock funds and
produce regular income. For these reasons, investors often use income funds to diversify,
provide a stream of income, or invest for intermediate-term goals. Like stock funds, income
funds have risks and can make or lose money.

Money market instruments are relatively stable because of their short maturities and high
quality. Money market funds are good for short-term investment and savings goals as they
preserve the value of the investment while earning income.

Income and Money Market Funds are generally:

• Corporate bond funds seek a high level of income by investing in corporate bonds of
varying maturities.

• Global bond funds invest in global debt securities of varying maturities.

• Government bond funds invest their portfolios in government securities of varying


• High-Yield funds seek a high level of current income by investing their portfolios in
lower-rated corporate bonds.
• Mortgage-backed funds invest their portfolios in pooled mortgage-backed securities.

• Islamic income funds invest in Islamic debt securities

Hybrid Funds:

Hybrid funds invest in a mix of equities, bonds or money market in fixed or variable

• Asset allocation funds seek high total return by investing in a mix of equities, fixed-
income securities and money market instruments. Allocation limits can be upto 100%
in one asset class.

• Balanced funds invest in a specific mix of equity securities and bonds with the three-
part objective of conserving principal, providing income, and achieving long-term
growth of both principal and income.

• Islamic allocation or balanced funds see investments in a mix of shariah complaint

equities or debt securities.

Pension Funds

Pension Funds are funds made up of sub-funds and created from the contributions made over
regular intervals by the participants over their working lives. They include all income or
investment returns earned net of fees, charges and expenses related to the management of the
investments of sub-funds to provide for a regular income after retirement for the participant.

Basic Structure

A participant starts his fund by choosing when to start saving, the amount to save and what
investment allocation scheme to pursue based on his return and risk preferences. The
participant also selects his retirement age which can be any age between 60 and 70 years.
Upon retirement, the participant can withdraw upto 25% of the accumulated amount tax-free.
However any withdrawals over 25% are subject to tax under Income Tax Ordinance, 2001
(Refer to Section: Withdrawals).

The remaining amount is reinvested in an approved annuity plan (monthly income plan) from
a life insurance company of the participant’s choice or entered into the income payment plan
to withdraw the remaining amount in monthly installments till the age of seventy-five years
or earlier, after which the remaining amount can be used to purchase an annuity from a life
insurance company of his choice.

How to Start:

A participant can start his pension fund with an asset management company or a life
insurance company with a minimum amount as set by the company. The company sets up an
individual pension account from the time of receiving the first contribution, and subsequently
all further contributions are added to this account. The participant has to further select an
allocation scheme, according to his/ her risk and return requirements, which is used to invest
the account into sub-funds in a fixed ratio. The company usually offers a choice of Equity
sub-fund, Debt sub-fund and Money Market sub-fund and the participant can make
allocations from two or more of these funds.

Allocation Schemes

Allocation schemes and their criteria is set by the SECP and published in the offering
documents of funds. Allocation schemes range between aggressive and conservative levels
based on the higher or lower share of investment in the equity sub-fund as specified below:

Allocation Scheme Debt Sub-Fund Equity Sub-Fund Money Market Sub-

Aggressive Min 20% Min 65% Nil
Balanced Min 40% Min 35% Min 10%
Conservative Min 60% Min 10% Min 15%
Very Conservative Min 40% Nil Min 40%

Generally aggressive schemes have the potential to offer higher returns at the expense of
higher risk; this relationship reverses as the investor moves towards more conservative
schemes. Each company provides investors advice on the risk and return profile of their
investment choice. However the following relationships hold true in general:

Allocation Scheme Investment Goals Risk & Return Investor Lifecycle

Profile, Investment

Aggressive Maximize capital High return/ high risk: Early to middle working
growth long age

Balanced Maximize total return Moderate return/ Early to middle working

i.e. capital growth and moderate risk: long to age
income medium

Conservative Maximize total return Low returns/ low risk: Middle to retirement age
with emphasis on medium to short
capital preservation

Very conservative Maximize regular Very low risk: short Post-retirement

income and capital

Participants may also make choices based on their personal attitude towards risk. The pension
fund manager is required to ensure that the allocation scheme agreed with the client is
adhered to and the portfolio is rebalanced incase the ratios change. Changes should only be
made as and when requested by the client.


