Funds Flow and Performance of Managed Funds in Pakistan

The main purpose of this study is to examine the mutual fund industry of Pakistan, to examine the assets allocation pattern of mutual funds, how efficiently they are allocated into various assets categories and how investors base their future investment decisions either on past performance or on the basis of risk, size of fund, and availability of alternative investments. On the basis of results it is noted that on average small and medium investors prefer investments in less risky assets and base their future investment decisions on the basis of past performance whereas big corporate investors calculate risk and make their investment decisions after complete analysis. This study uses panel regression model to test the relationship between past performance and excess returns. The results indicate that fund managers use past performance of a fund as marketing tool to attract investors to invest in a fund which are performing well in recent past. These findings are of immense importance for policy makers as well, to formulate policies which are beneficial for investors and do not allow fund managers to get advantage from investors.

funds flow of US equity mutual funds, the study concluded that consumers base their investment decisions on prior performance information, but do so asymmetrically, investing disproportionately more in funds that performed very well in prior period.
A study on Cognitive dissonance and mutual fund investment reveals that the investors are biased towards some funds, without any regard to their past performance; they are significant only at top quartile of the fund performance, Goetzmann and Peles (1996). Lynch and Musto (2003) documented that investors interpret past performance consistent with fund incentives, and discard those funds which underperform consistently. The model developed by Lynch and Musto (2003) reveals that change of strategy by fund managers only take place after consistently bad performance of the fund, and hence it is noted that past performance may not reveal future performance of the fund. Sawicki (2003) finds a positive relationship between past performance and funds flow, but not the convexity observed in the US funds market.
Performance persistence on Australian managed retails funds was tested by Bilson et al. (2005), it was tested by using five different matrices and they find that the inadequate adjustment of risk may cause spurious persistence in excess fund returns.
The other major aspect of mutual funds is the investor's behavior towards their investment decisions. Behavioral studies on Mutual fund investors Del Guerico and Tkac (2002) reveal that the behavior of investors is significantly different between the US mutual funds and pension funds investors. Pension fund clients move their money away from poorly performing funds and do no flock disproportionately towards winners. They use various risk measurement tools like Jensen's alpha, and tracking error to evaluate performance of the funds. Whereas a mutual fund investor is inclined towards recent winners and avoiding the risk adjusted performance measures. Ranganathan, studied the behavior of individual investors towards mutual funds, and the study was an attempt to understand the financial behavior of managed funds investors in connection with scheme preference and selection.
A study on ability of mutual funds investors by Lu Zheng (1998) discussed that investors base their investment decision on the basis of short term performance of a fund during a period and make future investment decisions on the basis of fund specific information rather than evaluating the overall funds performance. Prospect theory has been originally defined by Kahneman and Tversky (1979), which defines that investors are very much depressed by the losses they face and are equivalently happy with the prospective gains on their investments. Economists have researched over this fact that investors considers the loss of $1 as twice as painful as the pleasure of $1 gain received on their investments. Different investors have different prospects on their gains and losses some are persistent with the fund that is if a fund is continuously performing bad they stick to it while some move to other good performing funds. Kahneman and tversky gave an example on this scenario about prospects of different investors, they presented groups of subjects with a number of problems, and one of the groups was presented with the following problem: 1. In addition to what you own, you have been given $1000. You are now asked to choose between a.
A sure gain of $500 b.
A 50% chance to gain $1,000 and a 50% chance to gain nothing Another group of subjects were presented with another problem.
2. In addition to whatever you own, you have been given $2000. You are now asked to choose between: a. A sure loss of $500 b.
A 50% chance to lose $1,000 and 50% chance to lose nothing The results were that from the first group 84% of the respondents selected A, while from second group 69% selected B.
the two problems were same in terms of net cash, however the phrasing of the question was different and interpreted differently by the respondents. Therefore it is concluded that the investors are always look forward to have gain on their investments rather the term loss is discouraging for them. Bailey et al. (2011) has studied the behavioral aspects of the US mutual funds investors, the study majorly is concerned with the two behavioral biases first being the disposition effect and narrow framing -it is evident that behavioral biased investors are poor in decision making about expenses, trading frequency and time.
The choice of investment vehicles by different groups of investors in Australian retirement funds is investigated by Speelman et al. (2007). Their results provide an interesting insight into the gender differences in investment choices.
