metadata: authors: 0: author: Fernando,Deepthi N.
1: author: Klapper,Leora
2: author: Sulla,Victor
3: author: Vittas,Dimitri
count: World
docna: 0: docna: The global growth of mutual funds
docty: Policy Research Working Paper
subtopic: Pensions & Retirement Systems,Social Funds and Pensions,Capital Markets and Capital Flows,Securities Markets Policy & Regulation,Non Bank Financial Institutions,Capital Flows,Mutual Funds
teratopic: Infrastructure Economics and Finance
abstracts: cdata!: With few exceptions, mainly in Asia,
            mutual funds grew explosively in most countries around the
            world during the 1990s. Equity funds predominated in
            Anglo-American countries while bond funds predominated in
            most of Continental Europe, and in middle-income countries.
            Capital market development (reflecting investor confidence
            in market integrity, liquidity, and efficiency) and
            financial system orientation were the main determinants of
            mutual fund growth. Restrictions on competing products acted
            as a catalyst for the development of money market and
            (short-term) bond funds.
repnme: repnme: The global growth of mutual funds
display_title: The global growth of mutual funds
listing_relative_url: /research/2003/05/2390969/global-growth-mutual-funds
topicv3: Pension Funds m1326066 611,Mutual Funds m1326970 2180,Securities Markets m1327223 1918,Equity Finance m1327686 334,Retirement m1504007 2896
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Infrastructure Economics and Finance
origu: Development Research Group (DECRG)
no_of_pages: 52
author_keys: 0: author_key: 166693
1: author_key: 390572
2: author_key: 563332
3: author_key: 92949
model_extractions: | POLICY RESEARCH WORKING PAPER _3055_

# Abstract

With few exceptions, mainly in Asia, mutual funds grew explosively in most countries around the world during the 1990s. Equity funds predominated in AngloAmerican countries while bond funds predominated in most of Continental Europe and in middle-income countries. Capital market development (reflecting investor confidence in market integrity, liquidity, and efficiency) and financial system orientation were the main determinants of mutual fund growth. Restrictions on competing products acted as a catalyst for the development of money market and (short-term) bond funds.

> This paper-a product of Finance, Development Research Group-is part of a larger effort in the group to study mutual

> funds development. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Agnes Yaptenco, room MC3-446, telephone 202-473-1823, fax 202-522-1155, email address ayaptenco@worldbank.org. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at dfernando@worldbank.org, lklapper@worldbank.org, vsulla@worldbank.org, or dvittas@worldbank.org. May 2003. (44 pages)

> _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._

Produced by Partnerships, Capacity Building, and Outreach
# The Global Growth of Mutual Funds

Deepthi Fernando, Leora Klapper, Victor Sulla and Dimitri Vittas The authors are from the World Bank. The authors<sup>thank ReenaAggarwaland AjayShah for helpful</sup> comments.
# **I. Introduction**

**Explosive growth.** One of the most interesting financial phenomena of the 1990s was the explosive growth of mutual funds. This was particularly true in the United<sup>States</sup> where total net assets of mutual funds grew from USD 1.6 trillion in 1992 to 5.5 trillion in 1998, equivalent to an average annual rate of growth of 22.4 percent. But, with<sup>the</sup> exception of some East Asian countries (including Japan), it was also<sup>trueof mostother</sup> countries around the world.

The 15 countries that are members of the European Union witnessed an increase in their total mutual fund assets from USD I trillion in 1992 to 2.6 trillion<sup>in1998</sup> (average annual growth rate of 17.7 percent). Among EU member countries,<sup>Greece</sup> recorded the highest growth rate at 78 percent, followed by Italy at 48 percent<sup>and</sup> Belgium, Denmark, Finland and Ireland, all with growth rates of around<sup>35percent.</sup> Some developing countries, such as for example Morocco, registered even<sup>highergrowth</sup> rates, but from much smaller starting points.

In the United States, not only did mutual fund assets grow explosively over this period, but household ownership of mutual funds also experienced rapid<sup>growth.Survey</sup> estimates reported by the Investment Company Institute (the trade association of<sup>US</sup> mutual funds) show that the proportion of US households owning mutual funds<sup>grew</sup> from 6 percent in 1980 to 27 percent in 1992 and 44 percent in 1998 (ICI 2002).' The global growth of mutual funds was fuelled by the increasing globalization of finance and expanding presence of large multinational financial groups in a large<sup>number</sup> of countries and by the strong performance of equity and bond markets<sup>throughoutmost</sup> of the 1990s. A third factor was probably the demographic aging that characterizes the populations of most high and middle-income countries and the search of financial instruments that are safe and liquid but also promise high long-term returns by growing numbers of investors.

**Mutual fund attributes.** Mutual funds offer investors the advantages of portfolio diversification and professional management at low cost. These advantages are

> ' The proportion of US households owning mutual funds continued to increase after 1998 and reached 52 percent in 2001, before falling back slightly to 49.6 percent in 2002 (ICI<sup>2002).</sup>

2
particularly important in the case of equity funds where both diversification and professional management have the potential to add value. For bond and money market mutual funds, the main advantage is transactional efficiency through professional management. In fact, as argued below, tax incentives and regulatory factors have played a big part in stimulating the development of bond and money market funds.

One of the distinguishing features of mutual funds is a high level of operational transparency relative to other financial institutions, such as. banks, thrifts, insurance companies and pension funds, that also cater to the needs of households. Unlike banks and insurance companies, mutual funds do not assume credit and insurance risks<sup>2</sup> and thus do not need to make subjective provisions against non-performing loans or to create actuarial reserves against future insurance claims. Mutual funds invest in marketable instruments and are able to follow a "mark-to-market" valuation for their assets. But the investment risk is borne by investors who, especially in the case of equity funds, participate in the upside potential of corporate equities but are also exposed to substantial losses when markets are falling.3 For their successful operation and development, mutual funds require a robust and effective regulatory framework.<sup>4</sup> As in all cases of agency contracts, investors need to be protected from fraudulent behavior on the part of mutual fund managers and the diversion of funds into projects or assets that benefit fund managers (agents) at the expense of fund investors (principals). Fund investors bear the investment risk, but they rely on the advertised investment strategies of mutual fund managers for making their selections. It is therefore essential that fund managers should abide by their advertised strategies and should not deviate from their declared objectives without proper prior authorization.

> 2 The operational transparency of mutual funds is reduced if they promise guaranteed rates of return, a practice that has been followed in some countries, most notably India, but is frowned upon by experienced practitioners and regulators. It is also reduced if they invest in unlisted or illiquid instruments when markto-market valuations are replaced by subjective or, at most, mark-to-model valuations. Operational transparency is a relative concept and is clearly more relevant for mutual funds that invest predominantly in liquid listed instruments.

> 3 The high volatility of market retums has stimulated the development of funds offering protected investments whereby the nominal or real value of the principal invested (and sometimes a small additional return) is protected but investors give up some of the upside potential of investment retums. These funds invest in both cash and derivative markets and raise important regulatory concerns that have yet to be properly addressed.

3
Accounting and auditing. rules as well as<sup>information disclosureandtransparency</sup> requirements are of paramount importance.

Mutual funds also require well-developed securities<sup>marketswith a highlevel of</sup> market integrity and liquidity. Market integrity<sup>impliesthatinsidersarebarredfrom</sup> taking advantage of privileged information,<sup>whilelargeshareholdersandmarket</sup> intermediaries are prevented from engaging<sup>in market manipulation. Market integrity also</sup> requires that officers of listed corporations<sup>observehigh standardsofcorporate</sup> governance and honesty and do not engage<sup>in extensivefraud and theft. Marketliquidity</sup> ensures that transaction costs are low and investors<sup>do not suffer from large adverseprice</sup> movements when they initiate transactions in individual<sup>securities.</sup> The recent corporate, accounting and securities<sup>marketscandals intheUS have</sup> undermined confidence in the integrity of<sup>USmarketsand mayhavecontributedtothe</sup> increased volatility of markets. Their implications<sup>forthe futureevolutionof mutual</sup> funds are difficult to assess at this juncture,<sup>although effortstostrengthencorporate</sup> governance, ensure auditor independence,<sup>andenhancethecredibilityofpublished</sup> corporate information would help in averting<sup>anyfurther erosion of investorconfidence</sup> in market integrity.

**Statistical problems.** This paper uses aggregate<sup>datafroma crosssectionof 40</sup> developed, developing and transition countries<sup>tostudythestructureand growthpattern</sup> of mutual funds in different countries and<sup>analyzethedeterminantsof mutualfund</sup> growth. The data cover the period 1992-98 and<sup>werecollectedfrom a varietyof sources.</sup> Some were primary, such as mutual fund<sup>industry associationsandcapital market</sup> regulatory authorities. Others were secondary,<sup>such astheEuropean Federationof</sup> Investment Funds and Companies (FEFSI),<sup>the InvestmentCompany Institute(ICI) of the</sup> United States, the Organization of Economic<sup>Co-operationandDevelopment(OECD),</sup> and Goldman Sachs Investment Research.

The collected data suffer from a number of<sup>importantdeficiencies.Mutualfunds</sup> have been created to serve the financial needs<sup>ofhouseholds.Indeed,undertheright</sup>

> 4 Beneficial regulation has been attributed<sup>asa keyfactor behind thestrong growth of the US mutualfund</sup> industry (Reid 2000).

4
circumstances, they have the potential to become the most important financial institutions for households, surpassing banks and insurance companies. But in several countries, mutual funds are also heavily used by corporations and institutional investors. This is often the case with money market mutual funds and short-term bond funds, which meet the liquidity needs of small corporations, while equity funds tend to be used by pension funds operated by small companies.

Brazil is a country where the non-household sector accounts for a large share of mutual fund shares. This is partly attributed to the tax on financial transactions that pension funds avoid by investing in mutual funds that are exempt from it. Other.countries with a large presence of non-households in mutual fund ownership include France and the United States. Presence of non-households among mutual fund investors complicates the analysis of the determinants of mutual fund growth since non-household investors are likely to be influenced by different factors in their investment decisions than household investors.

The use of mutual funds by nonresident investors creates another complication. Luxembourg is an extreme example of this phenomenon, but Hong Kong, Ireland, Singapore and Switzerland also have a strong nonresident presence. The holdings of nonresident investors are also probably large in absolute terms in the United States, although their relative share is unlikely to be important. In the case of Hong Kong and Singapore, reported statistics cover the whole of the asset management industry, including assets of foreign investors that are entrusted to local managers but are not invested in collective investment schemes. It is difficult to disentangle such investments from holdings of mutual fund shares.