Pension funds mature at the retirement age specified by the participant at the time of opening
of the account which can be between 60 and 70 years. Pension funds can also be withdrawn
prior to retirement age due to permanent disability or death of the client or simply an early
withdrawal by the participant.

Withdrawal Procedure
The participant is required to submit the retirement application to the company at least thirty
days before the chosen date of retirement. This form should specify the selected date of
retirement and the selected benefits options. In the event that the participant is planning to
withdraw more than 25% he must also provide his tax details for the last three years as this
will be used for calculating his tax on the withdrawn amount in excess of 25%.
On the date of retirement as selected by the participant all the units of the sub-fund in his
individual pension account will be redeemed. The redemption is to be based on the net asset
value at the retirement date (if that day is a dealing day otherwise on the next dealing day).
The amount due is credited to the participant’s individual’s pension account.

The cheque for the amount is mailed to the participant/ his bankers, (if so instructed) within
six business days provided that all the details relating to the participant are complete. The
remaining amount (if any) can be invested in the in an income payment plan offered by the
same company or any other registered pension fund manager, whereby he can withdraw from
the remaining amount in monthly installments till the age of seventy five years or earlier,
after which the remaining amount can be used to purchase on annuity from a life insurance
company of his choice.

The participant can also choose to directly invest the remaining balance, after retirement,
with a life insurance company in an approved annuity plan. Please note that all investment
after retirement will be subject to applicable income taxes.

Withdrawal due to Permanent Disability of Participant

In case of permanent disability (Please see Voluntary Pension Rules, 2005 for details) the
participant has to submit a medical report from an SECP approved medical board and the
funds are then retired on the same conditions that would apply to a standard retirement

Withdrawal due to Death of Participant

Incase of death of a participant, the nominees (as identified by the nomination form) are
recognized as having any title to or interest in the balance held in individual pension Account
of the deceased. In case no nominations have been made, the executors, administrators or
succession certificate holders of the deceased participant are recognized as having title to the
accumulated balance of Individual pension account of the deceased participant

The nominee(s) can:

• Withdraw his share of the amount subject to the conditions laid down in the Income
Tax Ordinance, 2001; >
• Transfer his share of the amount into his existing or new individual pension account
to be opened with the pension fund manager, according to the Voluntary Pension
System Rules;
• Use his share of the amount to purchase an approved annuity plan on his/ her life from
a life insurance company, only if the age of the survivor is fifty five years or more; or
• Use his/ her share of the amount to purchase a deferred approved annuity plan on his
life from a life insurance company to commence at age fifty five years or later.

If any amount in excess of the allowable amount is withdrawn as cash by the nominee(s),
then tax will be deducted before making any such payments.

Procedure incase of Death of Participant

• The units will be redeemed on the dealing day on which the intimation of death of the
participant is received in writing and transferred to the individual pension account of
the deceased.
• Each of the nominees as nominated in the nomination form shall be required to submit
retirement application to the company. The total amount in the individual pension
account of the deceased participant will then be divided among the nominated
survivor(s) according to the percentages specified in the nominations form.

Early Withdrawal

A participant can redeem all or part of the units in his individual pension account before
attaining the retirement age. However, such redemptions will be subject to deduction of
income tax at his/ her average tax rate for the last three consecutive years. Participant must
submit the early redemption form to the company for an early withdrawal to take place,
accompanied by the documentary evidence for the taxable income and tax paid by the
participant for the last three years to enable the company to determine the average tax rate
which is required to be deducted. The redemption will be at the net asset value at the close of
the dealing day on which the request, complete in all respects, is received. The amount is
credited to the individual pension account, from which the redemption payment shall be made
after deducting the applicable tax, as required. The redemption amount shall be paid by direct
transfer to the participant’s designated bank account or a crossed cheque/ draft for the amount
will be dispatched to the registered address of the participant.
Tax Issues - Tax Rate
The tax rate that is applied to the redemption money in case of early withdrawal or in case of
withdrawal in excess of 25% (regular retirement, permanent disability or death) is calculated,
according to the Income Tax Ordinance, 2001, as follows:
A is the total tax paid or payable by the person on the person’s total taxable income for the
three preceding tax years; and
B is the person’s total taxable income for the three preceding tax years.

Tax Credit
Participants can avail tax credit for contributions made to pension funds in each tax year as
per the Income Tax Ordinance, 2001.

