In the developed markets mutual funds has been given utmost importance and its performance has been measured and studied. But in case of Pakistan this is still gaining popularity as any extensive research in this area is still needed. The data regarding mutual funds is also available and therefore can help in this study.

The advantages of mutual funds were highlighted in by SIPRA (2006). These are:

The reduction in investment risk due to diversification

Professionally managed by the experts in the stock market

Small investors can hold on to a diversified portfolio by the pooling of investment funds

In the start, mutual funds sector was in the hands of the Government of Pakistan through the National Investment Trust (NIT) and National Investment Corporation of Pakistan (ICP) but due to the bureaucracy that was present in most of the government organizations it could not perform as well as it was expected and then the Funds of ICP were taken in the hands of privatized sector and due to that strong growth was viewed in this era.

Several funds were introduced while the sector started to grow and it also initiated the attraction of investors due to the diversification it created by introducing investment vehicles that were mutual funds. By June of 2008, around 61 mutual funds were listed in the stock exchanges of Pakistan. And as the number of funds continue to grow it also will give path for more research in the time to come.

The research on the mutual funds industry was initially started in the US in 1900 when the impact on capital markets was taken into consideration. The available mutual funds data was used during that time to study this and that resulted in the formulation of the famous capital asset pricing model (CAPM), security market line and other portfolio related theories.

Jensen (1968) evaluated the ability to earn returns that was the result of prediction of security prices higher than the investors expected return on the same risk. He defined alpha. He was actually investigating the emerging efficient market hypothesis and he also wanted to find out if the historical returns of a mutual fund manager specified ability to outperform the market overall. A simple way to do this was to make a comparison of the annual mutual fund returns with the market portfolio returns. But this would not take into account the risk factor. Since in 1964 the Capital assets pricing model (CAPM) was also published by Sharp and it indicated that with the increase in the systematic return (beta) the portfolio’s expected return also increases.

According to the CAPM from one year to other portfolios may underperform or over perform the market randomly. And in the long run the performance of portfolio will then fall on the capital market line or under the capital market line.

So Jensen’s findings suggested that it was not possible with the mutual funds to predict the security prices so well to outperform a simple buy and hold strategy that was employed by any investor. Thus the fund can underperform even when the management fee expenses are not included. Thus the funds were not that much successful to trade that much so that they can fulfill and overcome their expenses like the brokerage expenses. The alpha defined by Jensen measures performance in a linear regression model where alpha is positive when extra returns are earned and vice versa.

The equation is as follows:

The model tells that with a random selection buy and hold policy one should not expect on average to do no worse than alpha=0 means no extra returns. Thus when the alpha is negative it shows that the ability of funds to forecast the security prices is not well enough to cover the research expense, management fee and commission fee expenses.

In 2006 Sipra and in 1965 Treynor worked to find such a portfolio measure that also includes risk and thus introduced the security market line. The security market line defines relationship between portfolio returns and market rates of returns and in it the slope of line measures the relative volatility. This is represented by beta.

Treynor came up with a ration known as Treynor ratio. It measures the returns that are in excess of what could have been produced through an investment that has no diversifiable risk. This measure is:

(Portfolio Return – Risk-Free Rate) / Beta

Here beta is the non diversifiable risk of portfolio, which is found by taking the covariance of the portfolio with the market portfolio and is then divided by the variance of the market return; the higher this ratio, the greater the performance of the portfolio.

In 2006 Sipra used the alpha defined by Jensen to evaluate mutual funds performance in Pakistan from the period of 1995 to 2004. Sipra and Treynor used another measure that was sharp measure. Sharp measure defined as:

This study showed that when on a comparison over ten years of the sharp index values of mutual funds and market portfolio no fund had a performance better than the market portfolio. The funds that had some better performance in the last five years did not have that in the early five years or the overall ten years. Jensen had some ability to beat the market in terms of performance by the funds. Treynor also measured around the same results and so the two measures showed consistency to some extent.