A third complication arises from the institutional coverage of published statistics. Indeed, the annual mutual fund report of ICI publishes a table with aggregate data on mutual funds around the world but also includes a strong warning that because of differences in definitions and coverage, the, published data lack comparability. Differences relate, _inter alia,_ to the inclusion, or not, of closed end funds, unit-linked funds operated by life insurance companies, and retirement funds that operate on mutual fund principles (such as the AFP system of Chile or the defined-contribution pension 5
plans that have proliferated in Australia, New<sup>Zealand,SouthAfricaandtheUnited</sup> States).<sup>5</sup>

**Determinants of Mutual Fund Growth.** The growth<sup>ofmutualfundsinthe</sup> United States and other high-income countries<sup>has stimulateda large andeverincreasing</sup> literature on the factors that explain the<sup>performanceof mutualfunds.Mostof these</sup> studies follow the structure-conduct-performance<sup>paradigmandareusuallyfocusedon</sup> the performance of mutual funds in one country.<sup>Thereisalsogrowinginterestinthe</sup> impact of international fund investment on emerging<sup>markets(Kaminskyetal2000).</sup> Very few studies have examined the development<sup>andperformanceof mutualfundsin</sup> several countries. An interesting exception<sup>is thestudyby OttenandSchweitzer(1998)</sup> that compared the US and European mutual<sup>fundindustries. OttenandSchweitzer found</sup> that the European mutual fund industry<sup>is lagging theAmerican industrywithregardto</sup> total assets, average fund size and capital market<sup>importance.European investorshavea</sup> preference for fixed income mutual funds,<sup>whilemutual fundmarketsinindividual</sup> European countries are dominated by a few large<sup>domesticgroups,mostlybank-centered,</sup> possibly implying a lower level of competition.<sup>Otherpapers, such as Walter(1999) and</sup> Davis (2001), have looked at the European asset<sup>andpensionmanagementindustries</sup> respectively rather than mutual funds _per se._

Seen as financial institutions that serve the<sup>needsof households,the growthof</sup> mutual funds is likely to be determined by a<sup>numberof factors.Firstandforemostis the</sup> level of income and wealth of the residents<sup>of acountry.Conceptually,investingin</sup> mutual funds, like purchasing life insurance<sup>and savingfor retirement, shouldbe seenas</sup> a luxury good with a positive income elasticity of<sup>demand.Inpractice,however, the</sup> relationship between per capita income (used as<sup>an indicatorof economic development</sup> and wealth) and holdings of mutual fund assets<sup>(expressedasapercentageof national</sup> income) is not always positive.

The availability or not of substitutes as well as complements<sup>alsogreatly affects</sup> the growth of mutual fund assets. Houses are distant<sup>substitutesof mutual fundshares in</sup>

> 5 Reported Australian statistics on mutual funds registered<sup>a verylarge jumpin 1999,the most likely</sup> explanation of which is the inclusion of the mandatory<sup>pension plans that operate on mutual fulnd</sup> principles.

6
household wealth but most other instruments are either close substitutes or close complements, in some cases both at the same time. Bank deposits, both the traditional form of checking accounts and savings deposits and the more modem money market deposit accounts, are close substitutes of money market mutual funds. The interest rate spread between bank deposits and money market funds would be expected to play an important part in determining the demand for money market mutual funds.

The role of bonds, equities and contractual savings (savings with life insurance and pension funds) is more complex. At the level of individual investors, marketable securities are substitutes of mutual fund shares. Demand for mutual funds would depend on their cost efficiency in offering portfolio diversification and professional management. But at the aggregate level, mutual fund shares and marketable securities look more like complements. As already noted, Mutual funds need well-developed markets for bonds and equities for their successful operation. Given the importance of complementarity between mutual funds and securities markets, indicators of investor confidence in market integrity, liquidity and efficiency tend to acquire major significance and to outweigh the impact of income and wealth.

Contractual savings and mutual funds would also be expected to be substitutes, at least at the margin. However, the growing tendency of insurance companies and pension funds to offer products that are either directly linked to mutual funds or have many similar features has created an increasing complementarity between the two types of instruments.

The regulation of the investments of pension funds and insurance companies could also affect the growth of mutual funds. The impact of contractual savings institutions on mutual fund growth would be smaller in countries where they are compelled to invest in government bonds. In contrast, freedom to invest in mutual funds or "funds of funds" would stimulate the development of the mutual fund industry.

The demand for mutual funds would be expected to respond to differences in the level and volatility of real returns on mutual funds and alternative instruments. The challenge here lies in constructing good indicators of rates of return and their volatility and allowing for differences in the time horizons and responses of mutual fund investors.

7
Return differentials are also affected by tax policies and financial<sup>regulation.In</sup> several countries, investing in mutual funds enjoys a significant<sup>tax incentivein theform</sup> of a rate of withholding tax that is lower than the marginal<sup>tax rate of wealthyinvestors.</sup> This often explains the strong demand for bond mutual funds<sup>incountrieswhere</sup> securities markets are not well developed.

In addition, demand for mutual funds may be distorted<sup>by indirecttaxes (VATor</sup> transaction taxes) that are imposed on other financial instruments<sup>oron transactionsby</sup> other financial institutions but from which mutual<sup>fundsareexempt.InBrazil,the</sup> exemption of mutual funds from the tax on financial transactions<sup>has been a majorfactor</sup> behind the creation of exclusive mutual funds for company<sup>pension funds which,in turn,</sup> has contributed to the rapid development of the Brazilian<sup>mutual fund industry.</sup> In several countries, including in particular the United<sup>StatesandFrance,the</sup> growth of money market mutual funds has been stimulated<sup>by theimpositionof tight</sup> restrictions on the interest rate that banks could pay<sup>on retaildeposits:SuchRegulation</sup> Q-type restrictions tend to have a ratchet effect on<sup>thegrowthof mutualfunds.Their</sup> removal does not result in a reversal of the process, because<sup>oncemoneymarket mutual</sup> funds have taken hold, investors are unlikely to revert<sup>to their banks,unless thelatter can</sup> offer some attractive service or benefit that mutual<sup>funds cannot match.</sup> A factor of major importance that would be of universal<sup>relevanceandwould</sup> explain the growth of mutual funds in many countries<sup>istheadventofelectronic</sup> technology and the concomitant large reduction in the<sup>costof operatinga large numberof</sup> accounts and an even larger volume of transactions.<sup>Thishasmademutualfunds,</sup> especially money market funds, more competitive vis-A-vis<sup>banks.</sup> A final factor that may affect the growth of mutual funds<sup>in a particularcountry is</sup> the "proximity" of a better developed or tax advantaged<sup>overseascenter offeringmutual</sup> fund investments to foreign investors. The countries<sup>with largeoffshorebusiness,such as</sup> Luxembourg, Ireland and Switzerland in Europe or Hong<sup>Kong andSingaporein Asia,</sup> have a negative effect on the growth of mutual funds<sup>intheirneighboringcountries.</sup> However, it is difficult to estimate the impact of such<sup>proximitysincethisdependsnot</sup> only on geographical distance but also on cultural and<sup>otherfactors.Forinstance,the</sup> 8
large presence of German banks in Luxembourg is likely to have a bigger restraining impact on the growth of mutual funds in Germany compared to other neighboring European countries. When combined with an unfriendly regulatory regime (as was the case in Germany before the 1990s), the negative impact can be very large as well as difficult to reverse after domestic regulations are relaxed.

**Main Findings:** Bearing in mind the deficiencies of the collected data and the difficulties of correctly modeling the various influences set out above, the main findings of this paper are as follows:

- Mutual fund assets grew from 8 to 16 percent of GDP between 1992 and 1998 for the countries covered in the paper.

- In high-income countries, mutual fund assets expanded from 10 to 24 percent of GDP over this period, but in middle-income countries they first grew from 4 to 8 percent but then fell back to 4 percent of GDP after the East Asian crisis. This reversal was mostly caused by the experience of Asian countries.

- A total of 16 countries had mutual fund sectors with net assets exceeding 20 percent of GDP in 1998. 11 of these countries were from Continental Europe.

- In 12 countries equity funds represented more than 40 percent of total mutual fund assets. However, in only 5 countries (Hong Kong, South Africa, Sweden, Switzerland and the United Kingdom) did they exceed 60 percent of the total.

- In 10 countries bond funds accounted for more than 40 percent of total assets. In 4 of these, they represented more than 60 percent of the total (Brazil, Hungary, Thailand and Tunisia).

- In 4 countries (Argentina, Chile, France and Greece) the largest share of the sector was held by money market funds. With the exception of France, the share of money market funds exceeded 60 percent of the total.

- In 4 countries (Czech Republic, India, New Zealand, and Poland) balanced funds were the predominant type.

- Mutual funds are more advanced in countries with better developed capital markets (reflecting investor confidence in market integrity, liquidity and efficiency and a greater supply of investable securities) and market-based financial systems.

9
- Higher market returns and liquidity and lower<sup>volatilityhave alsocontributedto</sup> mutual fund growth.

- Openness to trade and a high share of high-tech exports<sup>aresignificant factorsin high</sup> income countries, while per capita income and strong<sup>banking systems arerelated to</sup> mutual fund development in middle-income countries.

- Per capita income has been strongly significant<sup>withthecorrect signin middle-</sup> income countries, but weakly significant with<sup>anegative signinhigh-income</sup> countries.

- Legal origin is significantly correlated<sup>withmutualfunddevelopment.Equityfunds</sup> are more advanced in common law countries,<sup>while bondfundsare more developed</sup> in countries with civil law systems.

- Restrictions on competing products, namely<sup>limits on interest rateson sight and retail</sup> time deposits of banks, have been a significant<sup>determinantof thegrowthof money</sup> market and (short-term) bond mutual funds. Such<sup>restrictionshaveprobablyplayed</sup> the role of catalyst in many countries and<sup>havehad a ratcheteffect.Their removalhas</sup> not reversed mutual fund progress.

This paper is divided in two main parts. Following<sup>thisintroductionand summary</sup> of findings, the next section reviews the structure<sup>andgrowth patternsof mutualfundsin</sup> different countries. This is followed by a section<sup>thatsummarizesthe quantitativeresults</sup> of the study. A concluding section notes a<sup>numberof questionswith importantpolicy</sup> implications at the macro level.

