project on mutual funds (2)

8/8/2019 Project on Mutual Funds (2)

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PROJECTOn

Rela t ionsh ip between Mutua l Funds , GDP ,GNP, Domest ic Sav ings and Net In f low o fFore ign Por t fo l io in Pak is tan dur ing the

per iod1997 1998 to 2006 2007

Superv ised By :S i r As i f Mehmood

Submi t ted By :Shu jaa t A l i 9051

MBA (F inance )

Depar tment o f Bus iness Admin is t ra t ionIQRA Un ivers i ty , Peshawar Campus

Sess ion 2007 2009

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CHAPTER 1

INTRODUCTION OF THE STUDY

1.1 INTRODUCTION

M utua l fu nds e njoy streng th b ec au se o f en ou gh a va ilab ility of

profess ional s, ab il ity to d ivers ify, the cons is tent market r esearch &

ana ly si s adopt ing t he mat ch ing concept o f R is k & r et ur n and l ar ge

liquidity. An average investor might not be well versed with the capital

market , or perceiving the same as more technical or t ime consuming in i ts

nature. Investment in Mutual Fund at USA is popular in the masses and

80 Million plus people are connected with the same.

I n a n e nv ir on me nt w he re i nv es to rs a nd s av er s l am en t th e la ck o f

inves tment options , f inancia l savings in the economy do not show an

encouraging growth pat tern, and a minimum rate of return on savings

deposits has been implemented by the central bank to encourage savings,

the exponential growth of mutual funds in recent years has served to meet

these very needs by mobilizing savings and providing lucrative investmentoptions to both retai l and ins ti tu tional investor s. The mutual funds

indus try, which s tar ted out in the 1960s with two s ta te owned funds ,

National Investment Trust (NIT) and Investment Corporation of Pakistan

( IC P) , i s n ow a t hr iv in g s eg me nt o f t he fi na nc ia l s ec to r, w ith a n

astonishing growth in both numbers and volumes, particularly since FY03.

As of endJune FY08, there were 95 mutual funds on offer , with total Net

Assets of Rs . 330 bi l l ion, in compar ison wi th Rs . 24.8 bi l l ion in FY02.

These mut ua l f unds a re managed by 39 l icensed ass et management

companies, equipped with the requisi te professional expert ise to manage

these funds.

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Since equi ty funds dominate the indus try, growth in NAV i s d irect ly

attr ibutable to the consistently strong performance of equity markets in

recent years . Some asset management companies have also introduced

other types of funds to cater to a wider variety of investor preferences.

1.2 BACKGROUND

In Pakistan, the evolution of Mutual Funds dates back to 1962, when the

public offer ing of Nat ional Inves tment Trus t (NIT) was init ial ly made

which is an open-end mutual fund. After 04 years i .e . in 1966 another

fund namely Investment Corporation of Pakistan (ICP) was established.

Since then ICP had been car ry ing the l egal mandate , thus was f r ee to

o ff er , a s er ie s o f c lo se d e nd m utu al f un ds . U p t o e ar ly 1 99 0 t hi s

inst i tut ion had f loated twenty six (26) closed-end ICP mutual funds. The

fur ther journey of ICP ended in June 2000 during the revamping cum

res tructur ing-dr ive of the Govt. organizat ions , autonomous bodies &

c or po ra ti on b y th e th en c ar eta ke r F in an ce M in is te r Mr .S ho uk at

A zi z. Re vi ti liz in g t he p ri va ti za ti on C om mi ss io n o f P ak is ta n t he

Government started privatization of the ICP. Thus 25 out of 26 close-end

funds of the same were spli t into two lots . There had been a competi t ive

bidding for the acquis i tion of funds by var ious par t ies . Management

Right of Lot-A comprising 12 funds was acquired by ABAMCO Limited.

Later on out of these 12 the f irst 9 funds were merged into a single close-

end fund and subsequently were r enamed as ABAMCO capi ta l fund,

except 4 t h ICP mutual fund. The main known reason of not renaming the

4 t h ICP fund i s the cert if ica te holders of the same had not formally

approved the proposed scheme of the arrangement of Amalgamation into

ABAMCO capital fund in their extra ordinari ly general meeting held on

December 20, 2003. The fund has therefore been recognized as a separate

close-end t rus t and named as ABAMCO growth fund. Rest of the three

funds were merged into another s ingle and named as ABAMCO s tock

market fund. On the o ther hand the Lot-B was compri sed of 13 ICP

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funds, for al l of these thir teen funds, the management Right was obtained

by PICIC Asset Management Company Limited. All of these thirteen funds

were merged into a single close-end fund which was renamed as PICIC

Investment Fund

1.3 PROBLEM STATEMENT

The problem statement for this research is that What is the Relationship

( Posi ti ve o r negat ive) bet ween Mut ua l Fund and GDP, GNP, Gross

Domestic Savings and Net inflow of Foreign Portfolio?

