The World of Mutual Funds

The World of Mutual Funds Ajay Khorana, Henri Servaes and Peter Tufano Ajay Khorana The Darden School - University of Virginia Henri Servaes London Business School and CEPR Peter Tufano Harvard Business School and NBER Draft: April 25, 2003 Copyright ©2003 Ajay Khorana, Henri Servaes and Peter Tufano Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without the permission of the copyright holder. Copies of working papers are available from the authors. The World of Mutual Funds* This paper studies the mutual fund industry in 55 countries around the world and tests various hypotheses for why the fund industry would be preferred by investors over two alternative asset management choices: “do-it-yourself” options where the investors purchases primary assets and “opaque financial institution” options, such as banking or insurance investments. Consistent with the law and economics literature, we find that the mutual fund industry is larger in countries with stronger rules, laws, and regulations, specifically where mutual fund investors’ rights are better protected. The industry is smaller in countries where barriers to entry are higher, measured by the time and cost required to set up a new fund. The mutual fund sector is smaller when banks face restrictions when entering the securities business. The fund industry is larger in countries with a wealthier and more educated population. Finally, the fund industry is larger in countries in which defined contribution pension plans are more prevalent. These results indicate that laws and regulation, supply-side, and demand-side factors all affect the size of the mutual fund industry. Ajay Khorana The Darden School University of Virginia P.O. Box 6550 Charlottesville, VA 22906 KhoranaA@ darden.virginia.edu Henri Servaes London Business School and CEPR Regent’s Park London NW1 4SA hservaes@london.edu Peter Tufano Harvard Business School and NBER Soldiers Field Boston, MA 02163 ptufano@hbs.edu * We would like to thank Viral Acharya, Sally Buxton (Cadogan Financial), Kurt Cerulli (Cerulli Associates), Elizabeth Corley (Merrill Lynch Investment Managers), Neil Fatherly (KPMG), Julian Franks, Francisco Gomes, Diana Mackay (FERI Fund Market Information), Wolfgang Mansfeld (Union Asset Management and FEFSI), Ben Philips, Mark St. Giles (Cadogan Financial), Wanda Wallace, Rodney Williams (FERI Fund Market Information) and seminar participants at City University (London), College of William and Mary, HBS European Research Colloquium, London Business School, and Washington University for their useful comments and suggestions and Katie Boggs and Stefano Rossi for valuable research assistance. Financial support for this project was provided by the Division of Research of the Harvard Business School. Any opinions expressed are those of the authors and not those of any of the organizations which supported or provided information to this study. Over the past few decades, there has been explosion of the mutual fund industry -- and an attendant expansion of academic research on this topic. However, while the fund industry has grown all around the world, academic studies of mutual funds have remained geographically narrow. While at the end of 2001, funds originating in the U.S. accounted for only 15 percent of the number of funds available globally and 60 percent of the world’s fund assets,1 in the last ten years, almost every article published in the top finance journals relates to the U.S. fund industry. While there have been isolated and excellent studies of the fund industry in various countries,2 most readers of U.S. journals would probably be surprised that the nation domiciling the second largest fund industry (measured by fund assets) outside the United States is Luxembourg with 6.5 percent of world mutual fund assets or that France and Korea offer the second largest number of mutual funds available worldwide (13 percent of the world total for each country). In this paper, we study the fund industry around the world. We seek to understand why this form of intermediated asset management has thrived more in some countries than in others. In functional terms, a nation’s savers can choose to directly invest in primary securities (do-it-yourself), may invest their money in transparent narrow financial intermediaries (funds), or may prefer more opaque and typically broader financial intermediaries (banks or insurance firms).3 Under what circumstances have relatively transparent financial intermediaries been preferred by a nation’s savers? One set of hypotheses, drawn from the ample literature on law and economics, focuses on laws and regulations to explain differences in this direction of financial development. Funds prosper when laws and regulations make this sort of investment attractive relative to others. “Supply-side” hypotheses focus on competitive dynamics both within the mutual fund industry and from elsewhere in the financial services sector to explain these differences. For example, a concentrated banking sector could plausibly encourage or discourage the formation of a strong fund industry. “Demand-side” hypotheses focus on characteristics of the potential 1 These data come from the Investment Company Institute’s 2001 Mutual Fund Fact Book, pages 100 and 101. 2 See, for example, Bams and Otten (2002), Blake and Timmermann (1998), Brown, Goetzmann, et al. (2001), Cai, Chan, and Yamada (1997), Dahlquist, Engstrom, and Soderlind (2000), and Dermine and Roller (1992). 