The period 1992-98 covers several years of fast<sup>growth inequitymarketsand</sup> mutual funds. It also covers the East Asian crisis<sup>that has hadan adverseeffecton mutual</sup> fund growth in Asian countries. But it does not<sup>include1999whenequitymarketsand</sup> mutual funds continued their rapid expansion<sup>inmostdevelopedcountries.Equity</sup> markets and mutual fund growth reversed gear after<sup>1999,raisingsomeinterestingand</sup> unanswered questions regarding the long-term<sup>persistenceand significanceofrecent</sup> trends.

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# **H. Structure and Growth Patterns**

**Historical Overview.** The first mutual funds in the form of closed-end investment trusts appeared during the last quarter of the nineteenth century. The first open-end mutual fund was created in Boston in 1924. Mutual funds of both the closed and openend varieties experienced hectic growth in the 1920s, but they suffered a major setback from mismanagement and fraud as well as from the stock market crash of 1929. Between 1930 and 1970 mutual funds grew relatively little, although there was an upsurge<sup>of</sup> interest in equity funds during the stock market boom of the early and mid 1960s. However, this was reversed in the 1970s following the first oil crisis and the<sup>poor</sup> performance of equity markets. The collapse of International Overseas Services,<sup>a</sup> fraudulent fund management group, in the late 1960s contributed to the loss of investor confidence in mutual funds.

A major product innovation occurred in the 1970s with the launching of money market mutual funds. These specialized in investing in money market instruments<sup>and</sup> competed with banks by offering market-related returns and lower spreads<sup>than</sup> traditional bank deposits, while ensuring liquidity and ease of access. Money market mutual funds were launched in the United States in the 1970s in response to<sup>the</sup> regulatory restrictions that prohibited US banks from paying market rates of interest on their retail deposits at a time when high inflation was pushing market rates to very high levels compared to the ceilings imposed on banks. They also achieved high levels of development in other countries with rigid restrictions on bank deposit rates,<sup>suchas</sup> France, Greece and Japan. But even in the absence of regulatory distortions, money market mutual funds, once invented, tend to grow to meet the demand from sophisticated investors who need a convenient place for parking their liquid investment balances.

Growth of equity and bond funds resumed in the early 1980s as macroeconomic performance and equity markets started to improve. But growth did not become explosive until the early 1990s. It is still unclear why investors started to change<sup>theirfinancial</sup> asset allocations so drastically after 1990. In the United States, the widening of bank spreads as commercial banks attempted to rebuild their capital following their<sup>disastrous</sup> results of the late 1980s may have provided an early stimulus to equity funds.<sup>As the gap</sup> 11
between returns on bank deposits and<sup>returnsonequityfunds widenedconsiderably,</sup> investors showed an increasing preference<sup>for equity funds.</sup> In the United States, the increased demand<sup>formutualfundsreflecteda broader</sup> pickup in demand for financial assets,<sup>buoyed byrisingequityprices,lowandstable</sup> interest rates, and subdued inflation (Reid<sup>2000).Theexpansionof retirementsavings</sup> plans, both the employer-sponsored<sup>401(k)plansandindividual retirementaccounts</sup> (IRAs), provided additional stimulus.<sup>Assetsofretirementsavingsplansinvested in</sup> mutual funds rose from one-fifth of all<sup>fundassetsintheearly1990sto morethanone-</sup> third, by the end of the decade. The response<sup>oftheindustry,bothbyexpanding the</sup> number and variety of mutual funds<sup>andbyloweringthecostof acquiringandholding</sup> mutual funds, was another contributing<sup>factor.</sup> In Europe and other regions, the growth of<sup>equity funds lagged somewhat behind,</sup> both because equity markets were<sup>less wellestablished outside Anglo-American</sup> countries and because the operating costs<sup>of mutual fundscontinued to be relatively high.</sup> But bond funds experienced steady growth<sup>asgovernmentsfavoredthedevelopmentof</sup> long-term bond markets and provided incentives<sup>for investmentsin mutual funds.</sup> Total Net Assets. The total assets of mutual<sup>funds for the 40 countriescovered in</sup> this paper amounted to over 9 trillion US<sup>dollars in1998.The US marketaccountedfor</sup> 60 percent of total worldwide assets (Table<sup>1),followedby thecountries of the European</sup> Union with nearly 30 percent. Japan<sup>andotherEast Asian countriesrepresented6</sup> percent, while all developing countries<sup>as a group accounted forless than 4 percentof the</sup> total.

Among the countries for which data are<sup>reportedin thispaper,Luxembourgisa</sup> special case because of its very large<sup>role asanoffshorecenter.Other countrieswhere</sup> business with nonresidents is relatively<sup>largeinclude IrelandandSwitzerlandinEurope</sup> and Hong Kong and Singapore in Asia.<sup>Thepresenceofthese centershasimportant</sup> implications for the evolution of markets<sup>inother countries,especially thosefromthe</sup> same region, but these are difficult to assess<sup>becausethe business with nonresidentsitself</sup> is difficult to identify.

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**Table 1: Overview of Mutual Funds, 1998**

|**Country**|**Assets**<br>|**%of **<br>|**Numberof**<br>|**Average**<br>|**Equity**<br>|**Bond**<br>|**Balanced**<br>|**MM**<br>|
|---|---|---|---|---|---|---|---|---|
||**(US$Bn)**|**Total**|**Funds**|**FundSize**|**Funds**|**Funds**|**Funds**|**Funds**|
|||||**(US$ Mn)**||**%**|**%**|**%**|
|AneloAmerican|||||||||
|Australia|43.92|0.48|569|77.2|23|6|17|21|
|Canada|213.45|2.34|1130|188.9|53|10|17|11|
|Ireland|N/A||||||||
|New Zealand|7.25|0.08|633|11.5|16|18|40|7|
|SouthAfrica|12.16|.0.13|191|63.7|63|6|9|17|
|UnitedKingdom|285.54|3.13|1541|185.3|83|.<br>8|8|1|
|United States|5,525.20|60.57|7314|755.4|54|15|7|24|
|Scandinavian|||||||||
|Denmark|19.46|0.21|240|81.1|45|54|I||
|Finland|5.72|0.06|114|50.2|36|24|24|16|
|Norway|11.17|0.12|264|42.3|57|16|4|23|
|Sweden|55.25|0.61|366|151.0|75|11|14||
|CentralEuropean|||||||||
|Austria|63.69|0.70|821|77.6|10|58|26|_5_|
|Belgium|56.54|0.62|631|89.6|56|15|26|3|
|<br>Germany|195.55|2.14|848|230.6|43|40|3|14|
|<br>Luxembourg|509.73|5.59|4524|112.7|28|46|8|16|
|<br>Netherlands|77.95|0.85|334|233.4|58|23|9|7|
|Switzerland|71.84|0.79|325|221.0|70|30|||
|SouthernEuronean|||||||||
|France|589.70|6.46|5581|105.7|18|26|24|31|
|Greece|32.15|0.35|179|179.6|5|19|9|66|
|Italy|435.93|4.78|703|620.1|18|51|8|19|
|Portugal|23.26|0.25|197|118.1|13|39|10|30|
|<br>Spain|238.85|2.62|1866|128.0|20|37|18|25|
|Turkey|1.11|0.01|197|5.6|1|33|3|31|
|East European|||||||||
|CzechRepublic|0.56|0.01|56|10.0|1|19|40|40|
|<br>Hungary|1.47|0.02|66|22.3|4|60|24|12|
|<br>Poland|0.51|0.01|||28|21|51||
|**Latin American**|||||||||
|Argentina|6.93|0.08|229|30.3|4|14|5|77|
|<br>Brazil|118.69|1.30|2438|48.7|8|80|7|6|
|Chile|2.91|0.03|102|28.5|7|17||76|
|Mexico|12.20|0.13|312|39.1|||||
|Asian|||||||||
|HongKong|98.77|1.08|712|138.7|70|13|10|6|
|<br>India|8.69|0.10|97|89.5|15|37|47|1|
|Japan|376.54|4.13|4534|83.0|17|40|10|33|
|<br>Korea|||||||||
|Malaysia|10.19|0.11|95|107.3|||||
|<br>Thailand|1.63|0.02|128|12.7|22|76|2||
|SriLanka|0.04|0.00|10|3.9|||||
|MENA|||||||||
|Israel|5.50|0.06|||15||15||
|Morocco|1.93|0.02|48|40.3|||||
|Tunisia|0.66|0.01|19|34.8||87|13||

13
Table 2: Net Assets of Mutual Funds (USD billion and average growth rate)

|Country|1992|1998|°|
|---|---|---|---|
|**AngloAmerican**||||
|Australia|12.07|43.92|24.0|
|Canada|52.92|213.45|26.2|
|Ireland1992-97|5.93|23.73|31.9|
|NewZealand|0.59|7.25|51.9|
|South Africa|4.52|12.16|17.9|
|United Kingdom|91.12|285.54|20.9|
|UnitedStates|1642.60|5525.20|22.4|
|Scandinavian<br>||||
|Denmark|3.43|19.46|33.5|
|Finland1994-98|1.09|5.72|51.4|
|Norway1994-98|5.14|11.17|21.4|
|Sweden<br>|18.17|55.25|20.4|
|**CentralEuroDean**||||
|Austria|15.08|63.69|27.1|
|Belgium|8.91|56.54|36.1|
|Germany|70.41|195.55|18.6|
|Luxembourg|182.59|509.73|18.7|
|Netherlands|32.73|77.95|15.6|
|Switzerland|19.57|71.84|24.2|
|Southern Euronean||||
|France|448.44|589.70|4.7|
|Greece|1.02|32.15|77.7|
|Italy|41.24|435.93|48.1|
|Portugal|7.96|23.26|19.6|
|Spain|54.79|238.85|27.8|
|Turkey1993-98|1.05|1.11|1.1|
|EastEuromean||||
|Czech Republic1996-98|0.46|0.56|10.4|
|Hungary 1996-98|0.73|1.47|41.9|
|Poland1993-98|0.43|0.51|3.5|
|LatinAmerican||||
|Argentina|0.18|6.93|83.8|
|Brazil|18.76|118.69|36.0|
|Chile|0.92|2.91|21.2|
|Mexico|16.57|12.20|-5.0|
|Asian||||
|HongKong|16.35|98.77|35.0|
|India|7.69|8.69|2.1|
|Japan|346.92|376.54|1.4|
|Korea1992-97|85.61|86.24|0.1|
|Malaysia|6.02|10.19|9.2|
|Thailand1993-98|0.36|1.63|35.3|
|SriLanka1996-98|0.05|0.04|-10.6|
|MENA||||
|Israel|10.38|5.50|-10.0|
|Morocco1996-98|0.31|1.93|149.6|
|Tunisia1993-98|0.10|0.66|45.9|

14
Growth rates have varied considerably across countries and regions (Table 2). Most Anglo-American countries, where mutual funds were already well developed in the early 1990s, registered growth rates of between 20 and 30 per cent per year. In Europe, some countries, such as Greece and Italy, experienced very rapid growth, while others, most notably France, recorded low growth. Among middle-income countries, Morocco, Argentina, Hungary and Tunisia achieved very high growth from low starting points. Except for Hungary, where mutual funds are increasingly integrated into the European market, the experience of mutual funds in the other three countries has suffered in later years.