1.4 RESEARCH DESIGN

1.4(1) the main Objective of the Study are:

The main objective of the study includes;

1. This research looks at the performance of Pakistani mutual funds

industry over a span of ten years period from 1997 to the year 2007.

2. The main object ive of the s tudy is to f ind the relat ionship among

mutual fund wi th four independent var iables i .e . GDP, GNP, Domest ic

saving and net inf low of foreign por t fol io inves tment in order to know

whether there is a significant relation?

1.4(2)Scope of the study

The scope of this study is narrow, because we have select the duration

only ten years, i .e. 1997 2007, for checking the relationship between

mutual fund and GDP, GNP, gross domestic savings and net inflow of

foreign portfolio.

1.5 RESEARCH METHODOLOGY

1.5(1)source of data

Since, we are going to check the relat ionship between mutual funds and

GDP, GNP, gross domestic savings and net inflow of foreign investment,

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this s tudy is purely based on Secondary Data col lected on annual bas is

f rom dif ferent mutual funds in Pakis tan. So the source is secondary in

nature.

Secondary Sources:

Official website of MUFAP

SBP annual report

Planning and Development Commission of Pakistan

Books

Journals

1.5(2) Limitation of the study

As common to every study, this part icular research also had to go through

certain limitations:

The time limitation was the biggest hurdle in the study.

1.6 SCHEME OF STUDY

The scheme of study of the report is as under:

Chapter - 1: INTRODUCTION OF STUDY

Background

Objective

Scope

Research Methodology

Scheme of Study

Chapter - 2: LITERATURE RIVEW

This chapter includes the literature review for the research.

Chapter 3: MUTUAL FUNDS, GDP, GNP, GDS, NIFP

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Int roduct ion to Mutual Funds , GDP, GNP, Gross Domest ic Savings and

Net Inflow of Foreign Portfolio are discussed in this chapter.

Chapter 4: RESEARCH METHODOLOGY

This chapter discusses the methodology for the research adopted.

Chapter - 5: DATA ANALYSIS

This chapter discusses the data analysis and interpretation of the results

Chapter - 6: FINDINGS & CONCLUSION

Bas ed on dat a ana ly si s and i nt er pr et at ion o f r es ul ts f indi ngs and

conclusion are discussed in this chapter.

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CHAPTER 2

LITERATURE REVIEW

This chapter provides review of s tudies conducted on the performance

evaluation of mutual funds industry.

Cheema, Moeen and Sikander (2007) fur ther advances the argument that

inst i tut ional investors, with special consideration to mutual funds has a

g reat pot en ti al t o augment t he cor pora te gover nance i n emerg ing

e co no mi es . T he r eg ul at ory f ra me wo rk & m ec ha ni sm n ee ds to b e

restructured in a manner that would encourage the growth of the mutual

fund indust ry and enable i t to play a nippy & upbeat role in corporate

governance matters . The paper reviews the regulation of mutual funds in

Paki s tan in the l ight of the above propos i t ions which i s The Role of

Mut ua l Funds and Non-Banki ng F inanci al Compani es i n Cor pora te

Governance in Pakistan.

Sipra (2007) agrees that Mutual Funds are the most popular vehicle of

investing in the stock market and their performance evaluation is a themecomparatively dear & easier both to/for the investors and researchers in

the f ield of Finanace. Astoundingly, mutual funds have not played a very

imperative character in Pakistani s tock market and conceivably more or

less nothing has been in black and white about their performance in any

journal . The paper looked at the performance of Pakistani mutual funds

over the span of last five and ten years periods up to 2007. Sharp, Jensen

and Tenor measures of portfolio performance analysis had been uti l ized

therein . Both the performance of Mutual Funds & tha t of the market

por tf ol io def ined as t he Kar achi S tock Exchange( KSE) 100 wer e

comparatively analyzed taking the later as the benchmark for the same,

by means of the Sharpe method giving the s ignificant resul ts that the

performance of practically al l the funds was originated to be inferior to

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that of the market por t fol io. The Jensen and Treynor measures showed

about 50% of the funds to be outperforming the market portfolio over the

las t f ive years, but when the r isk measure was corrected via Kama's net

selectivity measure the market portfolio outperformed all the funds except

one. These resul ts suppor ted the semi-s t rong form of market ef f iciency

hypothesi s even more s trongly than i t has been demonst ra ted in the

developed markets.