Female investors are more risk averse than male investors and young female investors exhibit the highest level of risk Lyunch and Muso (1997) in their study concluded that the past and future performance is negatively related to fund manager's style of investment, whereas Sirri and Tufano (1998) studied the investor's behavior towards investing in a managed fund is akin to purchasing an automobile. Marketing plays an important role to highlight the performance of funds that are performing outstanding on the contrary poor performing funds are rarely brought to light and therefore are less performance sensitive. Goetzman and Peles (1997) studied the psychological perspective of investors' investing behavior although they acknowledge that economic costs may actually be causing mutual funds investors' inertia to spend in a particular fund. Huhmann and Bhattacharyya (2005) has worked on content analysis on advertisements of Mutual funds they studied the investors behavior on the basis of advertisement. Research demonstrates that mutual funds publicize to expand discernments of value, triumph, and respectability frequently without furnishing the data that is an investor's necessity to settle on optimal investment choices. While Gupta and Jithendranathan (2012) studied the Australian Managed funds and identified that fund managers often use past performance to advertise performance of their funds. This is an important point to note for policy makers as many fund managers use their funds past performance to attract small investors.
Another study by Chen et al (2004), on fund size erode mutual fund performance, they concluded that fund size does not erode performance but liquidity of a fund and its organizational diseconomies erode the performance of a mutual fund. Capon et al (1996), investigated the manner in which consumers make their investment decisions, they reported that investors considers many non performance attributes while making their investment decisions. When they are grouped by similarity of investment decision process, a single small group appears to be highly knowledgeable about its investments.
However, most investors appear to be naive, having little knowledge of the investment strategies or financial details of their investments. The illustration below represents a summarized view of literature available on the funds flow and performance of managed funds, the performance of a fund depends on certain factors including, risk analysis, type of fund, nature of fund, comparison with benchmarks and the personal attributes and fund managers style of management in a fund all support its performance. Performance persistence of a fund is another key attribute that allows a fund to perform without having survivorship bias, low management fee and high momentum for the fund to perform under critical circumstances.
Individual or retail fund investors are risk averse and prefer stable returns over wholesale investors who invest in risky assets to get higher returns on their investments. All attributes revolve around fund managers investment style, either they may make smart decisions and increase returns for investors or spoil the investment and earn low returns on even less risky assets. There is clear evidence from existing literature that investors base their investment decisions on past performance of the fund, although the fund manager is not performing well but market conditions are good and the fund is performing well then the investor will most probably invest in a fund that has good market value and is performing good in past as well.
A study on performance persistence, measuring short term performance persistence on mutual funds industry of India, Jhanwar and Sehgal (2007) examined there is no persistence found on monthly data of mutual funds, while every day information, they studied that for funds plans sorted on former period four-component unusual returns, the victors portfolio does give terrible anomalous returns of 10% per annum on post-development groundwork. Therefore observational discoveries are steady with the effective business sector theory and have suggestions for mutual funds and other oversaw portfolios depending on creative financing styles, including the "funds of fund" exchanging systems that certainly expect transient industriousness. Lynch and Musto (2003) in their study has focused on the fund managers performance which is at the core of investment, the investors invest in a mutual fund as they have less information about market trends it is fund managers who are market players and study the market trends they play tactics in investing funds in open market and generate returns for their customers. If a fund is performing continuously bad then question mark is on the performance of fund manager. Therefore our model also predicts that the relationship between fund performance with its persistence and funds flow mainly depends on the performance of fund managers which are the key players in the market.
Following Diagram is the snapshot of Studies on Performance of Mutual funds categorized by key attributes:  Table I and category description are presented in Table II Table III presents the complete funds profile with average returns, maximum and minimum returns for the period of the study. Size of the fund is measured using Net Assets during a quarter; data has been taken from MUFAP official website, NCF is the net funds flow for the ith fund for the quarter t.
For regression analysis a panel data will be created for each individual investment category. To avoid the survivorship bias, funds that were terminated or transferred are included in the dataset, provided each fund had at least 14 continuous quarterly data points. One of the likely issues that may arise in the analysis is the sudden increase or decrease in net flows during a quarter. To address this issue, those outliers in the net flows the data for a quarter where the net flows is greater than 0.75 of the funds under management at the beginning of the quarter, will be dropped from subsequent analysis.

