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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 Henri Servaes Peter Tufano
The Darden School London Business School Harvard Business School
University of Virginia and CEPR and NBER
P.O. Box 6550 Regent’s Park Soldiers Field
Charlottesville, VA 22906 London NW1 4SA Boston, MA 02163
KhoranaA@ hservaes@london.edu ptufano@hbs.edu
darden.virginia.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
fourth section of the paper reports our findings and the fifth section offers conclusions. An Appendix
contains a detailed description of the variables employed and the associated data sources.
I. Mutual Funds, UCITS and Collective Investment Schemes
In the U.S., the mutual fund “industry” is defined largely by regulation, in particular by the
Investment Company Act of 1940 (the ’40 Act). The ’40 Act, as interpreted over the years, empowers the
SEC to oversee a variety of “investment companies,” which include “mutual funds, closed-end funds,
Unit Investment Trusts, Exchange Traded Funds, and interval funds,” as well as variable insurance
products, federally registered investment advisers, and public utility holding companies.
4
The Act
functionally defines the set of investment companies overseen by the SEC. Interestingly, the popular
term “mutual fund” is neither defined nor used in the Act. While all of these investment companies are
vehicles to pool savers’ assets, they differ along various dimensions. American “mutual funds” are
management companies that (1) invest in diversified portfolios of assets; (2) are “open-end” in that they
will redeem their shares at net asset value (NAV) at any time upon shareholder request.
5
In other countries, different names and definitions are used for similar businesses. The European
Union, in an attempt to create a “harmonized” fund industry has adopted a common definition of
“Undertakings for Collective Investment in Transferable Securities” or UCITS.
6
Mirroring the U.S.
definition of mutual funds above, UCITS are defined as undertakings that (1) are collective investments in
transferable securities for the purpose of risk-sharing, and (2) are repurchased out of the assets of the fund
at net asset value.
Across the world, organizations have identified an analogue to mutual funds or UCITS, called
“collective investment schemes” or CIS. For example, the International Organization of Securities
4
SEC, Division of Investment Management Web Site, http://www.sec.gov/divisions/investment.shtml.
5
A “management company” is a catch-all phrase used in the Act to designate all investment companies other than
specifically defined ones. For a further discussion, see the Investment Company Institute (industry association for
the fund industry) http://www.ici.org/aboutfunds/organization_operation.html.
6
For the full text of the first of many directives about UCITS, see
4
Commissions (IOSCO) defines a CIS as “an open end collective investment scheme that issues
redeemable units and invests primarily in transferable securities or money market instruments.”
7
Thus, mutual funds, while going by a variety of names, are fairly comparable around the globe.
8
In
this paper, we contrast mutual funds with other ways in which households might save and invest in
financial assets, which we characterize broadly as “do-it-yourself (DIY)” and “opaque financial
intermediaries.” Whereas a mutual fund is defined as a pooled diversified investment vehicle, “do-it-
yourself” investments are direct investments by households in primary securities (bonds, stocks or cash).
Whereas open-end mutual funds are defined world-wide in terms of their transparency in the form of their
redemption at net asset value of their underlying assets, “opaque financial investments” include pension,
insurance and banking products that invest in portfolios of assets which are not readily identifiable, and
where there is not always a direct contractual link between the value of their assets and claims by
investors. While we recognize that our categorization is imperfect, it captures three different modes of
household investing behavior. Our objective is to understand when the mutual fund model succeeds in
attracting assets relative to these other modes.
Our analysis takes the country as a unit of observation. As is perhaps not a surprise, determining the
“nationality” of a fund is complicated. A fund may be identified with many different countries. It may be
legally domiciled (registered) in one country, invest in securities of a second country, and be sold to
citizens of a third country. The first two geographical identities are fairly easy to ascertain, while for
many funds, the third is not. For this paper, we will identify funds’ nationalities by their legal domicile,
which determines the relevant regulation and the legal system. For many countries, such as the U.S., this
will also determine the nationality of its investors. In these instances, our country categorization also
captures the nature of competition among potential rivals and savings patterns of potential investors.
http://www.europefesco.org/DOCUMENTS/DIRECTIVES/Dir-85-611.PDF. As one might imagine, there has been
on-going refinement of the notion of UCITS, including new discussions of what assets may be held and what types
of investment companies can manage them.
7
International Organization of Securities Commissions, Report on Investment Management, 1994. Available on-
line at http://www.iosco.org/iosco.html.
8
This is not to say that a fund in the U.S. is identical to a fund in Luxembourg or Germany. There are substantial
differences in terms of marketing, regulation and other characteristics which we discuss below.