Aziz (2007), Mutual Fund is an inst i tut ion es tabl ished wi th the aim of

inves ting a pool of funds in various type of Secur it ies with the sole

object ive of benef i t ing al l the s takeholders . Due to the involvement of

t echnica li ti es in the r esearch ac tivi ti es there in capi ta l market ands el ec ti ng t he l ow-r is k i nves tmen t por tf ol io a t a r el at ivel y meager

magnitude of investment, many investors opt for placing & diversifying

t he ir f unds i nd ir ec tl y, mos tl y i n cap it al mar ke ts t hr ough Mut ua l

Funds /Ass et Management Compani es hav ing exper ti se o f por tf ol io

m an ag em en t p ers on ne l. T he " Po rt fo lio M an ag er ", h as t he p rim e

respons ib il ity of ex tensive & cons is tent r esearch in the dynamic

secondary market unmistakably identifying the investment opportunit ies

which can convince the aspiration of the investors.

Bams (2004) put forwards a synopsis of the Mutual Funds & Investigated

via a survivorship bias controlled sample of 506 funds from the f ive most

impor tant countr ies of Europe. He had done another analys is us ing the

Carhart (1997) asset-pricing model of 04 Factors. Besides that they also

logica l ly invest iga ted tha t whether fund managers of Europe put on

display 'hot hands ' , a t tent iveness in performance. Final ly the weight of

fund characteristic on risk adjusted performance is well thought-out. Their

overal l fal lout sugges t that in European market for mutual funds , and

above all small cap funds are proficient to add value, as indicated by their

pos i t ive af ter cos t intercepts . I f on addi t ion of some management fees ,

four out of f ive countr ies exhibi t s ignif icant out-per formance a t an

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aggregate level . Finally, they detected strong persistence in mean returns

for funds investing in the UK. Their result deviate form most US studies

that are of proposition that mutual funds under-perform the market to the

tune of expense they charge.

Malkei l and Radis ich (2001) are of logical& cuasal f indings that index

f unds a re consi st en tl y p roduci ng r at es o f r et ur n i n exces s o f t hose

dynamic funds by 100 to 200 basis points per annum in the USA over the

decade of 1990s .They in-fact found two reasons for surfei t performance

i.e. by passive funds management fee and trading costs concerned .

Warmers (2000) carr ied out a research on mutual funds performance in

USA and found that fund hold stocks can out perform by market @1.3%

per year, while on further investigation their net result under perform by 1

%. Out of this 1.6 % is due to expense and transaction cost related to the

same investment.

Blake an d Timmermann (1998) from th e U niversity of Californ ia upon the

empirical analysis of performance of UK mutual funds concluded that the

average UK equity fund appeared to under perform by approximately 1.8% per annum on r isk adjusted basis . The authors are also of the stronger

proposition that there is also some indication of di l igence of performance

on standard, a portfolio comprising of the tradit ionally & relat ively best

performing quart i le of mutual funds performs superior in the succeeding

per iod than a por tfolio Composed of the historically worst performing

quartile of the same.

Grinblatt and Titman (1992) analyze performance of 279 funds over the

per iod of 1975 to 1984 us ing a benchmark technique and f ind evidence

that performance differences between funds persists over time. Hendricks,

Patel , and Zeckhauser (1993) s tudy 165 no- load growth-or iented funds

over the period 1974 to 1988 and obtain similar results . In a study of 728

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mutual fund returns over the period 1976 to 1988, Goetzman and Ibbotson

(1994) f ind that two-year performance is predict ive of performance over

the successive two years. Volkman and Wohar (1995) extend this analysis

to examine factor s tha t impact performance pers is tence . Thei r da ta

c on sists o f 3 22 fun ds ov er th e p eriod 19 80 to 19 89 , a nd sh ows

performance pers is tence i s negative ly r ela ted to s ize and negative ly

related to levels of management fees.