Procedure for Claiming Tax Credit

A participant who is employed can provide documentary evidence of contributions made

during each tax year ending on June 30 to their employers who may then make adjustments
of tax credit admissible from the tax to be deducted from salary. A self-employed participant
may claim the tax credit at the time of filing of his tax return for each tax year ending on June
30. The participant may claim a tax rebate depending upon the amount of his contributions
for that tax year and his applicable taxes.


The pension fund management company usually offers insurance with the pension account,
however the terms and conditions for each facility vary and the person seeking to open a
pension fund account can obtain more information from the company.

Fee Structure

Pensions funds charge a minimum fee for their services and are allowed by SECP a
maximum front-end fee (sales charge) of 3% of all the contributions received from any
participant of the pension fund and an annual management fee of 1.5% of the average of the
values of the net assets of the pension fund calculated during the year for determining the
prices of the units of the sub-funds. However, these rates are subject to further change by

Participants are also not charged front-end fee in the event of the transfer of the individual
pension account from one pension fund manager to another pension fund manager.

Islamic Pension Funds

Islamic pension funds operate in the same way as other pension funds however all
investments made for Islamic pension funds must be Shariah compliant.

Rules Governing Pension Funds

Voluntary Pension System Rules, 2005
Income Tax Ordinance, 2001.
Islamic Funds (Shariah Compliant Funds)

Islamic funds must conduct all their activities according to the Islamic Shariah based on the
guidelines provided by the Shariah Advisory Board appointed for the fund. A Shariah
Advisory Board comprises of eminent Islamic and financial scholars, who have considerable
experience in the field of Islamic studies. Islamic funds can be pure equity/ income, hybrid or
pension funds, as long as the policies meet the Shariah principles.

Specialty Funds

Special types of funds which are not simple equity or income funds can be classified as
specialty funds.

• Fund of Funds are funds that have their portfolio invested only in other mutual funds.
These funds could be equity fund of funds, income fund of funds etc.

• Index Tracker Funds are passively managed and their objective is to duplicate the
strategy of a selected index.

• Principal-Protected Funds guarantee the initial principal invested at a specified

maturity period, while earning a rate of return on it.

Risks in Mutual Fund Investing

There is some degree of risk in every investment. Although it is reduced considerably in

mutual fund investing. Do not let the specter of risk stop you from becoming a mutual fund
investor. However, it be-hooves all investors to determine for themselves the degree of risk
they are willing to accept in order to meet their objectives before making a purchase.
Knowing of potential risks in advance will help you avoid situations in which you would not
be comfortable. Understanding the risk levels of the various types o mutual funds at the
outset will help you avoid the stress that might result from a thoughtless or a hasty purchase.

Let us now examine the risk levels of the various types of mutual funds.

• Low Level Risks

• Moderate level Risks

• High Level Risks

Measuring Risks


Mutual funds characterized as low-level risks fall into here categories

1. Money market funds

2. Treasury bill funds
3. Insured bond funds

Mutual funds considered moderate-risk investments may be found in at least the eight types
categorized below.

1. Income funds
2. Balanced funds
3. Growth and income funds
4. Growth funds
5. Short-term bond funds (taxable and tax-free)
6. Intermediate bond funds (taxable and tax-free)
7. Insured government/municipal bond funds
8. Index funds.


The types of funds listed below have the potential for high gain, but all have high risk levels
as well.

1. Aggressive growth funds

2. International funds
3. Sector funds
4. Specialized funds
5. Precious metals funds
6. high-yield bond funds (taxable and tax-free)
7. Commodity funds
8. Option funds

Figure below depicts three types of mutual fund portfolios structured according to risk level.
You may wish to use this as a guide to building a portfolio based on your level of risk
tolerance. The percentages of each type of fund recommended in the portfolios reflect a
reasonable degree of diversification, balance, and risk level as indicated.

Portfolio Allocations Based on Risk Levels





Growth &


10% Index



al Funds


15% High


As you become a more experienced investor, you may want to examine other, more technical,
measures to determine risk factors in your choice of funds.

Beta coefficient is a measure of the fund’s risk relative to the overall market. For example, a
fund with a beta coefficient of 2.0 means that it is likely to move twice as fast as the general
market – both up and down. High beta coefficients and high risk go hand in hand.