Another study was carried by Shah and Hijazi in 2005 on the mutual funds performance in Pakistan and it showed that the mutual funds industry in Pakistan outperform the market on the overall basis. The beta also showed that very defensive strategy was used in investing in the mutual funds of Pakistan. Sharp ratio and the Jensens alpha showed that some funds underperform and that was because of the lower diversification. If looked on a global scope then the industry witnessed a tremendous growth and which was the result of growth in the maturity of foreign capital markets as well as size of the mutual funds. The study therefore concluded that by mobilizing the savings of the individual investors through diversification i.e. offering variety of funds to invest in will help the mutual funds industry to grow further. It will also help the investors to compare the level of risk and return.

Most of the earlier researches emphasized on the measurement of mutual funds performance by doing a comparison of the funds and some index. For example, bond index for income funds or the index of capital market for equity funds. But from the last two decades this emphasis is measures are based on any one single attribute.

Dahlquist EngstrÄom SÄoderlind (2000) studied the relation between fund performance and more than one fund attributes such as size, past performance, turnover, expenses and trading activity. Estimated performance was used to analyze this relationship. The conclusion of the research was that good performance was observed in small equity funds, funds with high trading activity, funds with low fee, and in some cases funds with good history of past performance.

In 2000 the decomposition of mutual funds was done into several measures like selectivity, long term style based returns, style timing, expense ratio, transaction costs, and net return to the shareholders. In estimating the returns of the actively managed funds the tax impact has been ignored. It was thus found that on an overall level equity funds do outperform the market. But the non stock holdings underperformed and the expenses and transaction costs also increased that resulted in the underperformance of equity stocks. The mutual funds on the basis of their net returns outperform the market as they cover their costs well. Both studies held the same conclusion that was, the actively managed funds even after they are adjusted for the costs outperform the market.

The above studies mainly focused on the attributes like transaction costs and expenses. We now go towards observing on other attributes like fund size, book to market value, number of securities and funds flow turnover into or out of the funds.

Kothari and Warner(2001) estimated the performance of mutual funds on the basis of several funds characteristics as book to market, size, number of securities and turnover. The style characteristics of funds is one of the main performance measure that has the ability to detect the abnormal funds returns when they differ from the weighted value market portfolio and these returns are economically large in magnitude.

Daniel et al(1997) based the benchmark to measure fund performance on the characteristic of stocks. These benchmarks were actually of some passive portfolios against the held stocks and they were based on the basis of prior to market, market capitalization, and prior year return characteristics. Funds showed stock selection ability to some extent.

Carhart in 1997 took hold of the common factors in stock returns and mutual fund investment cost differences to explain the short term equity persistence. Irrespective of momentum it goes on to explain the basis of prediction in the mutual funds returns. Two models were used here to measure the performance. They are; Sharpe and Lintner Capital Asset Pricing Model and Carhart four factor model. For comparative analysis Fama and French three factors model was used. According to this study it was argued that, although the investment cost is earned back the top performing mutual funds but still most of the funds underperform by the magnitude of the investment expenses. The suggestion was that the funds with persistent poor performance should be avoided by the investor, the funds who have high returns the last year have higher expected returns more than average the coming year but not in afterwards so the transaction cost, expense ratios of investment cost, and load fees have a direct but negative effect on performance.

SIZE OF FUNDS:

In order to evaluate the mutual funds performance, the size of funds comes as an important and dominant factor. It also helps to explain the currency value of the investment in the mutual funds. Overall returns of a fund are directly related with the size of the fund. With the increase in the fund size, the fund manager can take the benefit of investing in diversified places like money market and capital market instruments. A mix relationship exists between size of funds and equity and bond market funds performance. This is due to the fact that the bond funds are relatively small in size as compared to equity funds that are relatively large.

Big funds can encounter certain problems like:

Agility: Whenever a large security is bought it drives up its price which can harm the returns on that fund. While whenever a large security is sold it drives down its prices. Thus large funds have to take the positions slowly or unwind to avoid causing the stock to move too much. Because if they are caught with a big holding then they cannot get out of it quickly.

Some researches c