Carhart (1997) shows that expenses and common factors in stock returns

such as be ta , market capi ta l iza tion, one-year r eturn momentum, and

whether the por tfolio i s value or growth or iented "almost completely"

explain short term persistence in r isk-adjusted returns. He concludes thathis evidence does not "support the existence of skilled or informed mutual

fund por t fol io managers" (Carhar t , 1997, p. 57) . In the Kahn and Rudd

1995 s tudy of 300 equi ty funds and 195 bond funds between 1983 and

1993, only the bond funds show evidence of persistence. In an art icle in

this issue, Detzel and Weigand (1998) use a regression residual technique

to control for the ef fects of inves tment s ty le, s ize and expense rat ios .

T he y f in d, a ft er c on tr ol li ng f or t he se v ari ab le s, n o e vi de nc e o f

performance p ersistence.

In Gruber (1996) in his art icle based on USA data claims that most of the

older studies are subject to survivorship bias. When this effect is adjusted,

is argued that mutual funds on average under-perform the market proxy by

the amount of expenses they charge the investors.

Otten and Bams (2002) Maastr icht Universi ty, in 2002 carried a research

on European mutual funds. Results suggest that Europeans mutual funds

espec ia ll y s ma ll cap it al is at ion f unds a re abl e t o add val ue . I f t he

management fee is added back, some exhibits significant out performance.

The author also pointed out that European mutual funds industry is s t i l l

l agging behind the US indus try both in total asse ts s ize and market

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capitalisation.

Mal ki el and Rad is ich ( 2001) f inds t ha t i ndex f unds have r egul ar ly

produced rates of return exceeding those of act ive funds by 100 to 200

basis points per annum in the United States over the 1990s and find that

there are two reasons for the excess performance by pass ive funds:

management fee and trading costs.

In 2002 Research conducted by Bauer, Koedijk, and Otten (2002) using an

in ternat ional da tabase contain ing German, UK and US e th ica l funds

remarked that the exis t ing empir ical evidence on US data suggests that

ethical screening leads to similar or s l ightly less performance relat ive to

comparable unrestricted portfolios.

Evidence on the performance of ethical mutual funds is mostly l imited to

the US and UK markets . For UK market four influential papers appeared

during the last decade. The early studies compared ethical funds to market

wide indices l ike the FT all share index. Using this methodology Luther,

Matatko and Corner (1992) inves t igated the returns of 15 ethical uni t

trusts . Their results provided some weak evidence that ethical funds tendto out perform general market indices.

In 2004, Otten and Bams (2004) in art icle t i t led How to measure mutual

fund performance: economic versus s tat i st ical relevance says that the

major i ty of US s tudies conclude that actively managed por tfolios, on

average, under perform market indices . He quoted the examples of the

studies conducted by Jensen (1968) and Sharpe (1966). He argued mutual

funds under perform the market by the amount of expenses they charge the

investors.

Shah and Hijazi (2005) Mutual Funds , which are ac tive ly managed,

generally under perform the market on average. This trend is more visible

in the money market funds where difference between market return, r isk

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free rate and fund performance is in the range of 1%. The low risk nature

of these inves tments as compared to equi ty funds resul t in lower return

which in turn l eaves l i t t l e or no room for management expenses . The

mutual fund industry of Pakistan is in growing stage.

Naim Sipra (2006) Equi ty Funds outperformed the market and posi t ive

return af ter deduct ing cos ts . The funds also have the potent ial to add

value due to present lack of diversif ication indicated by the difference in

Sharpe and Treynor Ratios. The proportion of fund which are able to beat

the market in a given time period is low.

M al ki el a nd R ad is ic h ( 20 04 ) n o f un d w as a bl e t o b ea t t he m ark et

consis tent ly which indicate the semi s t rong form of market ef f iciency.

Index funds are able to beat the market by 100-200 basis points than the

actively managed funds. The major reasons for active funds

underperformance are management fees and trading costs.

Gupta and Gupta (2001) in the ir Empir ica l analys is on mutual funds

industry of India investigated the relat ive shares of four major players in

September 1999. The main players are (1) UTI (2) public Sector banks (3)Insurance corporation and (4) private sector fund. The total assets under

the management of mutual fund industry stood at Rs.85487 Crore. These

four types consist of 37 players, 11 are in the public sector including UTI

and the remaining ones are the private sector . The UTI alone account for

74 percent , publ ic sector funds is wi th the share 10.2 percent whi le the

remaining resources of 15.8 percent are avai lable to the pr ivate sector

funds. There are a total of 311 schemes are offered out of the same 182,

142 are Close ended & open ended, respectivly .