Empirical Methodology:
Investment in mutual fund involves two steps -first to identify which asset category to be selected for investment and then select a fund type within an asset category. Some investors are risk averse while others are risk takers; the decision of investment into a particular fund type depends on the risk preference of the investors. Small and medium investors have low preference for risk they invest in stable funds with constant returns, while wholesale investors have more capacity to tolerate risk, Gupta and Jithendranathan (2012). Fund managers uses their past performance as advertisement tool for future investments, if a fund is performing well in past they advertise to investors and gain their confidence, ultimately resulting in investment by investors in that particular fund type, resulting in more investment into high performing funds and withdraw their investments from low performing funds.
Returns are the most common measurement tool for investment by investors in a fund, a benchmark is used for comparing the returns however, Sensoy (2009)  An alternate significant pointer of fund performance is its size, Chen et al. (2004) show that the performance of the funds diminishes with size and to control for the size impact we will utilize the lagged log size of the fund as a control variable.
To modify for the momentum impact of net funds, the lagged worth of the net funds is incorporated as an autonomous variable. A panel data for each of the asset categories is created using the available quarterly data for the funds and the fixed effects regression will be conducted using the following equation: NCFi,t is the log value of net cash flow of the fund, ri,t-1 is the excess return on investment measured by quarter to corresponding quarter change in returns, sigma is the tracking error (Standard deviation), Sizei,t is the log value of fund size, NSS rate is the national Saving scheme rate an alternative to the mutual fund investment which gives risk free return, and FE is the fixed effect of ith fund.

DATA ANALYSIS:
This section of the report covers the analysis of the results. Table II presents descriptive statistics (fund category wise) based upon quarterly data. According to the results on average the highest return yielding fund is fund of funds with mean return of 11.29% and standard deviation 1.066, the lowest return yielding fund is Islamic capital protected fund -8.43% and its standard deviation is 0.2495. Whereas balanced fund is high on risk 0.0405 and its volatility is 0.0732, while Islamic income fund is low on risk 0.00093 and deviation from mean is 0.0019. However pension funds and Islamic Pension funds are big in size while low on risk and return, net cash flows inward and outward movement of cash is high in pension and Islamic pension fund. On average mutual funds have volatile returns and risk factor is also not high except of balanced fund. Coming towards the control variable of National Saving Scheme rate it is evident that during the period of study the highest yield on this form of investment is 11.95% and the lowest is 11.429%, simultaneously it is less risky and the volatility in the market rates is very rare as the government announces saving rates in every quarter. The skewness and kurtosis (see Appendix) shows that the data is rightly skewed. Value of Kurtosis is greater than 3, in four variables and less than 3 for two variables which indicates that leptokurtic distribution of data exists with sharper than normal distribution with values concentrated around mean and thicker tails. 10% return on average. The pattern also predicts that the Islamic funds perform better as compare to conventional funds, as Islamic funds involve less risky assets and give investors stable returns, high volatility is not witnessed in Islamic funds.
Other major finding of assets allocation pattern is that in close end funds all fund perform good and have high returns Equity fund 13%, Income fund 11% and balanced fund 6%.
In comparison with open end and close end funds pension funds are also growing with an extraordinary pace, its growth is almost 54%, the objective of pension fund is to provide steady returns with a moderate risk for investors by investing in a portfolio of equity, debt, and money market instruments. Pension Funds are means for individuals to save for their retirement encompassing a broad array of savings plan from social security to individual contribution defined or benefit defined company plans. The awareness of investing in pension fund is growing among pension holders which earlier were not well informed, but now as the advertisement of various AMCs are increasing the pension holders are getting knowledge about investment into moderate risky assets and channelizing their savings in a proper way.