5
However in a few instances notably Luxembourg are Ireland the link between domicile and investors
is more tenuous.
II. Sample Construction and Primer on the World Fund Industry
A. Data
We begin our sample construction with a list of the top 75 countries in the world based on GDP at the
end of 2001.
9
This list is matched with countries identified as having a fund industry in publications of
either the Investment Company Institute (ICI) or Fédération Européenne des Fonds et Sociétés
d'Investissement (FEFSI).
10
The asset size for the countries not listed in the ICI and FEFSI data sources
is gathered through web-based sources and discussions with industry experts. We are able to obtain a
sample of 55 countries with data on the relative size of the fund industry, measured as a fraction of the
universe of primary securities at or close to the end of 2001. This sample includes five countries with no
mutual fund industry. Unless we could obtain definitive evidence for a country, we did not assume the
lack of a fund industry and instead chose to classify the country as having missing data.
Mutual funds hold assets that are claims against companies and governments. We seek to compare the
funds’ investments with the universe of these claims, which we call “primary securities.” For
governments, these claims include sovereign debt. For corporations, these claims include equity,
corporate bonds, and commercial loans. Therefore, we gather data on the size of the equity, bond, and
bank loan market to calculate the size of the primary securities market for each country.
11
In addition, we
gather data on (1) local laws, taxes, and regulation, (2) the structure of the financial sector (supply-side),
(3) characteristics of the retail investing public (demand-side), and (4) the trading costs and turnover of
equity markets. While we attempt to gather as many proxies as possible for the country characteristics,
9
While time-series data on industry size are available, we restrict ourselves to a cross-sectional analysis using data
as of 2001 for two reasons. First, the inclusion of time-series data would substantially restrict the number of
countries for which we have data available on industry size and for the explanatory variables. Second, there is little
or no time series variation in many of the explanatory variables we employ.
10
FEFSI is an association of the mutual fund industry of the member states of the EU, the Czech Republic, Hungary,
Norway, Poland, and Switzerland.
6
the lack of consistency in the set of countries included in various data sources and surveys reduces the
number of data points we can employ in our specifications, especially in the multivariate analyses. The
Appendix lists and describes the explanatory variables employed in this study along with the source of the
data. Whenever possible, we use data from international sources which are comparable across countries
(e.g., World Bank, IMF, United Nations, OECD, IOSCO), but in some cases resort to country-by-country
data collection.
In section III, we discuss the hypotheses and the proxies used in greater detail, but we first turn to a
description of the size of the fund industry across the world.
B. Description of the World Fund Industry
Table I provides a description of the size of the mutual fund industry across the world at the end of
2001. At that time, the worldwide mutual fund industry held $11.7 trillion in assets. The countries with
the largest fraction of the industry (not reported in the table) were the U.S. (60 percent), Luxembourg (6.5
percent), France (6.1 percent), Italy (3.1 percent) and Japan (2.9 percent). The countries at the other end
of the spectrum included Bangladesh, Romania, and Sri Lanka. In addition, we identified five countries
with no fund sector Algeria, Burma, Libya, United Arab Emirates, and Yugoslavia (Serbia and
Montenegro).
We measure the assets under management (AUM) for each country relative to (i) the size of primary
securities as measured by the sum of the equity market and bond market capitalization and bank loans, (ii)
its GDP, and (iii) its population. Median assets under management as a function of the country’s GDP
are 8.8 percent with a high of 3991 percent for Luxembourg, followed by Ireland with 186 percent and a
low of 0.011 percent for Bangladesh (after excluding the countries with zero mutual fund assets). When
we measure assets under management relative to the universe of primary securities, the fund industry
holds 4.3 percent of all primary securities in the median country, with Luxembourg once again at the high
11
Our measure excludes privately-placed debt issued by corporations. Bank deposits are included implicitly since
they are employed to finance bank loans and security purchases.
7
end with 484 percent, followed by Ireland with 82 percent. Finally, average mutual fund assets per capita
are $32,439, with a median of $585.
Given the dramatic size of the mutual fund industry in Luxembourg and Ireland by any measure,
additional discussion is warranted to explain this phenomenon. Favorable banking and tax laws have led
to a transformation of Luxembourg into a major center for offshore mutual funds. This growth was partly
fueled in 1992 when the German government decided to levy a 25 percent withholding tax on interest on
investment assets and bank deposits. This led to a movement of capital to Luxembourg-based fund
management subsidiaries of German banks. The benefit of Luxembourg as a tax haven has been further
accentuated by the presence of stringent bank secrecy laws, which are among the toughest in Europe. The
success of Ireland on the other hand, has been driven by the establishment of an International Financial
Services Center (IFSC) in Dublin which provided important incentives to fund operators in the form of a
reduced tax of 10 percent on income earned for specific types of servicing and financing operations. In
addition, they get a double tax deduction for rents. Finally, the harmonization of regulations permitting
funds to be sold throughout Europe facilitated the growth of these centralized hubs.