Alpha coefficient is a comparison of a fund’s risk (beta) to its performance. A positive alpha
is good. For example, an alpha of 10.5 means that the fund manager earned an average of
10.5% more each year than might be expected, given the fund’s beta.
Interest rates and inflation rates are other factors that can be used to measure investment
risks. For instance, when interest rates are going up, bond funds will usually be declining, and
vice versa. The rate of inflation has a decided effect on funds that are sensitive to inflation
factors; for example, funds that have large holdings in automaker stocks, real estate
securities, and the like will be adversely affected by inflationary cycles.

R-Square factor is a measure of the fund’s risk as related to its degree of diversification.

The information is supplied here merely to acquaint you with the terminology in the event
you should wish to delve more deeply into complex risk factors. The more common risk
factors previously described are all you really need to know for now, and perhaps for years to

One caveat is in order, however. There is no such thing as an absolutely 100% risk-free
investment. Even funds with excellent 10 year past performance records must include in their
literature and prospectuses the following disclaimer: “Past performance is no guarantee of
future results.” However, by not exceeding your risk tolerance level, you can achieve a wide
safety and comfort zone with mutual fund portfolios such as those shown in Figure above.
A mutual fund can generate profits from three different sources, which are:

• Dividend
• Capital Gains
• Appreciation of Share Price

Mutual fund generates income from dividends received from other joint stock
companies whose shares the fund holds. A mutual fund uses this dividend
income to distribute dividend to its own stock holders.
Capital Gains:
As discussed earlier the portfolio manager changes the portfolio of the fund with
the passage of the time and also with the changes in economic and business
conditions. So due to the sale and purchase of shares, the mutual fund generates
capital from the sales/ purchase of stocks. The capital gain generated by the
mutual fund is also used to pay dividends to the investors of the fund.
Appreciation of Share Price:
Mutual funds also increase the wealth/investment of their shareholder through
appreciations of share price of the mutual fund. For example if the subscription
price of a mutual fund is Rs.11.00, and after a period of seven months the price
goes upto Rs.18.00, thus the investor gets a profit of Rs.7.00 if he sell the mutual
fund's shares in the market.

Advantages of Mutual Funds:

• Mutual Funds substantially lower the investment risk of small investors

through diversification in which funds are spread out into various sectors,
companies, securities as well as entirely different markets. It is always the
objectives of a fund manager to maximize a funds return for a given level
of risk, however the dangers of "over-diversification" are always prevalent
which would inevitably lead to a reduced return on the portfolio.

• Mutual Funds mobilize the saving of small investors and channel them
into lucrative investment opportunities. As a result, mutual funds add
liquidity to the market. Moreover, given that the funds are long term
investment vehicles, they reduce market volatility by offering support to
scrip prices.

• Mutual Funds are providing the small investor access to the whole market
which individually, would be difficult to achieve.

• The investors save a great deal in transaction cost given that he has access
to a large number of securities by purchasing a single share of mutual

• The investors can pick and choose a mutual fund to match his particular
Disadvantages of Mutual Funds:

As such there is no major disadvantage attached to the mutual funds. However,

the possible disadvantages could be:

• Economic and Business Conditions: As the business and economic

conditions do not remain constant, the mutual fund may face some
difficulties in future. Especially if the manager does not shuffle the
investment portfolio with the passage of time, or some other major
unforeseen disaster/event changes the investment scenario.

• Portfolio Managed by Managers: Portfolio of a mutual fund is managed

by the portfolio managers due to which the investor has no say in the
affairs of a mutual fund.


Mutual fund industry in Pakistan has shown impressive growth in recent years. Its acceptance
as a useful tool to deploy funds is on rise amongst both individual and corporate investors.
However, at the same time, the increasing number of asset managers as well as funds has
necessitated the need of an independent opinion on their performance. PACRA follows a
comprehensive approach to rate the two distinct ingredients of the mutual fund industry –
asset managers and funds.
These two are rated on separate scales. While the asset manager rating seeks to determine the
professional capacity of asset managers, the rankings/ratings of mutual funds aim to highlight
relative positioning of a particular fund with reference to certain identified parameters.
PACRA has so far developed three different products for ranking/rating mutual funds, given
the varying nature of these funds and the different investment consideration and information
requirement of investors. The main product, mutual fund performance ranking (commonly
referred to as Star Ranking), is applicable to a large number of funds’ categories and focuses
on relative actual recorded performance of a mutual fund. The other two products namely,
funds’ stability rating, and funds’ capital protection rating are applicable to income and
money market funds, and capital protected funds, respectively.