Correlation Matrix
Correlation matrix in Table IV presents the correlation among dependent and independent variables of 21 fund categories, the correlation between net flow and return is 9.79%, for net assets and net flows it is 67.99% statistically significant at 1% level of significance, risk and net flows is 7.31% and funds flow and NSS rate is 9.52%. The correlation between size and return is 2.12% highly significant at 5% level of significance, correlation between risk and return is 6.52%, risk and size is 15.83%, NSS with return, size and risk is 3.06%, 5.00% and 8.52% respectively. Correlation matrix indicates that the chances of multicollinearity is very low as there is no clear pattern seen in the data as not a single variable has high collinearity with another variable, the results are statistically significant at 1% level of significance. The higher correlation does not indicate that there is sufficient evidence that there will be higher cointegration among the variables. Correlation matrix only shows the magnitude of relationship among variables whereas the coefficient of correlation shows the magnitude and direction of the relationship among variables. However from the correlation matrix it is evident that NSS rate has least relationship between the variables of funds flow and past performance, this is might be because NSS is a substitute for investments in mutual funds of those investors who prefer risk free investments and fixed returns on their investments. Standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1

Panel Regression Model Selection Criteria:
For selection of appropriate model first poolability test of Balgati (2005) was applied, the results are presented in Table V, suggests that Pooled regression model can be applied to data. Returns, size and NSS rate are significant at p<0.01, the value of rho is 0.24047 which is greater than 0 therefore fixed effect model can be applied, whereas the results of Hausman Specification test shown in Table VI; are also significant for pooled regression but the value of adjusted R square is 70.04% which is very high for panel data, therefore moving towards fixed effect it is noted that its results are also statistically significant and value of adjusted R square is 55.90% meaning that there is less probability of multicollinearity error in the data as compare to pooled results and the Hausman test favored to apply Fixed Effect model on the data.
Therefore for this study we may apply both pooled and fixed effect model, but the results of fixed effect are theoretically sound as compare to pooled regression model.

RESULTS:
An important result of this study is the statistically significant negative relationship between funds flow and size of fund, which is evident from the past studies as well, Chen et al. Similarly size of fund has negative relationship with funds flow of close ended funds and negative relationship with risk, as the investors of close ended funds are risk averse and the alternative investment like NSS have impact on their investments. High yield rates on NSS are detrimental to the close ended funds, since they are traded on exchange, any systematic risk cannot be ruled out for example if NSS rates raised, the equity market will face pressure as fixed avenue is now yielding more, once equity face pressure, anything listed on exchange such as closed end funds face some systematic risk.

Panel Regression model:
The The negative sign of coefficients of risk indicates that there exists negative relationship between net flows and returns. On average small investors are very much influenced by past performance of the funds rather than analyzing the variability of the returns by standard deviation of lagged excess returns 1 . Ratings of funds are another major proxy for investors to make their investment decisions either to invest in a particular fund or invest in another fund which yields higher return and have well past performance. A possible explanation can be found in the way investors choose their funds using fund ratings.
Unlike the developed countries mutual fund rating methodology, which until recently was completely based on quantitative assessment, while some rating agencies use mixture of qualitative and quantitative factors for assessment of a fund (Faff et al., 2007). Since risk is one of the quantitative variables, its relative weight within the Pakistani mutual fund rating system may be lower than in the developed countries.
Relationship between net flows and lagged net flows is insignificant for all funds while it is highly significant for aggressive income fund. Whereas for the overall panel regression model the magnitude of net flows and lagged net flows is highly significant with positive relationship, similar results are noted by Frino et al (2005), they stated that the relationship between past net flows and current quarter net flows is rather difficult to explain, however a possible explanation could be that this positive relationship is due to general growth in the particular asset class. Gruber (1996) explained such a relationship may have been due to the fact that investors are locked into a particular fund due to restricted choices allowed by their savings accounts and this restriction may also be associated with the effect of marketing and reputation of the fund.
The results of control variable NSS rate for this regression model are insignificant for individual funds except money market fund, but it is highly significant for overall panel regression model. It is due to the fact the individually funds are not affected by NSS rate but as a whole it affects the entire mutual funds industry and it is a potential alternative for channelizing savings and making effective investment decisions. While discussing the various aspects of panel regression model we should not overlook the fact the there are some differences between the investors and choice of their investment into a particular type of fund. For example, it is evident that the investors who chose equity, income and Islamic investments clearly increased the cash net flows to those funds that performed well, on contrary investors of other funds did not increase their investments based on past returns.