I n 2002 Res ea rch conduct ed by Bauer , Koedj ik , and Ott en usi ng an

internat ional database having German, UK and USA ethical funds came

with the stronger proposit ion & logical ending that the exist ing empirical

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evidence on US data indicates that ethical screening paves the way to

e qu al in g o r s li gh tl y re du ce d p er fo rm an ce r el at iv e t o a na lo go us

unres t ricted por tfolios. Evidence on the performance of ethical mutual

funds is general ly res t r icted to the US and UK markets . For UK market

f ou r l ea din g p ap er s p re se nt ed d ur in g t he l as t d ec ad e. T he e arl y

comparative studies of ethical funds to market wide indices like the FT all

a re shares index. By means of thi s methodology Luther, Matatko and

corner (1992) inves t igated the returns of 15 ethical uni t t rus ts . Their

f indings provided some weak substantiat ion that an ethical fund tends to

out perform general market indices.

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CHAPTER 3

MUTUAL FUNDS, ECONOMIC INDICATORS AND NET

INFLOW OF FOREIGN PORTFOLIO

3.1 WHAT IS MUTUAL FUND?

A mutual fund is managed by a management company. The management

company is a bank of human resources , considered to be profess ional ly

qua li fi ed per sonnel . The por tf ol io o f mut ua l f und i s managed by a

"Portfolio Manager" , whose responsibi li ty i s to be invested in, and

sat is f ies the des ire of the inves tors . While selecting the secur i ties for investment, these managers analyze economic condit ions, industry trends,

government regulations and their impact on the stocks, and forecasts for

the speci f ic s tocks to the project the future outcome generated by the

companies. As we al l know that the economic and business condit ion do

not remain constant, so these managers also revise their portfolio with the

passage of time, as the circumstances demand.

3 .2 CON CEP T OF MU TU AL FU ND S

The concept i s very s imple, smal l inves tors inves t thei r money into a

common pool or fund and hand over the inves tment deci sion to fund

manager/ portfolio manager. This is expected to have several advantages

for the small investors: no more searching for good buys or relying on the

neighborhood sub-broker for advice or even wai t ing anxiously for the

allotment. All this is taken care of by the cumulative bargaining power of

the fund, which has trained professionals managing it.

Every day, the fund manager/ portfolio manager counts up the value of al l

fund ' s hold ing , f igures out how many shares have been purchased by

shareholders , and then ca lcula tes the Net Asset Value (NAV) of the

mutual fund, the pr ice of a s ingle share of the fund on that day. I f you

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want to buy shares, you just send the manager your money, and they will

issue new shares for you at the most recent price. If the fund manager is

doing good job, the NAV of the fund will usually get bigger your shares

will be worth more.

The history of mutual fund dates back to 19th century when the process of

pooling money for investing purposes started in Europe in 1868. Similar

practices are reported even in the t ime of Egyptian and Phoenicians when

they tr ied to minimize their r isk by sell ing shares to caravans and vessels

(Finance India 1996) . The f ir st mutual fund appeared on the f loor of

financial market in 1893 when formation of a faculty fund came into being

for Harvard Universi ty staff . I t was l ike close-end Mutual Fund. The f irstoff icial open end mutual fund took bi r th on March 21, 1924 when two

broker (Hatherly Foster and Charles Earoyd) pooled their $50,000 as seed

money in Boston, Massachuset ts to form an inves tment t rus t . This fund

got popularity because of liquidity and ease in use.

3.3 TYPES OF MUTUAL FUNDS

There are two types of mutual funds, which are:

Open-end mutual funds

Closed-end mutual funds

OPEN-ENDED MUTUAL FUND:

Open-end mutual funds are those where subscr ipt ion and redempt ion of

shares are al lowed on a continous basis . The price at which the shares of

open-end funds offered for subscription and redemption is determined by

the NAV after adjusting for any sales load or redemption fee. In Pakistan

there exists thir teen open ended mutual funds; National Investment (Unit)

Trust (NIT) in the public sector and Atlas Income Fund, Crosby Dragon

Fund, Fay sa l Bal anced Growt h Fund, Dawood Money Mar ke t Fund,

Pakistan Income Fund, Pakistan Stock Market Fund, MetroBank-Pakistan

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Sovereign Fund, Meezan I sl amic Fund, Unit Trus t of Paki stan , UTP

I ncome Fund, UTP I sl amic Fund and Uni ted Money Mar ke t Fund i n

private sector.