Setting Luxembourg aside as a very special case, the United States is in a class of *its own in the development of mutual funds. Following their spectacular growth in the 1990s mutual fund assets rose from the equivalent of 26 percent of GDP in 1992 to 65% in 1998 (Table 3). Only in Hong Kong (China) do mutual funds come anywhere near this level, having grown from 16 percent of GDP in 1992 to 52 percent in 1998.6 In Canada and several European countries (Spain, France, Italy and Austria) mutual fund assets correspond to between 30 and 40 percent of GDP. Several European countries, including Belgium, Greece, the Netherlands, Portugal, Switzerland, Sweden and the United Kingdom, have mutual fund assets ranging between 20 and 30 percent of GDP.

In continental Europe, Denmark, Finland, Germany and Norway continue to have relatively underdeveloped mutual fund sectors. In the case of Germany, this is partly offset by two factors: the strong presence of closed-end funds, which are not included in the above statistics; and the use of mutual funds based in Luxembourg by many German investors, mostly for tax reasons. The effect of Luxembourg on the size of German mutual funds is likely to be much greater than on mutual funds in other European countries because of the prominent role played by leading German banks in the Luxembourg market.

> **6** It should be noted, however, that the data on Hong Kong mutual funds represent an estimate of the component that relates to domestic holdings. By far the largest component of the market is represented by holdings of nonresidents.

15
**Table** 3: **Net Assets of Mutual Funds, 1992-98 (percent of GDP)**

|**Country**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|Average|
|---|---|---|---|---|---|---|---|---|
|**An2loAmerican**|||||||||
|<br>Australia|4.13|5.54|5.39|5.18|10.32|10.92|10.16|7.38|
|Canada|9.27|15.65|16.59|18.66|25.54|31.63|35.69|21.86|
|Ireland|11.55|10.96|14.82|13.50|72.92|32.46||26.03|
|NewZealand|1.48|3.08|3.45|9.45|11.75|11.57|10.14|7.27|
|SouthAfrica|3.77|4.92|6.20|6.89|7.42|9.84|8.57|6.80|
|UnitedKingdom|8.68|13.90|13.09|13.89|16.24|18.38|21.31|15.07|
|UnitedStates|26.31|31.57|31.03|38.70|46.02|55.09|64.92|41.95|
|**Scandinavian**|||||||||
|Denmark|2.34|3.17|3.59|3.56|5.05|7.76|10.41|5.13|
|Finland|||1.12|0.95|2.01|2.99|4.33|2.28|
|Norway|||4.18|4.63|6.04|8.65|7.65|6.23|
|Sweden|7.33|13.99|10.21|11.65|13.93|20.33|22.03|14.21|
|**CentralEuropean**|||||||||
|Austria|8.06|9.99|11.91|14.43|17.28|22.03|30.04|16.25|
|Belgium|3.96|7.10|8.14|8.77|10.20|14.00|21.15|10.47|
|Germany|3.57|4.14|5.51|5.57|5.70|7.08|8.47|5.72|
|Luxembourg|1450.05|1958.90|1811.91|1835.30|2060.42|2445.07|2792.95|2050.66|
|Netherlands|10.16|14.62|14.20|15.04|16.98|21.06|20.62|16.10|
|Switzerland|8.12|14.75|15.10|14.64|16.51|16.97|20.40|15.21|
|**SouthernEuropean**|||||||||
|France|33.97|38.76|37.48|34.07|34.37|36.05|38.57|36.18|
|Greece|1.04|3.76|5.65|8.92|12.74|21.81|26.79|11.53|
|Italy|3.38|6.80|7.83|7.34|10.63|18.33|34.46|12.68|
|<br>Portugal|8.42|11.13|14.65|12.69|14.32|17.65|20.73|14.23|
|<br>Spain|9.50|15.05|17.57|17.92|23.42|33.77|40.82|22.58|
|<br>Turkey||0.56|0.54|0.30|0.63|0.45|0.52|0.50|
|**EastEuropean**|||||||||
|CzechRepublic|||||0.81|0.69|0.98|0.82|
|Hungary|||||1.64|1.46|2.71|1.94|
|Poland||0.50|0.63|0.24|0.35|0.40|0.34|0.35|
|**LatinAmerican**|||||||||
|Argentina|0.08|0.09|0.14|0.23|0.63|1.62|1.94|0.68|
|Brazil|4.80|5.48|9.97|9.04|13.39|13.51|13.42|9.94|
|Chile|2.20|2.74|4.10|3.87|4.05|5.49|3.43|3.70|
|Mexico|4.55|6.43|2.73|2.68|3.16|3.42|2.75|3.68|
|**Asian**|||||||||
|HongKong|16.19|26.84|22.54|24.24|26.63|33.60|51.60|28.81|
|India|2.83|2.98|3.80|2.93|2.70|2.36|1.99|2.80|
|Japan|9.33|10.62|9.29|9.14|9.13|7.41|8.15|9.01|
|Korea|27.80|31.58|32.05|31.12|29.62|19.47||24.52|
|Malaysia|10.33|16.23|19.24|19.90|23.89|8.81|9.46|15.41|
|<br>Thailand||0.28|0.63|1.14|2.34|0.39|1.47|1.04|
|SriLanka|||||0.33|0.30|0.25|0.29|
|MENA|||||||||
|Israel|12.81|19.45|8.32|5.75|3.99|5.08|5.95|8.76|
|Morocco||||0.01|0.83|3.27|5.25|2.34|
|Tunisia||0.66|2.86|3.66|2.73|3.27|3.18|2.73|

16
An interesting feature of the European market is the growing strength of mutual funds in several countries with unfunded social security systems (Austria, Belgium, France, Greece, Italy, Portugal and Spain). Some of these countries have also experienced strong growth of their life insurance industries. For instance, French life insurance assets exceeded 55 percent of GDP in 1997, a level that is much higher than in Canada, Germany or the United States and close to the levels prevailing in the Netherlands, Switzerland and the United Kingdom. This provides indirect evidence that the saving public is responding to various tax incentives to accumulate long-term savings as a defense against the likely future inability of their' national social security systems to honor promised benefits in full.

Among Anglo-American countries, which generally have well-developed securities markets and common law traditions, Australia, New Zealand and South Africa are notable for their relatively underdeveloped mutual fund industries with total assets around 10 percent of GDP. However, in all three countries mutual funds experienced considerable growth during the 1990s. The presence of a well-developed contractual savings industry in South Africa and the continuing credibility of tax-financed universal pensions in Australia and New Zealand are clearly relevant factors. As already noted, inclusion of the compulsory pension funds, which are mostly based on DC plans, causes a very large increase in the reported Australian statistics.

In East Asia, the experience of Japan is worth noting. Since the collapse of the Tokyo stock market in 1990, the mutual fund industry has stagnated. Total assets under management declined in relation to GDP from 9 to 8 percent. Mutual funds were better developed in Korea at the beginning of the decade with assets corresponding to 28 percent of GDP. They subsequently rose further to 32 percent of GDP by 1994 but suffered a major setback in the aftermath of the East Asian financial crisis of 1997 when they fell to less than 20 percent of GDP. Mutual funds in Malaysia grew aggressively in the first half of the 1990s, rising from 10 to 24 percent of GDP but plummeted to 9 percent of GDP in 1997.

Among other middle-income countries Brazil has the most developed mutual fund sector with assets corresponding to over 13 percent of GDP. In most other developing 17
countries mutual fund assets are close to, or<sup>lower than,5 percentof GDP.Like Korea</sup> and Malaysia, mutual funds in Mexico<sup>fell in1994 in theaftermathof the Tequila crisis.</sup> In several developing countries, including<sup>Argentina,Chile,Morocco and Tunisia,</sup> mutual funds grew at spectacular rates,<sup>although from nonexistentbases.</sup>

**Structure.** There are five main types of mutual<sup>fund:equity and bond funds that</sup> predominantly invest in equities or bonds;<sup>balancedfundsthathavemore balanced</sup> portfolios of both equities and bonds; money<sup>market mutualfundsthatspecialize in</sup> short-term instruments; and finally funds of<sup>fundsthatmainly investinother mutual</sup> funds. Some types of funds are subdivided<sup>intoseveralothercategories.Thus,equity</sup> funds may be classified by sectoral or geographic<sup>specialization,by investmentobjective,</sup> by active or passive management, and by class of<sup>investor (institutionalor retail,withor</sup> without front loads, etc.). Bond funds<sup>aremainly dividedintoshort-termandlong-term</sup> funds.

Countries vary considerably in the structure of<sup>their mutualfund industries(Table</sup> 4). Five countries are characterized by a predominance<sup>of equityfunds.Usingaverage</sup> data for the period 1992-98, the United Kingdom<sup>(89percent)andSouthAfrica(79)</sup> show the highest allocation to equity funds,<sup>mostprobablyaresultof theresponseof</sup> investors to the high levels of inflation of<sup>the1970sandearly1980s.Eventhough</sup> inflation declined to low or moderate levels<sup>inthe1990s,a ratchet effectmay beat play.</sup> Once investors switch into equity funds, they<sup>are unlikely to return to bondfundsas long</sup> as equity returns are higher in real terms<sup>andtheir volatilityisnotintolerablyhigh.</sup> Sweden (74), Hong Kong (66) and Switzerland<sup>(63)aretheother three countrieswhere</sup> equity funds represent more than 60 percent of<sup>the total assets of mutualfunds.</sup> There are then several countries where equity<sup>fundsrepresentbetween40 and60</sup> percent of the total. These include Thailand<sup>(59),Denmrark(52),Norway(49),Canada</sup> (48), the Netherlands (46), the United<sup>States(44),andFinland(42).Thelowrelative</sup> level of equity funds in the United States<sup>doesnotrepresenta weaknessof USequity</sup> funds or markets, but rather a relatively strong<sup>presenceof other typesof funds,including</sup> in particular money market mutual funds.

