How we can harness the investment industry to improve our economy
The primary challenge and the opportunity in the capital markets today is mainly driven by inadequate supply of good companies and investment alternatives.
The Closed End Mutual Funds (CEMF) can play a very important, decisive, and sustainable role in providing much needed capital to the entire market as well as institutionalizing the investment industry. Multiple purposes can be served, including providing capital to the government (treasury) for key infrastructure projects, high potential listed and unlisted companies and simultaneously facilitating exits via listing and increasing supply of quality scrips to the markets for the retail investors.
The key reason that the well managed CEMFs can take the lead is because, (1) they have a track record that is auditable and all investors (local and overseas) will have adequate reported history to evaluate each manager independently - a key criteria for any investor (local or foreign). (2) CEMFs are ahead in terms of both establishing experienced teams and investment processes to take on such a critical role for the development of the investment industry.
Whether we like or not, global investment industry is highly transparent and if we are serious about developing the industry, priority must be given to experienced professionals with a track record (meritocracy), and (3) finally, although small in size, the CEMF has the required base of relatively longer term capital and can make the right long term investments without stressing over providing liquidity to fund investors -- in contrast to challenges undertaken by Open End Funds today.
In order to decisively resolve the issue mentioned above and serve a multi-purpose objective, the following structural and procedural changes are required immediately:
We have a serious shortage of qualified investment professionals in the industry. Independent Asset Managers should be provided incentives to develop professional teams and processes, in order to develop skilled management teams with adequate bench strength. We must also encourage NRBs as well as experienced overseas professionals to the investment industry (similar to the RMG industry with many overseas professionals in the middle management & leadership roles).
Without qualified teams (not individuals), the investment industry will most certainly fail. Investment is all about qualified human capital and everything else is secondary and a consequence of leadership and experience.
The regulators and policy-makers can play a much more accommodative and progressive role in developing the Mutual Fund industry similar to India. Approval processes for new funds can be simplified and shortened. In addition, key rules and regulations can be further simplified and be more transparent and minimize any interpretation risks for all stakeholders. Unless it is a money market fund that has high level of underlying liquid securities/instruments, all open-end funds should be converted to closed end form and/or perpetual under section 20a of securities law in Bangladesh to reduce a potential for a spiralling liquidity crisis in an illiquid market.
The reality is that we cannot have a managed fund providing frequent liquidity to investors when we do not have underlying securities that are liquid and easily tradeable without moving the market materially. Those of us who have been around the global markets understand -- short term funding with Long term or illiquid instrument is a formula for a liquidity crisis and serious consequences for any market. Open End Funds are most certainly possible and required but not in the current market scenario with limited scrips, and no real depth of institutional investors outside of ICB. In order to create the right environment for Open End Funds much work is required by all stakeholders including regulators for developing a commercial paper market, tradable Treasury Bills market and other highly liquid investable assets including transferable Savings Certificates.
In a down market or relatively illiquid market in Bangladesh, when unit-holders reallocate redeem investments, the Open-End Fund Managers are forced to sell in most cases the best quality and most liquid relative assets they hold. This imply that the remaining Unit holders will have a much higher exposure to less liquid names, and some investors in Open End Funds can be left holding the worst possible illiquid investment. Therefore, all Open End Unit Holders must be fully aware of incremental risks that exists in Open End Funds (relative to CEMFs) for providing liquidity based upon less liquid underlying investments and potential adverse consequences triggered by other investors in the same fund who can exit under more favourable terms -- especially in bear markets.
We must also modify investment restrictions for all mutual funds to provide more latitude to manage risk in turbulent markets. Security Selection is the ultimate goal of any fund Manager. The 60% requirement to remain invested in stocks causes serious performance issues in the down markets because managers are forced to buy instruments that are not desirable.
In order to reduce the unjustified discount factor for CEMFs, Funds should have the option to buy back its own shares (up to 25%) at Market Price to reduce unjustified discount rate. This is also practiced overseas to ensure that CEMFs trades close to NAV. If you own a portfolio of blue-chip stocks, the fund NAVs are accurate, and portfolio names are disclosed, I see no reason for CEMFs to trade more than 5-10% discount or premium accounting for all other investment risks and opportunities.
Unfortunately, this is not the case at present due to lack of clarity in regulations, confusion among investors, lack of professional institutional investor base, and overall adverse market sentiment issues. I believe by providing this option alone regulators can materially reduce the discount factor overnight.
At present market environment given the need for liquidity to avoid any challenges all Open End & Closed End Mutual Funds (CEMF) should be converted to perpetual and tradable funds and well performing Asset Managers should be able to issue incremental capital from new investors via a transparent price discovery process (Repeat Public Offering) via fast track approach similar to any listed companies. This is how most Closed End Perpetual Mutual Funds operate in Developed markets.
The fund industry represent a very small fraction of the entire market (less than 1% of GDP) and without immediate actions the industry will not grow, investment professionals will leave the industry, and the industry will fail to play the desired role of being the catalyst for growth which is much needed for today and for the future of the entire economy.
Many of the issues are well known and if we truly care for the future of the industry and the economy, the time is NOW to act by all stakeholders who can make a difference.
Reaz Islam is CEO of LR Global.