Every mutual fund investor has a distinct set of investment objectives and preferences. They
all usually have unique risk-return perception and investment horizons that make it difficult
to capture these preferences in a single yardstick, using which investment decisions can be
made. PACRA’ Mutual Fund Performance Ranking
(Star Ranking) attempts to address this investor need. The star ranking provides an initial
screening criterion to investors. The ranking is a purely quantitative measure, avoiding any
biases. It is based on historical returns of a fund relative to other funds in similar category.
PACRA has defined different fund categories – each having distinct characteristics – and
rankings of funds in a particular category are comparable. The ranking methodology is
designed in a manner that the star ranking of a fund conveys a sense of how skillfully the
fund has been managed; that is, the relative star rankings of two funds in a category should be
affected more by manager skill than by market circumstances or events that lie beyond the
fund managers’ control. PACRA’s mutual fund ranking, therefore, provides a useful
yardstick to existing and potential investors and facilitates their investment decisions.
PACRA assigns two types of star rankings i.e., a star ranking based on fund’s performance
during the trailing 12 months; and a long-term star ranking based on fund’s performance
during the trailing 36-months. These rankings are presently done on two cut off periods
ending; i) June 30, and December 31. However, as the industry matures further, PACRA may
enhance the time period of performance review for long-term star ranking, most likely to five
years compared to existing practice of three years, and may also increase the frequency of
updates to quarterly basis.
Fund categories define groups of funds whose constituents are similar in their risk factor
exposures so that return comparisons are meaningful. Moreover, the observed return
differences among funds relate primarily to security selection, or to variation in the timing
and amount of exposure to different elements affecting the category. Each of these, over time,
may be presumed to exercise a skill-related effect.
The following considerations apply while assigning a fund to a particular category:

• Funds are grouped by the type of investments that dominate their portfolios.

• In general, funds in the same category can be considered reasonable substitutes for the
purposes of portfolio construction.

• Category membership of a fund is based on long-term portfolio composition

philosophy for the fund as disclosed by its asset manager.

PACRA, after a detailed evaluation of mutual funds in Pakistan, has identified the following
categories (separate subcategories in respect of open and closed end funds has to be
• Equity Fund: A fund that at least invests around 50% of its net assets in equities at
all times.

• Balanced Fund: A fund that carries a mix of interest-based and equity securities and
at least invests around 30% of its net assets in equities at all times.
• Income Fund: A fund that invests in interest-based instruments / securities a
average maturity of its assets is more than 90 days at all times.

• Money-Market Fund: A fund that invests in money market and other short-term
interest based instruments / securities including spread transactions. The weighted
average maturity its assets is less than 90 days at all times.
• Asset Allocation Fund: A fund that can invest in any class of asset in any proportion
according to criteria set in its offering document
PACRA considers both absolute and risk-adjusted performance. Absolute return refers to the
appreciation or depreciation that a fund has achieved over a period of time and effectively
this is what an investor takes home at the end. However, at the same time, the level of risk
(extent of variability) that is involved with those returns is also important. Risk-adjusted
return shows the trade-off investors make between risk and return. Since star ranking is a
combination of both risk and return it is likely to provide investors a better measure to gauge
historical performance of different funds.

PACRA calculates a fund’s return for a given month as follows:


R = PE – PB +/- A
R = Total return for the month
PE = End of month NAV (net assets value) per share/certificate
PB = Beginning of month NAV per share/certificate
A = Adjustments on account of cash dividend, bonus issue and addition to capital RISK
To measure a Fund’s risk adjusted return, PACRA uses the Fund’s return volatility measured
through standard deviation:
R = Average monthly returns for the trailing 12 monthly periods (36 months for long-term
star ranking)
SD = Standard deviation of the monthly returns of the fund. SD is computed using the
returns for trailing 12 months (36 months for long-term star ranking)

Other elements considered while arriving at a ranking include:

The rankings are calculated on the basis of performance during a particular period (12 months
for short-term star ranking and 36 months for long-term star ranking). For measuring
performance, equal 50% weight age is assigned to return and risk adjusted return.
Only those funds are eligible for ranking that have remained operational throughout the given
period (i.e. one year for short-term star ranking and 3 years for long-term star ranking). A
month of a year is used as a reference period to calculate performance.
To summarise, the star ranking is strictly a quantitative measure and funds are rated within
their respective categories. The ranking exercise measures performance of funds in a risk and
return combination and then funds are ranked accordingly on the basis of their performance.
It is important to note that a fund’s particular star ranking is with reference to its category and
consequently, rankings are comparable only in the same category.