18
|Table4:Structureof M<br>**Country**|utualFun<br>Equity|dsbyMajor<br>Balanced|Category,<br>Bond|Average f<br>MMF|or1992-9<br>Other|8(percent)<br>Total|
|---|---|---|---|---|---|---|
|<br>**Anelo American**|||||||
|Australia|35|19|7|22..|17|100|
|Canada|48|13|12|14|12|100|
|Ireland|33|47|16|_5_||100|
|NewZealand|34|31|26|4|**5**|100|
|SouthAfrica|79|5|8|4|3|100|
|United Kingdom|89|6|4|1||100|
|UnitedStates|44|7|22|27||100|
|Scandinavian|||||||
|Denmark|52|3|46|||100|
|Finland|42|21|18|18||100|
|Norway|49|3|19|29||100|
|Sweden|74|8|18|||100|
|CentralEuropean|||||||
|Austria|6|21|72|1||100|
|Belgium|34|28|23|10|6|100|
|Germany|28|2|58|11||100|
|Luxembourg|14|13|48|24||100|
|Netherlands|46|7|37|9|1|100|
|Switzerland|63||37|||100|
|Southern European|||||||
|France|11|13|28|47||100|
|Greece|12|5|35|47|1|100|
|Italy|22|11|41|25|2|100|
|Portugal|6|6|55|30|2|100|
|Spain|5|10|39|46||100|
|Turkey|1|_5_|33|23|38|100|
|EastEuronean|||||||
|CzechRepublic|2|66|12|20||100|
|Hungary|9|12|68|11||100|
|Poland|28|51|12||9|100|
|LatinAmerican|||||||
|Argentina|27|4|36|27|6|100|
|Brazil|8|7|74|10|1|100|
|Chile|16||24|60||100|
|Mexico|||||||
|Asian|||||||
|Hong Kong|66|4|19|9|1|100|
|India|12|63|23|2||100|
|Japan|31|3|41|25||100|
|<br>Korea|||||||
|Malaysia|||||||
|Thailand|59|4|37|||100|
|SriLanka|||||||
|MENA|||||||
|Israel|25|25|||50|100<br>|
|Morocco|12|71|17|||100|
|Tunisia||38|62||0|100|

19
Balanced funds, which invest in both<sup>equitiesand debtinstruments,maydistort</sup> the relevance of these ratios. While in<sup>most countries(e.g.Morocco,India,theCzech</sup> Republic, Tunisia and several continental<sup>Europeancountries)balancedfunds are heavily</sup> invested in bonds, in a number of countries<sup>they may be-more"balanced"or even"tilted"</sup> in favor of equities. This is likely to be<sup>the case in Australia,Ireland,and New Zealand,</sup> partly explaining why equity funds in these<sup>Anglo-American countries represent less than</sup> 40 percent of total mutual fund assets.

In the majority of countries in continental<sup>Europe, EasternEurope, Latin America,</sup> Asia, and the Middle East and North<sup>Africamutualfund investorsshowastrong</sup> preference for fixed income funds, either<sup>long-termbondsorshort-termmoneymarket</sup> instruments. In several developing and<sup>transitioncountries,bondinstrumentshaveshort</sup> maturities and thus there is practically<sup>little differencebetweenbond and moneymarket</sup> funds. However, in the countries of Southern<sup>Europe (France,Greece,Italy,Spainand</sup> Portugal) as well as Australia, Japan, Norway<sup>andtheUnitedStates,thestrongrelative</sup> presence of money market mutual funds<sup>is notable.This seemstobe connected with the</sup> imposition of restrictive regulations on the<sup>paymentof intereston checkingaccountsand</sup> other short-term bank deposits that all<sup>these countrieshaveimposedforprolonged</sup> periods. Even though such regulations<sup>(liketheinfamousregulationQintheUnited</sup> States) have been withdrawn over time,<sup>onceestablishedmoneymarketmutual funds</sup> have continued to thrive.

The strong presence of fixed income<sup>funds(andcorrespondingweaknessof</sup> equity fumds) in Latin American and Eastern<sup>Europeancountries that havereformedtheir</sup> social security and pension systems (e.g.<sup>Argentina, Chile, Hungary,andPoland)has</sup> important implications for the regulation<sup>ofassetallocationbythepensionfunds.</sup> Arguments that absent restrictive investment<sup>regulations,pension fundswouldplacea</sup> higher proportion of their assets in equities<sup>are not supported by the experienceof mutual</sup> funds, which are free from such investment<sup>restrictions.Infact,giventhestrong</sup> preference of the investing public for<sup>fixedincomeinstrumentsand thestructural</sup> weaknesses of local equity markets, it<sup>is likely that withoutany investment rules, pension</sup> funds would have invested an even<sup>smallerproportionoftheir assetsincorporate</sup> equities.

20
**Evolution of Equity Funds.** Equity funds are very large in Hong Kong and the United States, where they exceed 30 percent of GDP (Table 5). In the United States, equity funds reflect the strong preference of the investing public for corporate equities, although this may weaken after the price reversals suffered by equity markets in the past couple of years.

The net assets of equity funds range between 10 and 20 percent of GDP in a small number of countries, including Belgium, Canada, Netherlands, Sweden, Switzerland, and the United Kingdom. In most of Continental Europe equity funds were underdeveloped in 1998, although they were growing rapidly in France, Italy and Spain.

Equity funds have a very small presence in most middle-income countries, even in Brazil and Chile where the equity markets are relatively well developed. This may be explained by a combination of factors: lack of confidence in the integrity of local markets; low risk tolerance of investors; and use of overseas mutual funds by wealthier and more sophisticated investors. The low level of equity funds in Australia and New Zealand may also be explained by the ready access that residents of these countries have to overseas mutual funds, operating in offshore centers, such as Hong Kong and Singapore as well as the United States and the United Kingdom.

**Evolution of Bond, Balanced and Money Market Funds.** The evolution of these types of mutual funds is often the mirror image of that of equity funds. Bond funds are well developed in a number of Continental European countries, such as Austria, France and Italy where government bond markets are large (Table 6). They are also well established in the United States, which has large government, corporate and mortgage bond markets, and Brazil. Outside these countries, bond funds have a relatively strong presence in Denmark, Greece, Hong Kong, Portugal and Switzerland. They are notably weak in most Anglo-American countries.

Balanced funds control a large share of the mutual fund sector in several countries (Table 4). In the Czech Republic, India, Ireland, Morocco and Poland they have close to or over 50 percent of the total. In Belgium, Israel, New Zealand and Tunisia their share ranges between 25 and 40 percent. However, in relation to national income, balanced funds are relatively large in only a few countries, including Austria, Belgium, Canada, 21
France, Hong Kong (China), Ireland and<sup>Spain.Inthesecountriesthetotalassetsof</sup> balanced funds correspond to between 5 and<sup>10percentofGDP(Table7).Balanced</sup> funds invest heavily in bonds in some countries<sup>(notablytheCzechRepublic,Morocco</sup> and Tunisia), while in others they adopt, more diversified<sup>investment strategies.</sup> Money market mutual funds have grown impressively<sup>inFrance, Greece,Spain</sup> and the United States (Table 8). The total assets of<sup>money market mutual fundsrepresent</sup> close to or more than 10 percent of GDP<sup>inthesecountries.There aresomecountries</sup> (e.g. Australia and Japan) where money market<sup>mutual fundshavea significantshare of</sup> over 25 percent of the mutual fund<sup>sector buttheir totalassetsare notlargeinrelation to</sup> national income.

The insignificant growth of money market mutual<sup>fundsin the United Kingdomis</sup> notable. UK banks and building societies<sup>havebeen freefrom restrictionson thepayment</sup> of interest on sight and retail time deposits.<sup>Despitetheprevalenceof securitiesmarkets</sup> and the active trading needs of investors<sup>and market participants,neither institutionalnor</sup> retail investors have shown a preference<sup>for parkingtheirliquid fundsin moneymarket</sup> mutual funds. This seems to be in sharp<sup>contrasttotheprevailingpatternintheUnited</sup> States.

22
**Table 5: Net Assets of Equity Funds, 1992-98 (percent of GDP)**

|Countrv|1992|1993|1994|1995|1996|1997|1998|Averace|
|---|---|---|---|---|---|---|---|---|
|AneloAmerican|||||||||
|Australia|1.64|2.73|2.34|2.12|2.49|2.47|2.33|2.30|
|Canada|3.42|6.84|7.82|9.37|13.23|17.08|18.88|10.95|
|Ireland|3.52|3.43|5.29|_5.01_|22.04|9.82||8.18|
|NewZealand|0.76|1.72|1.94|2.16|1.95|2.20|1.59|1.76|
|South Africa|3.24|4.09|5.50|5.78|6.09|6.80|5.40|5.27|
|United Kingdom<br>|8.11<br>|12.79<br>|11.91<br>|12.51<br>|14.35<br>|15.77<br>|17.79|13.32|
|UnitedStates<br>|8.36|11.41|12.45|17.44|22.53|29.19|34.99|19.48|
|**Scandinavian**<br>|||||||||
|Denmark<br>|1.38|1.81|1.94|1.89|2.36|3.53|4.68|2.51|
|Finland<br>|||0.67|0.49|0.63|0.95|1.58|0.86|
|Norway|||1.69|1.73|2.91|5.16|4.37|3.17|
|Sweden|5.07|10.01|7.67|8.60|10.39|15.73|16.53|10.57|
|**CentralEuropean**|||||||||
|Austria|0.28|0.49|0.77|0.73|1.00|1.60|3.13|1.14|
|Belgium<br>|0.85|1.96|2.23|2.48|3.49|6.45|11.74|4.17|
|Germany<br>|0.57|1.06|1.36|1.31|1.44|2.68|3.64|1.72|
|Luxembourg<br>|56.55<br>|83.56<br>|86.09|276.85|378.76|593.93|792.73|324.07|
|Netherlands|4.15|5.18|5.17|6.99|9.14|11.41|11.97|7.72|
|Switzerland||8.39|9.08|8.97|10.25|11.52|14.23|10.41|
|**SouthernEuronean**<br>|||||||||
|France<br>|2.70<br>|3.77<br>|3.56|3.23|3.76|5.06|7.00|4.15|
|Greece|0.50|0.49|0.49|0.40|0.26|0.71|1.47|0.61|
|Italy<br>|0.72<br>|1.37|2.26|1.96|1.77|3.63|6.27|2.57|
|Portugal|0.30|0.51|0.59|0.41|0.79|2.10|2.61|1.04|
|Spain|0.04|0.19|0.29|0.27|0.65|3.53|8.14|1.87|
|Turkey||||||0.01|0.00|0.01|
|East European<br>|||||||||
|CzechRepublic||||||0.04|0.01|0.02|
|Hungary<br>|||||0.01|0.34|0.11|0.16|
|Poland<br>|||||||0.09|0.09|
|LatinAmerican<br>|||||||||
|Argentina<br>||0.08|0.05|0.05|0.07|0.15|0.08|0.08|
|Brazil<br>|||||0.55<br>|1.46|1.02|1.01|
|Chile<br>|0.44|0.46|1.10|0.82|0.41|0.52|0.25|0.57|
|Mexico|||||||||
|Asian|||||||||
|Hong Kong|9.27|18.39|15.25|16.31|18.03|22.00|36.26|19.36|
|India<br>|1.05<br>||0.05|0.13||0.25|0.31|0.36|
|Japan|4.56|3.96|3.61|2.65|2.18|1.49|1.39|2.83|
|Korea<br>|||||||||
|Malaysia|||||||||
|**Thailand**||0.26|0.60|0.81|0.67|0.19|0.32|0.47|
|SriLanka<br>|||||||||
|MENA|||||||||
|Israel<br>|2.69|7.20|2.41|1.73|0.92|1.07|0.89|2.41|
|Morocco<br>Tunisia|||||0.07|0.52||0.30|