CONCLUSION:
Pakistan's mutual fund industry has grown tremendously over the last decade, the inclination towards savings and investment has led this industry to grow and excel. This paper is an attempt to study various segments of managed funds market in Pakistan, and to examine whether there are any significant differences in how assets are allocated into various assets categories. One aspect of this paper is to evaluate how investors base their investment decisions on the basis of inflows and outflows in funds. We have analyzed our data by categorizing the funds into two major categories; open ended fund and close ended fund, on the basis of this it is concluded that there is significant differences in asset allocation pattern and investment behavior of investors.
Investors base their future investments decisions primarily based upon past performance of the fund, this is evident in this study as well, however the investment pattern in scenario of Pakistan is such that major investments are in open ended fund and a few investors invest in close ended funds, therefore the inclination is majorly towards studying the investment patterns of open ended funds. Risk is the least significant variable of this study as small investors in Pakistan are not educated about the risk involved in their investments, they are only concerned about earning returns, however corporate investors carry out complete risk analysis before making the investments decisions for their company. Risk appetite of balanced fund is highest among all other funds reason being the investments in hybrid securities, Islamic income fund in Pakistan has the lowest risk involved in investment. It is clearly evident from the results that the Islamic funds are low on risk as compare to conventional funds, as Islamic Funds has grown tremendously over the past few years.
This study is of severe importance for policy makers to study an analyze the patterns of asset allocation in Pakistan mutual fund industry in order to erode the probability of misallocation of investments by uninformed investors, who play in the market to generate artificial hype and get advantage of increased prices, similarly like stock market's major players, who artificially create bullish trend in market and when the market collapse they are safe while the small investors have loss on their investments. This study is an important contribution in the mutual fund industry of Pakistan, which is still in its growth stage and there is ample potential in this industry. Lastly, our findings are of immense importance to policy makers as far as understanding investors' behavior and creating appropriate policies, particularly in light of those strategies pointed at furnishing investors without lifting a finger of moving their investments crosswise over various types of funds. Income A type of mutual fund that emphasizes current income, either on a monthly or quarterly basis, as opposed to capital appreciation.

Money Market
A money market fund's portfolio is comprised of short-term (less than one year) securities representing high-quality, liquid debt and monetary instruments. Investors can purchase shares of money market funds through mutual funds, brokerage firms and banks. Aggressive Income The investment objective of the portfolio is to provide an efficient investment medium whereby investors can participate in a portfolio that will seek to generate a high level of income, as well as the potential for capital growth.

Asset Allocation
A mutual fund that provides investors with a portfolio of a fixed or variable mix of the three main asset classes -stocks, bonds and cash equivalents -in a variety of securities. Balanced A fund that combines a stock component, a bond component and, sometimes, a money market component, in a single portfolio. Generally, they are called "Hybrid funds". Capital Protected A type of mutual fund that guarantees an investor at least the initial investment, plus any capital gains, if it is held for the contractual term. Commodity These funds are true commodity funds in that they have direct holdings in commodities. For example, a gold fund that holds gold bullion would be a true commodity fund.

Fund of Funds
A mutual fund that invests in other mutual funds. This method is sometimes known as "multi-management". Index Tracker An index fund that tracks a broad market index or a segment thereof. Such a fund invests in all, or a representative number, of the securities within the index.

Islamic Equity
Funds invested in shares in compliance with Shariah