Performance Evaluation of Mutual Funds in Pakistan

In Pakistan Mutual Funds were introduced in 1962, when the public offering of National
Investment (Unit) Trust (NIT) was introduced which is an open-end mutual fund. In 1966
another fund that is Investment Corporation of Pakistan (ICP) was establishment. ICP
subsequently offered a series of closed-end mutual funds. Up to early 1990s, twenty six (26)
closed-end ICP mutual funds had been floated by Investment Corporation of Pakistan. After
considering the option of restructuring the corporation, government decided to wind up ICP
in June, 2000. In
2002, the Government started Privatisation of the Investment Corporation of Pakistan. 25 Out
of 26 closed-end funds of ICP were split into two lots. There had been a competitive bidding
for the privatisation of funds. Management Right of Lot-A comprising 12 funds was acquired
by ABAMCO Limited. Out of these 12, the first 9 funds were merged into a single closed-
end fund and that was named as ABAMCO Capital Fund, except 4th ICP mutual fund as the
certificate holders of the 4th ICP fund had not approved the scheme of arrangement of
Amalgamation into ABAMCO capital fund in their extra ordinary general meeting held on
December 20, 2003. The fund has therefore been reorganised as a separate closedend trust
and named as ABAMCO Growth Fund. Rest of the three funds were merged into another
single and named as ABAMCO Stock Market Fund. So far as the Lot-B is concerned, it
comprised of 13 ICP funds, for all of these thirteen funds, the Management Right was
acquired by PICIC Asset Management Company Limited. All of these thirteen funds were
merged into a single closed-end fund
which was named as “PICIC Investment Fund”. Later on the 26th fund of ICP (ICP-SEMF)
was also acquired by PICIC Asset Management Company Limited. The certificate holders in
extraordinary general meeting held on June 16, 2004

Approved the reorganisation of SEMF into a new closed-end scheme renamed as PICIC
Growth Fund. The Securities and Exchange Commission of Pakistan subsequently authorised
PGF on July 30, 2004.
Initially there was both public and private sector participation in the management of these
funds, but with the nationalisation in the seventies, the government role become more
dominant. Later, the government also allowed the
private sector to establish mutual funds. Currently there exist Thirty-three funds by the end of
Financial Year 2005.

Twelve open-ended mutual funds are:

• public sector, 01;
• private sector, 11;

Twenty-one close-end mutual funds in Pakistan are:

• public sector, 0;
• private sector, 21.
Performance evaluation of mutual funds is important for the investors and portfolio managers
as well. Historical performance evaluation provide an opportunity to the investors to assess
the performance of portfolio managers as to how much return has been generated and what
risk level has been assumed in generating such returns. In this way the investors can also
compare the performance of fund managers.

On June 2004 the net asset value of close-end mutual funds was Rs 48 billion and open-end
funds net asset value was Rs 63.86 billion. Whereas on June 1997 thenet asset value of
closed-end mutual funds was Rs 04 billion and open-end mutual funds net asset value was Rs
25 billion. Total net assets value in 1997 was Rs 29 billion and at the end June 2004, raised to
Rs 112 billion. There is a big increase of investment (entrusted amount) in this sector since
1997 to 2004 which necessitate the performance evaluation of funds free of manipulation.


the last few years mutual fund industry has shown significant progress with reference to
saving mobilisation and important part of the overall financial markets. But still we are far
behind the developed countries mutual fund industry. Growth in mutual funds worldwide is
because of the overall growth in both the size andmaturity of many foreign capital markets.
These nations have increasingly used debt and equity securities rather than bank loans to
finance economic expansion. The Pakistan economy can prosper because of the benefits of
new investment opportunities arising from economic reform, privatization, lowered trade
barriers and rapid economic growth.
Individuals throughout the world have the same basic needs that are education for their
children, health, good living standard and comfortable retirement. In our country where
people are religious minded, mostly they avoid bank schemes for investments, if they are
provided an investment opportunity which suits the religion, we can mobilise savings from
masses which may be laying an idle money at present. By doing so we would be able to
improve the living standard of our countrymen through economic prosperity. This can be
achieved through the introduction of different species of mutual funds and their performance.
The success of this sector depends on the performance and the role of regulatory bodies.
Excellent performance and stringent regulations will increase the popularity of mutual funds
in Pakistan.