The $11.7 trillion of world fund assets are held in 55,004 open-end funds, with a median number of
288 funds per country. The U.S., which has the largest fund industry in terms of the share of assets held,
is also the largest in terms of the number of available mutual funds (8,307 funds at the end of 2001).
France and Korea are second and third with 7,144 and 7,117 funds respectively. It is intriguing to note
that there are over 55,000 different “products” in this industry a staggering number compared to almost
any other industry.
We also measure the size of the mutual fund industry across various asset classes. The total size of the
equity mutual fund industry (including balanced funds) is similar to that of the bond industry (including
money market funds). At the end of 2001, equity and bond fund assets stood at $5,783 billion and $5,340
billion respectively with median country assets of $9.3 billion and $12.9 billion across the two asset
classes.
8
[...]... Occasional Paper, No 1 World Bank, 2003, World development indicators database 28 Table I Size of the Mutual Fund Industry around the World at the end of 2001 This table reports the total, mean, median, standard deviation, sample size, and the high and low values of various measures of the size of the mutual fund industry (referred to as Assets under management (AUM)) around the world The assets under management... consists of 55 countries with total mutual fund assets of $11.7 trillion at the end of 2001, held in over 55,000 funds For the median country, the industry comprises 8.8% of GDP and 4.3% of all primary securities However, there is substantial cross-country variation in the development of the fund industry Luxembourg and Ireland are the countries with the largest industry relative to the size of the economy... phenomena, and therefore the size could partially be a function of the age of the industry However, it is difficult to date the age of the industry across the countries in our sample 20 In the specifications reported throughout the paper, we employ the level of per capita GDP and education as explanatory variables Using the logarithm of both variables instead does not affect the results 15 of the fund in... Explaining the Size of the Mutual Fund Industry Across Countries This table reports multivariate OLS regressions explaining the relative size of the mutual fund industry The dependent variable is the size of the mutual fund sector as a fraction of the primary securities (equities, bonds, and bank loans) in each country at the end of 2001 Luxembourg and Ireland are excluded from the analysis The figures... Explaining the Size of the Equity Fund Sector Across Countries This table reports multivariate OLS regressions explaining the relative size of the equity mutual fund industry The dependent variable is the size of the equity mutual fund sector (including balanced funds) as a fraction of the equity market capitalization in each country at the end of 2001 Luxembourg and Ireland are excluded from the analysis The. .. banking industry In the U.S., mutual fund growth (especially the growth of money market funds) came at the expense of the banking sector, whereas in Europe (outside of the U.K.), banks have been the primary promoters and distributors of funds This evidence suggests that it is ambiguous whether a strong or concentrated banking sector would inhibit the growth of the fund industry or whether banks would... proxies for studying the size of the equity mutual fund sector As illustrated in Panel D of Table II, institutional trading costs in the median country are 31 basis points, while the median share turnover is 60% per annum E Correlations and Caveats Before turning to the analysis of the determinants of the development of the fund sector, we study the correlation structure across the independent variables... relative size of the mutual fund industry across countries The dependent variable is the size of the mutual fund sector as a fraction of the primary securities (equities, bonds, and bank loans) in each country Separate regression results for equity funds (including balanced) and bond funds (including money market funds) are also reported Industry size is measured at the end of 2001 nm indicates that the analysis... presenting the coefficients of univariate regressions of our measure of fund size (assets under management in the mutual fund industry as a fraction of the universe of primary securities in the nation) on the explanatory variables discussed previously These results are displayed in Table III We report findings for the entire industry as well as for equity and bond funds separately In the analysis, balanced funds. .. offer mutual funds Our measure of restrictiveness, which is based on Barth, Caprior, and Levin (2001), ranges from 1 (least restrictive) to 4 (most restrictive) The median in our sample is 2 Since a number of countries use the banking sector to distribute mutual funds, the presence of a deposit insurance system for the banking sector could also affect the size of the fund industry On the one hand, the . description of the size of the fund industry across the world. B. Description of the World Fund Industry Table I provides a description of the size of the mutual fund industry across the world at the. number of 288 funds per country. The U.S., which has the largest fund industry in terms of the share of assets held, is also the largest in terms of the number of available mutual funds (8,307 funds. 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
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