CLOSED-END MUTUAL FUND:

Closed-end mutual funds are those where the shares are initially offered to

the publ ic and are then t raded in the secondary market . The t rading

usually occurs at a slight discount to the NAV.

Over a period of t ime, the mutual fund managers have developed a variety

of investment products to cater for the requirement of investors, having

different needs. These include:

GROWTH FUNDS

BALANCED FUNDS

INCOME FUNDS

GROWTH FUNDS

The "growth funds" offer potential for appreciat ion in share value, while

the current income may be low. The fluctuation in share price may also be

high. Such funds invest in stocks and have tendency to outperform otherfunds and other modes of savings over a period of time.

BALANCED FUNDS

The "growth and income funds" or "balanced funds", of fer prospects of

both moderate appreciations in share value as well as current income. The

f luc tua tion in share pr ice may be low. Such funds invest in s tocks ,

corporate debts and Government paper.

INCOME FUNDS

The "bond fund" or "income funds", offer good current income but very

li t t le potential for growth. Such funds invest in government paper, bonds

i ssued by munic ipa l or loca l bodies , corpora te debt s and in s tocks of

utility companies, offering regular return.

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3.4 SOURCES OF PROFIT GENERATION:

A mutual fund can generate prof i t s f rom three di f ferent sources , which

are:

Dividend

Capital Gains

Appreciation of Share Price

Dividend:

Mutual fund generates income from dividends received from other joint

s tock companies whose shares the fund holds . A mutual fund uses this

dividend income to distribute dividend to its own stock holders.

Capital Gains:

As discussed ear l ier the por t fol io manager changes the por t fol io of the

fund with the passage of the t ime and also with the changes in economic

and business condi t ions . So due to the sale and purchase of shares , the

mutual fund generates capi tal f rom the sales / purchase of s tocks . The

capital gain generated by the mutual fund is also used to pay dividends to

the investors of the fund.

Appreciation of Share Price:

Mutual funds also increase the wealth/inves tment of thei r shareholder

through appreciat ions of share pr ice of the mutual fund. For example i f

the subscription price of a mutual fund is Rs.11.00, and after a period of

seven months the price goes upto Rs.18.00, thus the investor gets a profi t

of Rs.7.00 if he sell the mutual fund's shares in the market.

3 .5 A DVAN TA GE S & D IS AD VA NT AG ES

Advantages of Mutual Funds:

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Mutual Funds substanti a lly lower the investment r isk of small

investors through diversif ication in which funds are spread out into

various sectors, companies, securi t ies as well as entirely different

markets . I t is always the objectives of a fund manager to maximize

a funds re turn for a g iven l evel of r i sk , however the dangers of

"over-diversif ication" are always prevalent which would inevitably

lead to a reduced return on the portfolio.

Mutual Funds mobi l ize the saving of smal l inves tors and channel

them into lucrat ive inves tment oppor tuni t ies . As a resul t , mutual

funds add l iquidi ty to the market . Moreover , given that the funds

are long term investment vehicles, they reduce market volat i l i ty by

offering support to scrip prices.

Mutual Funds are providing the small investor access to the whole

market which individually, would be difficult to achieve.

The investors save a great deal in transaction cost given that he has

access to a large number of securi t ies by purchasing a single share

of mutual fund.

The i nves to rs can p ick and choos e a mut ua l f und t o mat ch h is

particular ne eds.

Disadvantages of Mutual Funds:

As such there i s no major d isadvantage a tt ached to the mutual funds.

However, the possible disadvantages could be:

Economic and Business Conditions: As the business and economic

condit ions do not remain constant , the mutual fund may face some

difficulties in future. Especially if the manager does not shuffle the

investment portfolio with the passage of t ime, or some other major

unforeseen disaster/event changes the investment scenario.

Portfolio Managed by Managers: Por t fo l io of a mutual fund i s

managed by the portfolio managers due to which the investor has no

say in the affairs of a mutual fund.