The Sample
After 2002, mutual fund industry in Pakistan has witnessed significant changesand growth in
terms of private sector participation, divestment of public sector funds.At present we have 33
funds–21 closed-ends, out of which 09 are the infantcommenced in between 2003 and 2004
some of which emerged due to divestment andthen merger of ICP funds while others are
newly introduced. We have 12 open-endfunds, out of these funds 10 funds are infant, which
introduced in between 2003 and2004. As we are concerned with survivorship bias controlled
data, ICP funds which nomore exist at the end of June 2004 and merged into other funds are
excluded from theresearch sample and other funds which have life of two to three years have
also beenexcluded from the evaluation. Rests of 14 funds out of total 33 funds have lived a
longlife and still operative which serve our research purpose.
Sources of Data
Annual reports of equity and balanced funds for the period from 1997 to 2004have been used
for data collection. For this purpose different sources have beenused; Asset Management
Companies of the funds, Stock exchanges, SECP andinternet. Data for Treasury bills rate was
collected from Statistical Bulletins of StateBank of Pakistan.

Variables picked for the performance evaluation of mutual funds are netincome after taxes of
funds, net asset value, number of certificates/shares outstanding,earning per certificate and
net asset value per certificate/share, monthly returns ofKSE 100 index. Six months Treasury
bill rates. Return of fund was calculateddividing return per certificate by opening net asset
value per certificate. Return percertificate was calculated dividing fund income after taxes by
total number ofcertificates outstanding for the year. Net asset value per certificate was
calculated bydeducting total liabilities from total assets of the year or by taking
shareholdersequity. Return of a fund may also be calculated dividing net income after taxes
of a fund by opening net assets of the fund for that year.

Methodology and Empirical Results

There are four models which are used worldwide for the performance evaluation of mutual
funds (1) Sharpe Measure (2) Treynor Measure (3) Jenson differential Measure (4) Fama
French Measure. We have used first three measures excluding Fama French Measure. The
reason for not using Fama French Model is that for this model we needed data on book to
market ratio for all companies listed at KSE from 1997 to 2004 which could not be made

The Sharpe Model

In 1960 William F. Sharpe started to work on portfolio theory as thesis project. He introduced
the concept of risk free asset. Combing the risk free asset with the Markowitz efficient
portfolio he introduced the capital market line as the efficient portfolio line.

The model given by Sharpe, 1 we can proceed further to use it for the determination of
expected rate of return for a risky asset, which led to the development of CAPM capital asset
pricing model. Through this model an investor can know what should be the required rate of
return for a risky asset. The required rate of return has a great significance for the valuation of
securities, by discounting its cash flows with the required rate of return.

In order to determine which portfolio offering the most favourable risk/return trade-off, we
compute the ratio of the historical returns in excess of the risk-free rateto the standard
deviation of the portfolio returns. The portfolio offering the highest reward/risk ratio then is
the only risky portfolio in which investors will choose to invest. Using average returns of the
portfolio uses Sharpe ratio to measure ex-post portfolio performance.
This model is used to measure the performance of a managed portfolio in respect of return
per unit of risk. This ratio also measures the portfolio manager’s ability on the basis of rate of
return performance and diversification by taking into account total risk of the portfolio. The
study computes of the ratio of the historical returns, (ex-post returns) in excess of the risk-
free rate to the standard deviation of the portfolio returns of the funds for the period from
1997 to 2004. Weighted average of six months Treasury bills rate was used as a risk free rate.

sharpe ratio which indicate the managers inability in diversification but on overall basis
Sharpe ratio of funds is 0.47 (as compared to market which is 0.27) risk premium of per one
percent of standard deviation which shows better performance as compared to market.