23
**Table 6: Net Assets of Bond Funds, 1992-98 (percent of GDP)**

|**Countrv**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|**Avera2e**|
|---|---|---|---|---|---|---|---|---|
|AngloAmerican|||||||||
|<br>Australia|0.44|0.81|0.41.|0.34|0.32|0.38|0.56|0.47|
|Canada|1.39|2.35|2.21|2.27|2.37|2.68|3.69|2.42|
|Ireland|0.86|0.90|1.59|1.03||||6.04|
|New Zealand|0.53|0.86|0.83|2.90|3.11|2.51|1.78|1.79|
|South Africa|0.53|0.84|0.70|0.21|0.21|0.35|0.51|0.48|
|UnitedKingdom|0.22|0.38|0.35|0.49|0.75|1.13|1.64|0.71|
|UnitedStates|7.93|9.36|7.52|8.08|8.42|8.93|9.76|8.57|
|**Scandinavian**|||||||||
|Denmark|0.84|1.24|1.54|1.57|2.52|4.12|5.62|2.49|
|Finland|||0.11|0.23|0.32|0.55|1.05|0.45|
|Norway||.|1.09|0.99|1.01|1.21|1.22|1.11|
|Sweden|2.20|3.79|1.60|1.96|1.99|2.06|2.34|2.28|
|**CentralEuropean**|||||||||
|Austria|6.30|7.78|9.24|10.41|12.42|14.93|17.42|11.21|
|Belgium|0.88|1.75|1.94|2.35|2.53|2.94|3.26|2.24|
|Germany|2.94|2.98|3.06|3.04|3.19|3.41|3.36|3.14|
|Luxembourg|629.81|930.56|820.02|981.42|1064.62|1180.91|1294.37|985.96|
|Netherlands|4.55|7.05|6.58|5.70|5.13|5.59|4.83|5.63|
|Switzerland||6.36|6.02|5.66|6.26|5.45|6.17|5.99|
|**SouthernEuropean**|||||||||
|France|7.85|11.59|10.68|9.72|10.12|11.82|10.14|10.27|
|Greece|0.24|1.52|3.16|3.74|4.72|6.00|5.06|3.49|
|Italy|1.31|2.49|3.12|2.85|4.18|7.77|17.41|5.59|
|Portugal|5.62|8.01|10.03|6.58|8.24|5.45|7.99|7.42|
|Spain|3.89|5.87|6.76|6.40|9.51|13.83|15.06|8.76|
|Turkey||||||0.15|0.17|0.16|
|**EastEuronean**|||||||||
|CzechRepublic|||||0.06|0.07|0.18|0.10|
|<br>Hungary|||||1.23|1.00|1.62|1.28|
|Poland||||||0.01|0.07|0.04|
|**LatinAmerican**|||||||||
|Argentina||0.01|0.07|0.15|0.21|0.63|0.28|0.23|
|<br>Brazil|||||9.07|10.24|10.70|10.00|
|Chile|0.47|0.78|1.22|1.02|0.95|1.15|0.57|0.88|
|Mexico|||||||||
|**Asian**|||||||||
|HongKong|4.52|5.54|4.51|4.77|4.57|5.91|6.51|5.19|
|<br>India|1.78|||||0.73|0.75|1.09|
|Japan|3.63|4.21|3.59|4.06|4.07|3.48|3.23|3.75|
|<br>Korea|||||||||
|Malaysia|||||||||
|Thailand|||0.02|0.31|1.63|0.18|1.12|0.65|
|SriLanka<br>**MENA**|||||||||
|Israel|||||||||
|Morocco|||||0.10|1.75||0.92|
|Tunisia||0.48|0.92|1.18|1.67|2.82|2.78|1.64|

24
Table 7: Net Assets of Balanced Funds, 1992-98 (percent of GDP)

|Country|**1992**|**1993**|1994|1995|1996|1997|1998|Average|
|---|---|---|---|---|---|---|---|---|
|AneloAmerican|||||||||
|<br>Australia|0.49|0.95|1.35|1.33|1.74|1.87|1.74|1.35|
|Canada|0.85|1.74|2.30|2.51|3.53|5.09|6.03|3.15|
|Ireland|6.54|6.12|7.39|7.14|23.74|10.57||10.25|
|NewZealand||0.41|0.53|4.09|4.23|4.13|4.07|2.91|
|South Africa||||0.38|0.65|1.13|0.81|0.74|
|United Kingdom|0.29|0.65|0.76|0.84|1.05|1.39|1.75|0.96|
|UnitedStates|1.26|2.17|2.26|2.82|3.30|3.91|4.29|2.86|
|Scandinavian|||||||||
|Denmark|0.11|0.12|0.11|0.10|0.18|0.11|0.11|0.12|
|Finland|||0.34|0.18|0.24|0.64|1.02|0.48|
|Norway|||0.08|0.08|0.29|0.43|0.30|0.23|
|Sweden|||0.94|1.09|1.55|2.54|3.16|1.86|
|CentralEuronean|||||||||
|Austria|1.48|1.71|1.91|2.91|3.85|5.50|7.85|3.60|
|Belgium|0.33|2.39|2.78|2.87|3.18|3.93|5.58|3.01|
|Germany|0.06|0.10|0.11|0.11|0.14|0.20|0.29|0.14|
|Luxembourg|322.52|441.94|431.28|72.46|101.19|164.91|219.63|250.56|
|Netherlands|0.81|0.91|0.98|0.83|0.97|1.74|1.78|1.15|
|Switzerland|||||||||
|**Southern**Euronean|||||||||
|France|1.70|2.47|4.33|4.26|4.91|6.84|9.37|4.84|
|Greece||0.19|0.32|0.20|0.19|1.85|2.39|0.86|
|Italy|0.56|0.99|1.16|0.83|0.69|1.11|2.67|1.14|
|Portugal||0.03|0.03|0.11|0.06|3.80|2.13|1.03|
|Spain|0.59|2.06|1.20|0.97|1.37|3.73|7.47|2.49|
|Turkey||||||0.03|0.01|0.02|
|EastEuronean|||||||||
|Czech Republic|||||0.71|0.48|0.39|0.53|
|Hungary|||||0.07|0.12|0.64|0.28|
|Poland|||||||0.17|0.17|
|LatinAmerican|||||||||
|Argentina|||||0.04|0.20|0.10|0.11|
|Brazil|||||||0.94|0.94|
|Chile|||||||||
|Mexico|||||||||
|Asian|||||||||
|HongKong||0.54|0.55|0.63|0.78|1.44|5.29|1.54|
|India||2.15|3.62|2.80||1.38|0.93|2.18|
|Japan||0.13|0.12|0.15|0.22|0.33|0.80|0.29|
|Korea|||||||||
|Malaysia|||||||||
|Thailand||0.03|0.01|0.02|0.05|0.02|0.03|0.03|
|SriLanka<br>MENA|||||||||
|Israel|||||||||
|Morocco||||0.01|0.67|1.06||0.58|
|Tunisia||0.18|1.94|2.48|1.07|0.45|0.41|1.09|

25
**Table 8: Net Assets of Money Market Funds, 1992-98 (percent of GDP)**

|**Country**|**1992**|**1993**|**1994**|**1995**|**1996**|**1997**|**1998**|**Average**|
|---|---|---|---|---|---|---|---|---|
|**AngloAmerican**|||||||||
|<br>Australia|1.15|1.05|1.29|1.39|1.93|2.14|2.17|1.59|
|Canada|2.00|2.20|2.04|2.41|3.88|3.76|4.01|2.90|
|Ireland|0.63|.<br>0.51|.<br>0.23|0.31|5.09|2.26||1.50|
|NewZealand|0.02|0.08|0.15|0.31|0.65|0.65|0.74|0.37|
|SouthAfrica||||||1.02<br>|1.47<br>|1.25<br>|
|United Kingdom|0.06|0.08<br>|0.07<br>|0.05<br>|0.08<br>|0.09<br>|0.11<br>|0.08<br>|
|UnitedStates|8.75|8.62|8.80|10.36|11.77|13.06|15.88|11.03|
|Scandinavian|||||||||
|Denmark|||||||||
|Finland|||0.00|0.05|0.82|0.85|0.68|0.48|
|Norway|||1.31|1.83|1.83|1.85|1.77|1.72|
|Sweden|||||||||
|CentralEuronean|||||||||
|Austria|||||||1.64|1.64|
|Belgium|0.59|0.88|0.89|1.06|0.99|0.66|0.57|0.81|
|Germany|||0.98|1.11|0.93|0.79|1.17|1.00|
|Luxembourg|437.14|502.84|474.53|504.57|515.86|477.32|442.58|479.26|
|Netherlands|0.65|1.37|1.47|1.53|1.71|1.95|1.54|1.46|
|Switzerland|||||||||
|SouthernEuropean|||||||||
|France|21.72|20.93|18.91|16.86|15.58|12.32|12.06|16.91|
|Greece|0.30|1.56|1.68|4.58|7.56|13.24|17.78|6.67|
|Italy|0.79|1.96|1.29|1.57|3.87|5.09|6.45|3.00|
|Portugal|2.48|2.50|3.85|5.34|4.68|5.24|6.23|4.33|
|Spain|4.97|6.92|9.32|10.28|11.89|12.68|10.07|9.45|
|Turkey||||||0.07|0.16|0.12|
|EastEuropean|||||||||
|Czech Republic|||||0.04|0.11|0.39|0.18|
|Hungary|||||0.33||0.33|0.33|
|Poland|||||||||
|LatinAmerican|||||||||
|Argentina|||||0.29|0.64|1.49|0.81|
|Brazil|||||2.74|0.70|0.75|1.40|
|Chile|||1.78|2.03|2.69|3.82|2.61|2.59|
|Mexico|||||||||
|Asian|||||||||
|HongKong|1.81|2.01|1.83|1.99|2.89|3.89|3.29|2.53|
|India|||0.14|0.06|||0.01|0.07|
|Japan|1.22|2.32|1.96|2.29|2.67|2.11|2.72|2.18|
|Korea|||||||||
|Malaysia<br>Thailand<br>SriLanka<br>MENA<br>|||||||||
|Israel|||||||||
|Morocco|||||||||
|Tunisia|||||||||