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3.6 HISTORICAL REVIEW OF MUTUAL FUNDS IN PAKISTAN

The history of mutual fund dates back to 19th century when the process of

pooling money for investing purposes started in Europe in 1868. Similar

practices are reported even in the t ime of Egyptian and Phoenicians when

they tr ied to minimize their r isk by sell ing shares to caravans and vessels

(Finance India 1996) . The f ir st mutual fund appeared on the f loor of

financial market in 1893 when formation of a faculty fund came into being

for Harvard Universi ty staff . I t was l ike close-end Mutual Fund. The f irst

off icial open end mutual fund took bi r th on March 21, 1924 when two

broker (Hatherly Foster and Charles Earoyd) pooled their $50,000 as seed

money in Boston, Massachuset ts to form an inves tment t rus t . This fundgot popularity because of liquidity and ease in use.

Mutual Funds world wide assets have crossed the l imit of $25.82 tr i l l ion

showing a growth of 1.6% p.a. USA is dominant over the whole mutual

fund market with holding of 50% assets ($11.742 tr i l l ion) of the worlds

mutual fund market . Mutual Funds of United Kingdom (UK) holds about

$852 Billion assets.

Depreciat ion of US$ is also a cause of mutual funds growth in nominal

form. In China, net assets of mutual fund industry have quadrupled in last

year . Now total assets are about $450 bi l l ion. This enormous growth is

due to the change in investors behavior that s tarted investment into stock

market by withdrawing their money from traditional banks.

I nd ia , t he l eadi ng economy o f Sou th Asi a, adopt ed t he concept o f

cumulative investment vehicle i .e. Mutual Funds in 1963 by sett ing up of

f ir st s ta te o wn ed mu tu al f un d U ni t T ru st o f I nd ia (U TI ) b y a

parl iamentary ac t in order to suppor t capi ta l market for indust ri al

purposes. UTI was regulated by Reserve Bank of India (RBI). Monopoly

of UTI remained till it was reorganized in Feb. 2003. From its inception in

1963 to i t s opening to the pr iva te sec tor and l a ter robus t growth , the

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mutual fund sector in India is a mirror reflection of that in Pakistan as far

as h is tori ca l developments are concerned, Compari son of India and

Pakistans Mutual Fund industry is given in the following table:

Table : 3.1

S/No. INDICATOR PAKISTAN INDIA

1 Net Assets Under Management Rs. 385 billion(2008)

Rs. 2,318 billion

2 Net Assets value / GDP (2007) 4% 8%3 NAV / Bank Deposits 11% 20%4 Number of Assets Management

Companies29 41*

5 Number o f Mutual F unds (Schemesin India)

90 5763*

6 Ind ividu al/R eta il I nv estors ( %ag e of assets ownership

45 45#

7 Co rpo rate Inv esto rs (%a ge of assetsownership

55 60#

*www.mutualfundsindia.com#http://in.rediff.com/money/2005/jan/07nri1.htm

Pakistan, one of the emerging economies, s tarted f inancial innovation in

s ame per iod a s i t was s ta rt ed i n I nd ia . The decade o f 1960 i s ver y

important when Pakistan started thinking to suck corporate and householdsaving into a pool, for investing them into more diversif ied way in stock

exchanges. This concept took bir th in 1962 by the formation of National

Investment Trust (NIT) as f irst mutual fund into f inancial market (NBFI)

of Pakistan.

NIT i s Paki stans o ldes t and l arges t open-ended mutual fund having

market share of over 27.20% with 19 branches in al l Pakistan and UAE. I t

was cons t i tu ted under t rus t deeds and Nat ional Bank of Paki s tan as a

trustee. NIT has investment in more than 500 companies out of total 659

in Pakis tan l i s ted in Karachi Stock Exchange. I t has inves ted at current

market pr ice in assets of about Rs . 47 bi l l ions that makes i t the larges t

institutional investor in KSE.

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Number of investors in NIT that holds collectively 749 mill ions units are

53500 (NIT 2007). Government support was one of the major components

that helped NIT to keep i t s promises of high returns to inves tors (NIT

1992) but this pol icy was discont inued when Pakis tan s tar ted to fol low

economic reforms in 1990s . NIT had equi ty s takes in many government

owned ent it ies that was pr ivat ized following the f inancial reforms in

Pakistan and made it leader in mutual fund market.