The Treynor Model

Treynor introduced two types of risks. One risk is called Systematic risk which is associated
with market and cannot be diversified away. However, this type of risk can by calculated
through “beta”. Treynor says that portfolio expected return depend on its beta. The other type
of risk which he separated from systematic risk is
unsystematic risk. Unsystematic risk is specific to a company. The uncertaintyattached with
the specific company can be diversified away. Treynor model is used to measure the
performance of a managed portfolio in
respect of return per unit of risk (systemic risk). In this way the mutual fund provides the
highest return per unit of risk (systemic risk) will be preferred as compared to the fund
provides low return per unit of risk. Treynor ratio uses Beta as a risk measure hence considers
the Systematic risk. This ratio also measures the
portfolio manager’s ability on the basis of rate of return performance and diversification by
taking into account systemic risk of the portfolio. This ratio measures the historical
performance of managed portfolio in terms of return per unit of risk (systemic risk).
Treynor Ratio indicate that the portfolio offering the highest reward/risk (systemic risk) ratio
will be the only risky portfolio in which investors will choose to invest. The assumption is
that the portfolio manager has diversified away the diversifiable risk (unsystematic
risk/company specific risk) and the matter of concern for the investor should be the
systematic risk (non-diversifiable/market risk) only,

instead of total risk. I computed the ratio of the historical returns, in excess of the risk-free
rate (T-Bill rate) to the systemic risk of the portfolio returns of the Pakistani funds for the
period from 1997 to 2004. Results show (Table 2) that all funds have beta less than 1, in
some cases significantly less than 1, regarding systemic risk wecan conclude that all mutual
funds are defensive in their movement of returns ascompared to the market returns (KSE 100
index). Treynor ratio on overall basis/industry is 0.13 risk premium of per one percent of
systemic risk show
reasonable risk premium per one percent of systemic risk. If the diversifiable risk which is
company specific is fully diversified away by the funds portfolio manager, the results of
Sharpe ratio and Treynor ratio are same. Our funds are facing the diversification problem that
is why the results of both ratios are not the same.
Jensen Differential Measure
Jensen in 196 9 introduced alpha (α) in the capital asset pricing model to measure the
abnormal return of a portfolio—that is difference between the actual average return earned by
a portfolio and the return that should have been earned by the portfolio given the market
conditions and the risk of the portfolio. Jensen measure is calculated as follows:

This measure has great appeal for practitioners as has been derived from the capital market
theory Jensen differential measure applied on the data of mutual funds for the period from
1998 to 2004, the result shows (Table 3) that
although few funds show negative alpha but on overall basis funds industry alpha is positive
alpha of 6.03. Positive alpha of the mutual funds is an indication that the funds outperform
the market proxy—KSE 100 index by 0.86
percent per annum.

results of descriptive statistics Table 4, show that in the last seven years from 1998 to 2004
mutual funds, on average earned return of 15 percent with the standard deviation of 13.8
percent, whereas market return in this period was 19.5 percent with the standard deviation of
40.5 percent which indicates the controlled risk of funds. Therefore Sharpe ratio of funds is
0.47 (as compared to market which is 0.27) risk premium of per one percent of standard
deviation which represents reasonable risk premium. This investigation also proves funds
better performance to the market.
This paper provides an overview of the Pakistani mutual fund industry and investigates the
mutual funds risk adjusted performance using mutual fund performance evaluation models.
Survivorship bias controlled data of equity and balanced funds is used for the performance
evaluation of funds. Mutual fund industry in Pakistan is still in growing phase. Result shows
that on overall basis, funds industry outperform the market proxy by 0.86 percent. They are
investing in the market very defensively as evident from their beta. Mutual Fund industry’s
Sharpe ratio is 0.47 as compared to market that is 0.27 risk premium per one percent of
standard deviation. Results of Jensen differential measure also show positive after cost alpha.
Hence overall results suggest that mutual funds in Pakistan are able to add value. Where as
results also show some of the funds under perform, these funds are facing the diversification
problem. Worldwide there had been a tremendous growth in this industry; this growth in
mutual funds worldwide is because of the overall growth in both the size and maturity of
many foreign capital
markets, we are far behind. The need of an hour is to mobilise saving of the individual
investors through the offering of variety of funds (with different investment objectives). The
funds should also disclose the level of risk associated with return in their annual reports for
the information of investors and prospective investors. This will enable the
investors to compare the level of return with the level of risk. The success of this sector
depends on the performance of funds industry and the role of regulatory bodies. Excellent
performance and stringent regulations will increase the popularity of mutual funds in