26
# **III. Determinants of Mutual Fund Growth**

The growth of the mutual fund sector, like any other sector of economic activity, is the result of the interaction of demand and supply. In general, the same factors that influence the demand for mutual funds also shape their supply. For instance, the level of income and wealth is, or should be, a major determinant of the demand for mutual fund investments, but income and wealth also affect the supply of such services through their effect on market infrastructure and presence of skilled professionals. Similarly, securities market development is an important factor in stimulating the demand side but also helps promote the supply of mutual fund services. The availability or shortage of suitable financial instruments is a constraining factor for the growth of mutual funds in many countries. Sometimes, a particular factor acquires overriding importance. For instance, absence of enabling legislation has prevented or delayed the establishment of mutual funds in many countries and continues to do so today in some countries (e.g., Jordan). Regulatory restrictions can also play an important part, either in impeding or in stimulating the growth of mutual funds. Tax rules also tend to have a large impact.

In this section we examine a number of factors that may explain the growth of mutual funds in different countries. To help identify potential differences in the processes of mutual fund growth in developed and developing countries we divided our sample of 38 countries<sup>7</sup> in high and middle-income countries (those above or below an average per capita income of $15,000).

Chart 1 summarizes the growth of the net assets of mutual funds in high and middle-income countries. The chart shows respectively the total net assets of all, equity, bond and money market funds as a percentage of national income (GDP).<sup>8</sup> For all countries in the sample, mutual fund assets doubled from 8 percent in 1992 to 16 percent of GDP in 1998. For equity funds, the growth was from 3 to 7 percent of GDP over the same period. However, there were significant differences between high and middle-

> 7 Ireland and Luxembourg were excluded from the quantitative analysis.

> s Analternative approach would be to use mutual fund assets as a percentage of total financial assets. However, except for a few countries such as Luxembourg and Ireland where nonresident investors have a strong presence, such an approach would not provide a better indication of the level of development of the mutual fund industry.

27
income countries. In high-income countries, mutual fund assets expanded from 10 to 24 percent of GDP between 1992 and 1998, while in middle-income countries they grew from 4 to 8 percent in the first half of the 1990s but then fell back to 4 percent by 1998. All types of mutual funds grew between 1992 and 1998 in high-income countries, but in middle-income ones equity and bond funds exhibited little net growth.

**Chart 1- Mutual Funds Net Assets in high and middle-income countries (% of GDP)**

<!-- Start of picture text --> Total Net Assets / GDP Equity Funds Net Assets / GDP<br>24-12 -<br>L.14 -- 4-<br>4 4 0 * *<br>92 93 94 95 96 97 98 92 93 94 95 96 97 98<br>Years Yearn<br>ab5. l Total + -Deeloped a -- DelIoping [ 2. | Total + Dereloped -f-- - Daieloping<br>ae - Bond Funds , Net Assets GDP a a 2 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Money . . ............ Market Funds Net Assets L<br>7 -- --------- - -. GDP<br>co ~~2.5 - -<br>a22<br>3 ~~~~11.--------------<br>92 93 94 95 96 97 98 92 93 94 95 96 97 98<br>Yearn<br>Years<br>- Total -o De%eloped - -Dewlopin t Total --- Devwloped _-lW- De%oaoping<br><!-- End of picture text -->

The last result is explained by the declines experienced by some East Asian countries (Korea and Malaysia) as well as Israel and Mexico. In contrast, most Latin American countries as well -as Arab and Eastern European countries achieved high growth rates, but starting from low or nonexistent bases. Most high-income countries registered high growth rates.

28
To ascertain the significance of different factors in<sup>explainingthegrowthof</sup> mutual funds we estimated an empirical model that<sup>regressedthesizeof the mutualfund</sup> sector, given by the level of net assets in relation to<sup>nationalincome,on anumber of</sup> independent variables. Following established practice we<sup>includedamong the explanatory</sup> variables indicators of the level of economic development,<sup>securitiesmarketdevelopment</sup> and efficiency, financial stability, and regulatory effectiveness<sup>as wellasrelevant return</sup> variables. We did not include tax rules because they<sup>aredifficultto document.Dataon</sup> most of these variables were collected from the World<sup>Bank'sDatabaseforEconomic</sup> Indicators except for stock market returns, which were<sup>collectedfrom the Datastreamand</sup> Bloomberg databases.

GDP per capita is used as an indicator of economic development.<sup>Manystudies</sup> have shown that financial intermediaries tend to be larger,<sup>moreactive and moreefficient</sup> in high-income countries (Demirguc-Kunt and Levine<sup>1999).</sup> Capital market development is represented by the total<sup>valueof listeddomestic</sup> equities and issued bonds in relation to national income.<sup>Alternativemodel specifications</sup> use separately quantitative indicators of equity and bond<sup>marketdevelopment.However,</sup> as pointed out by Levine and Zervos (1998) large markets<sup>donotnecessarilyfunction</sup> efficiently. Taxes and other regulations may distort the<sup>incentive to list on theexchange,</sup> resulting in little trading activity and low levels of<sup>liquidity.</sup> Market efficiency is measured by two indicators: the equity<sup>market turnoverratio</sup> (which measures the value of traded shares divided<sup>bymarket capitalization)andthe</sup> value of traded shares in relation to national income. The<sup>first indicatorsuffersfromthe</sup> use of market capitalization as the denominator. It may<sup>show as highlyefficientmarkets</sup> with a low level of market capitalization and low<sup>absolutetrading valuesbutahigh</sup> turnover ratio. The value of traded shares is a better<sup>indicatorofmarketliquidity,</sup> although it is also not free from weaknesses. It tends<sup>to be higher when equity pricesare</sup> rising and lower when prices are falling, even though<sup>marketliquidity andefficiency may</sup> not change. A more relevant measure of market efficiency<sup>andliquiditywouldbe</sup> provided -by data on trading costs and price impact,<sup>butsuchdataarenotreadily</sup> 29
available. Use of data on market capitalization and trading aim to capture the extent of investor confidence in market integrity, liquidity and efficiency.

Return variables are likely to have a large effect on the growth of different types of funds. Equity mutual funds and the demand for equity investments more generally are likely to be negatively affected by high real interest rates on bonds-and bank deposits. If investors can earn high real returns on less volatile instruments, they would be less likely to invest in equities and equity mutual funds. However, if real returns on equity funds are much higher than real interest rates and if the volatility of equity returns is not particularly high, then equity funds would benefit.

The demand for bond and money market mutual funds is likely to be affected by the rate differential between such funds and bank deposits. When banks are forced to widen their spreads because of large losses on their lending portfolios or because of the high operating costs of their large branch networks, mutual funds that are free from such burdens are able to offer attractive returns on deposit-like instruments. However, because of the lack of detailed and reliable data on interest rate differentials, we retain the level of real interest rates, real equity returns and the volatility of equity returns among the independent variables used in the empirical analysis.<sup>9</sup> Additional variables, which highlight the overall level of country development, have been used. These include an indicator of the development of the banking sector (given by the ratio of commercial bank assets to the combined total assets of commercial banks and the central bank), the openness to international trade and foreign investment<sup>10</sup> (given by the share of exports and imports in relation to national income), the importance of high-tech industries" (measured by the share of high-tech exports to total exports), and

> 9 Interest rates on bank deposits were used where available; otherwise rates on treasury bills were used. Real interest rates were constructed through a Taylor series approximation. Equity returns were based on the Morgan Stanley Composite Index (MSCI) for developing countries and the Morgan Stanley Global Index (MSGI) for developed countries. For countries not included in either index we used a composite stock market index of the main stock exchange.

10 Openness to international trade and foreign direct investment are often used as indicators of integration with foreign markets with a strong positive impact on economic growth (Dollar 1992, Levine and Renelt 1992, Vamvakidis 1998).

**"** During the 1 990s, the period covered by our sample, high-tech companies have been able to list on both local and global equity markets and have raised large amounts of capital, giving a boost to stock market development and publicizing the advantages of equity markets and equity mutual funds. We expect a

30
legal12 and governance'<sup>3</sup> variables. Other variables include dummies<sup>forfinancialcrises</sup> (Caprio and Klingebiel 1999), likely to have a negative effect on<sup>mutualfundgrowth and</sup> indicators of financial system development and structure<sup>(Becketal2000),especially</sup> distinguishing between market-based and bank-based financial<sup>systems.Ofparticular</sup> relevance are restrictions on the payment of interest on checking<sup>accountsandother</sup> short-term bank deposits, which would tend to stimulate directly<sup>thedevelopmentof</sup> money market mutual funds and indirectly other types of mutual funds.

Cross-country panel estimations were used to help determine whether<sup>economic</sup> and financial variables play significant roles in the development<sup>of themutualfund</sup> industry. Several alternative model specifications were<sup>triedinordertotestthe</sup> robustness of different variables. All regressions were estimated<sup>usingrandomand fixed</sup> effects models. The fixed effects model included country dummies<sup>inadditiontoother</sup> independent variables discussed in previous sections. The<sup>modelhelpedtocontrolfor</sup> omitted variables assuming they remained constant over the<sup>estimationperiod.In</sup> addition, fixed effect modeling might control for differences<sup>inmutualfundindustry</sup> definitions used across countries. We used first lags of all variables<sup>to correctfor the</sup> possibility of reverse causality.