3 A mutual fund is an example of a transparent investment vehicle in that its underlying assets are clearly identifiable and the value of the fund is marked-to-market on a daily basis and reflected in the Net Asset Value of the fund. Investing in a relatively opaque financial intermediary entails an investor’s claim that is not contractually linked to the underlying asset (e.g., bank deposits and insurance products). 1 buyers of mutual funds in terms of, for example, their degree of wealth and education, to explain these differences. Finally, the characteristics of the country’s securities trading environment may affect investor choice. These are not mutually exclusive hypotheses -- rather all are likely to play some role in explaining worldwide patterns in the fund industry. Our goal is to study a broad sample of countries. We gather reliable data for 55 nations and measure the size of each country’s mutual fund industry relative to the country’s assets in “primary” domestic securities (which includes equities, bonds, and bank loans) that are available to prospective investors. For completeness, we also report the size of national fund industry assets relative to the country’s GDP and population. We study the industry as a whole, and equity and bond funds separately, because certain hypotheses apply only to one of the two subsectors. For the countries in our sample, the mutual fund industry comprises 16.8% of the primary financial assets, on average, with a median of 4.3%. As we discuss in more detail subsequently, two countries are substantial outliers -- the fund industries in Luxembourg and Ireland account for 484% and 82% of their country’s primary assets. We treat these two extreme observations with some care in our work. The naïve inclusion of these countries in multivariate analyses can produce misleading results, but given that these are two interesting data points in our analysis, it would be inappropriate to just treat them as outliers. Hence, we analyze the drivers of the fund industry for the remainder of our countries and separately discuss the unique factors driving the growth of Luxembourg and Ireland. We focus on four national characteristics to explain the size of the mutual fund industry across countries: law and regulation; demand characteristics; supply side factors; and the nature of the securities markets. Countries with a stronger judicial system, more stringent regulatory approval and disclosure requirements for funds tend to have a larger fund industry. This suggests that stronger regulation may be beneficial to the fund industry. Furthermore, for equity funds, the enforcement of insider trading rules has an adverse effect on the size of the mutual fund industry, consistent with the view that failure to enforce these rules discourages investors from purchasing equities directly. 2 When considering supply side factors, we study characteristics of the financial sector that would influence the speed of adoption of mutual funds. We examine the effect of bank concentration, restrictions placed on banks to enter the securities business, the number of distribution channels available for funds, the presence of an explicit deposit insurance system for banks, and the time and cost to set up a new fund. We find that nations that restrict banks from entering the securities business have smaller equity and bond fund sectors. In addition, countries with a more concentrated banking industry have smaller bond fund sectors. There is some evidence that barriers to entry are associated with small fund industries; in particular, the costs and time required to set up a new fund are negatively related to industry size. When considering demand side factors, we find that wealthier countries, measured by GDP per capita, and countries with a more educated population have a larger mutual fund sector. These effects are particularly pronounced for the equity sector, which may require a higher level of investor sophistication. Internet penetration is also positively related to the size of the mutual fund sector, but it is highly correlated with the other demand size variables. In addition, the mutual fund sector is larger in countries where a larger fraction of pension plans are defined contribution plans. We interviewed experts to explain the growth of Luxembourg and Ireland. Tiny Luxembourg grew to be a European mutual fund hub, fueled by favorable bank secrecy and tax laws as well as its central location. The growth of Ireland (Dublin in particular) on the other hand, was driven by a tax advantage given to management companies and a highly educated labor force. In particular, until recently, fund management companies paid a tax of only 10% on their income (relative to a 32% corporate income tax in Ireland) and they were allowed extra deductions for rental payments. The remainder of this paper is organized in four sections. The first section defines what we mean by a “mutual fund” in light of varying institutional arrangements used around the world. The second section describes the sources of our data on the world fund industry and provides a brief sketch of the industry. This descriptive part of the paper provides stylized facts about the industry. The third section discusses factors that might explain the differential penetration of the fund industry in different countries. The 3 ... - tailieumienphi.vn