The regression results are summarized in the tables in the Annex.<sup>Forthe</sup> regressions covering all mutual funds in all countries we find a<sup>strongcorrelationwith</sup> capital market development (both value of traded equities and<sup>bond market development</sup> are highly significant), while the accountability index<sup>andrestrictionsonthe</sup> remuneration of retail deposits also have a positive impact. Although<sup>they havetheright</sup> sign, the level of real interest rates and equity market returns<sup>areinsignificant. The</sup> volatility of equity market returns and financial system crises<sup>haveanegativeand</sup> significant impact as expected. In contrast, per capita income<sup>andopennesstotrade have</sup> positive correlation between this variable and the growth of mutual funds,<sup>especially</sup> in<sup>high-income</sup> countries.

> 12 Common law countries tend to have more transparent and more reliable<sup>accounting systems and to</sup> provide stronger protection of the rights of outside investors<sup>(Dermiguc-Kuntand Levine1999,Beck et al</sup> 2001). They are associated with better-developed capital markets.<sup>Legalorigin is expectedto havea</sup> positive effect on the,growth of mutual funds.

Two governance indicators from Kaufman et al (1999) are used:<sup>Voice and Accountability;and</sup> Regulatory Burden. They measure the consistency and accountability<sup>of governmentpolicy, including the</sup> 31
the wrong sign. Mutual funds are more<sup>advancedin market-basedsystemsbut,probably</sup> because of the large presence of bond funds<sup>in many countries,theyare more developed</sup> in civil law countries.

There are some interesting differences in<sup>theresultsbetweenhigh- andmiddle-</sup> income countries. In the former, openness<sup>to trade becomespositiveand significant,but</sup> systemic crises become less relevant, reflecting<sup>the relativeabsence of such crises in high</sup> income countries. In the latter, per<sup>capitaincomeandbankingsystem development</sup> become significant with right sign,<sup>but opennessto tradehas the wrong sign andsystemic</sup> crises are weakly significant.

Looking at equity funds, the main difference<sup>in resultsisthesignificanceof</sup> common law origin. This is true for<sup>theregressionscoveringallthecountriesin the</sup> sample as well as the sample of high-income<sup>countries.Restrictionson retaildepositsare</sup> insignificant, implying that any impact<sup>they mayhaveon equitymutualfunds wouldat</sup> most be indirect.

The empirical results suggest civil law countries<sup>and countrieswith restrictionson</sup> the remuneration of retail deposits have<sup>moredevelopedbondmutualfunds.Restrictions</sup> on retail deposits have a strong explanatory<sup>powerin thecaseof money marketmutual</sup> funds, especially in high-income countries.<sup>Theyhaveprobablyactedasacatalystfor</sup> bond and money market mutual fund<sup>developmentin severalcountries.</sup> existence of independent media to monitor<sup>the performanceof regulatoryagencies, and theimpact of</sup> regulatory policies.

32
# IV. **Broader Policy. Issues**

Most of the vast literature on mutual funds focuses on microeconomic issues, such as the investment performance of mutual funds and their ability to beat or equal the market, the level of expenses and fees and the role of distribution networks, the existence of economies of scale and scope and their impact on competition and contestability. Less attention has been paid to two questions of broader macroeconomic relevance: do mutual funds promote greater financial stability; and do they contribute to a more efficient allocation and utilization of economic resources? Also little attention has been paid to the question of whether independent, autonomous mutual funds can operate efficiently in developing countries with small financial systems.

As regards questions of microeconomic efficiency, the prevailing view is that in countries where securities markets are well established, mutual funds underperform the market, especially when fees are taken into account. The standard advice for investors is to invest in low expense index funds (Malkiel 1995, Bogle 1994 and 1999).

The relationship between mutual fund expenses and performance is reasonably well established. Funds that heavily underperform have very high expense ratios, while funds that are successful do not increase revenues by raising their fees but benefit from the increased size of their funds (Elton et al 1996, Carhart 1997), suggesting feedback trading and winner-riding strategies by investors (Patel et al 1994). Actively managed equity funds charge higher fees than index tracking funds or bond and money market funds, reflecting the higher costs of employing investment management staff to achieve' diversification and strategy (James et al 1999).

Fund governance plays a role in fee-setting policies since funds tend to charge lower fees when they have smaller boards and a larger proportion of independent directors (Tufano and Sevick 1997). Larger and more mature funds as well as no-load funds have lower expense ratios (Malhotra and McLeod 1997), while there is positive interaction between high performance and marketing effort and thus between performance and fees (Sirri and Tufano 1997.) 33
Fund fees are related to asset allocation strategies. Aggressive<sup>growth fundstend</sup> to charge higher entry and exit fees to discourage redemptions because<sup>they hold more of</sup> the smaller, less liquid stocks (Chordia 1996). Mutual funds and<sup>especiallyfund</sup> complexes benefit from scale and scope economies, emanating from<sup>activitiesthathave</sup> large overheads, such as record keeping, communication and marketing,<sup>althoughadverse</sup> price impact and managerial diseconomies of scale place a limit on the<sup>efficientsizeof</sup> funds (Baumol et al 1990, Sirri and Tufano 1993, Collins and Mack 1997,<sup>Jameset al</sup> 1999).

However, despite the basic academic advice offered to investors<sup>topreferlow</sup> expense index funds, actively managed funds continue to be popular (Gruber<sup>1996).In</sup> fact, index tracking funds represent less than 10 percent of total mutual<sup>fundassets.The</sup> popularity of actively managed funds is linked to the marketing and distribution<sup>efforts of</sup> large complexes and to the lack of sophistication of large groups of investors.

These studies have substantially different implications for mutual<sup>funds in</sup> developing countries (or, more generally, in countries with less well developed<sup>securities</sup> markets). Mutual funds in such countries are unlikely to enjoy<sup>thesameeconomiesof</sup> scale and risk diversification as mutual funds in large<sup>countries.Moreover,less liquid</sup> markets provide opportunities to mutual fund managers to outperform<sup>themarketindex,</sup> limiting the scope for index tracking funds.

Operating costs and expense ratios are much higher in developing<sup>countries.In</sup> Chile, in the 1990s they amounted to 6 percent for equity funds and 2 percent<sup>for bond</sup> funds plus entry and exit fees (Maturana and Walker 1999).<sup>Similarfee levelsapplyin</sup> most Latin American countries, although they tend to be significantly<sup>lowerinother</sup> developing and transition countries.

Recent trends in European Union countries suggest<sup>thatmutualfundsin</sup> developing countries would have better prospects if they became more<sup>closelyintegrated</sup> with international markets and effectively formed part of large<sup>globalcomplexesthat</sup> operate on a "hub and spokes" pattern. A study of the presence of<sup>mutual fundsin</sup> developing countries would then shift from its primary concern with the supply<sup>sideand</sup> growth of domestic institutions to focus instead on the presence<sup>and roleof international</sup> 34
mutual fund complexes in the local market and the efficiency and cost of offering mutual fund services to local investors.

The question of the implications of mutual funds for financial stability arises in two guises. The first is whether mutual funds are susceptible to a run by shareholders. similar to the depositor runs suffered by banks. The second is whether a mutual fund crisis can spread to other financial institutions and develop into a generalized financial crisis. Because mutual funds operate on a more transparent basis than banks and insurance companies and are not required to redeem their shares or units at par value, they are less likely to experience shareholder runs. Since investors bear the investment risk and suffer losses from falling prices, they are less likely to start selling in an indiscriminate way, sending prices in a descending spiral. Such panicky reaction may develop when investors lose all confidence in market integrity bur even then indiscriminate selling would not help. What is likely to happen if market prices were to collapse is that investors might shy away from making new investments in mutual funds for a prolonged period. Since market collapses usually happen in the aftermath of unsustainable bubbles and widespread incidents of fraud and mismanagement, the risk of investor abstention cannot be dismissed.

Some studies purport to show that individual investors react to incoming news and other factors in a manner similar to that of professional investors (Engen and Lehnert 2000). These studies appear to confuse the typical inertia of individual investors, that is often linked to inadequate or delayed access to critical information and a slow reaction pattern, with measured response on the basis of a sophisticated assessment of future prospects (which is what professional investors are supposed to be doing). Given the well documented lack of sophistication of individual investors, the claims of these studies are not very flattering for the professional investors. Nevertheless, the inertia of mutual fund investors and their assumption of the investment risk suggest that mutual funds would be less prone to contagion and systemic crises than banks.

The implications of mutual funds for macroeconomic efficiency are even more difficult to assess. The recent high technology bubble does not provide a promising precedent. Mutual funds (and other institutional investors) can act as a countervailing 35
force to the dominant position held by oligopolistic banks in the financial systems of most countries around the world, compelling them to be more efficient, competitive, innovative and responsive to the needs of their customers. A large presence of mutual funds may contribute to greater reliance on market scrutiny of projects and firms by financial analysts, rating agencies, accounting and auditing firms.

However, these potential benefits are less likely to materialize if the asset managers of the funds mobilized by institutional investors belong to financial conglomerates owned by banking groups. They are also less likely to materialize if securities markets suffer from the pervasive conflicts of interest, widespread market manipulation, extensive fraud, accounting and auditing scandals, infectious greed and irrational exuberance that have afflicted the US markets for most of the 1 990s. As most commentators have argued in the aftermath of corporate scandals that have bedeviled the US and other international markets, there has been a wholesale failure by all types of agents. Directors, bankers, analysts, accountants, auditors, actuaries, custodians, compliance officers, journalists and, above all, the regulators and politicians (who enacted many of the laws that have enabled the organized corporate fraud) have all failed to protect the interests of principals, who are the individual investors in companies, banks, insurance companies, pension funds and mutual funds.

Thus, the question of whether mutual funds may contribute to a more efficient allocation and utilization of economic resources remains open. The answer will depend on whether an effective system of corporate governance can be established that will adequately protect the interests of small investors. One related, and equally unanswered question, is whether passive fund management and reliance on index tracking funds, which are favored by academic observers, are compatible with effective corporate governance and market efficiency.

A final issue concerns the desirability of transferring the investment risk to households. This issue is more pronounced in the case of retirement assets since retiring workers have a lower tolerance for risk than younger people, but it applies more generally to the household sector as a whole. Financial institutions should have the required specialist knowledge to offer individual investors products that are protected 36
from the vicissitudes of market returns and the vagaries of<sup>inflationwhile allowing some</sup> participation in the higher returns promised by equities.<sup>The offer of "protected"</sup> investments that are based on a judicious use of derivative<sup>markets isrisingin many</sup> countries. However, a fundamental question remains to<sup>beaddressed.This relates to the</sup> regulation and supervision that should be applied to<sup>institutionsoffering protected</sup> investments in order to ensure that they will be able to<sup>honor their undertakings.Finding</sup> a workable answer to this question will be a major challenge<sup>for financialinstitutions and</sup> regulators in the years to come.

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