Chr onol og ical Devel opment o f Mut ua l Fund I ndus tr y i n Pak is tan

Devel opment o f mut ua l f und i ndus tr y i n Pak is tan t ook p lace ver y

sporadically. Important events are as under:

Table 3.2: Milestones in development of mutual fund sector in Pakistan

Years MILESTONES

1962 Birth of National investment Trust Open EndedMutual Fund

19 66 Estab lish men t o f in ve stme nt co rpo ratio n of Pa kistan(ICP) Close Ended Mutual Fund

1994 Jehangir Siddiqi group launched first private sector equity based mutual fund

2001 Government decided to wind up of ICP2 00 2 M an ag em en t p ow er s o f 2 5 m utu al fu nd s u nd er IC P w er e

sold ABMACO & PICIC2 00 3 P IC IC go t m an ag em en t r ig ht of sta te Ow ne d En te rp ris e

Mutual Fund (EEMF)2001 Tot al Ne t Ass et Val ue of the i ndus tr y was Ts . 18 b il li on

2003 05 Period of Robust Growth in Mutual Fund2008 Net a ssets o f m utual f und i ndustry s well t o R s. 3 85

b il lion; 90 funds managed by 68 asset managementcompanies

A mut ua l f und i s a veh ic le f or poo li ng t oget he r s av ings o f d iver seinvestors individuals as well as institutions to collectively invest these

savings in s tocks , bonds and/or money market ins truments. I t of fers

several advantages to investors, particularly retail investors, over taking a

direct exposure in capital and money markets. The expertise and resources

of the fund manager in identifying and selecting investment options is the

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m os t im po rt an t in ce nt iv e f or i nv es tin g in m utu al f un ds . B es id es

profess ional management , mutual funds offer a divers if ied inves tment

portfolio that helps to reduce exposure r isks for individual investors and

allows sharing of transaction costs among all investors.

The mutual funds sector has grown rapidly in the last few years ( Figure 1)

and accounted for the largest chunk of 55.3 percent in total assets of the

non bank financial sector in FY07. Between FY02 to FY07, net assets of

mutual funds have grown by more than 13 t imes to reach Rs. 330 bil l ion

by the close of FY07. The average payout of the mutual funds indust ry

also grew to 18.0 percent in FY07 (22.1 percent in FY06), as illustrated in

Figure 2.

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The growth in mutual funds in Pakistan is attributable to: (i) liberalization

of the sector ; ( i i) economic growth and macroeconomic s tabi li ty that

at tracted investors, including foreign investors, to the stock market; ( i i i )

increased l iquidity wi th inst i tut ional inves tors , which was channelized

into the stock market and mutual funds; ( iv) high corporate earnings that

increased the earnings potential for mutual funds; and (v) a buoyant stock

market that provided mutual funds with good returns in the form of capital

gains . His tor ical ly , the indust ry was dominated by publ ic sector funds .However, creation of an enabling legal framework to al low mutual funds

to be set up in the private sector and transfer of ICPmanaged closed end

funds to two priva te sec tor investment advi sers in FY03 boos ted the

number and s ize of funds under the management of the pr ivate sector ,

increased competi tion and eff ic iency of the sector and enhanced the

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quali ty of fund management. I t a lso provided oppor tuni ty to f inancial

inst itut ions, l ike banks and brokerage f irms , to d ivers ify in to fund

management through subsidiar ies and associated companies . As may be

seen from Table 3.3 , the share of pr ivate sector funds in the sector has

grown from 10.0 percent to over 79.2 percent over the last six years or so.

Table 3.3: Struture of Mutual Funds

amount in billion Rupees, share in percent

FY01 FY02 FY03 FY04 FY05 FY06 FY07

Net Assets 24.8 51.6 93.7 125.8 159.9 289.11 330

Share by Ownership

Public Sector 89.6 78.5 52.8 48.5 40.2 31.5 25.7

Private Sector 10.4 21.5 47.2 51.5 59.8 68.5 74.3

Share by type

Open-end Funds 78.1 78.2 73.6 70.1 72.7 82.4 86

Close-end Funds 24.9 21.8 26.4 29.9 27.3 17.6 14

Share by Category

Equity Fund 92.2 81.2 76.5 72.8 63 47.3 40.9

Income Fund 0 6.6 6.4 6.2 10.6 24.4 23.9

Money Market Fund 0 4.6 3.6 3.9 7.3 15 16.2

Balanced Funds 6.7 5.8 10.3 9 7.2 4.6 6.5

Islamic Funds 1.1 1.8 3.2 4.7 5.6 4.9 7.9

Tracker Funds nil nil nil nil 0.6 0.5 0.8

Fund of Funds nil nil nil 0.4 0.5 0.3 0.5

Other nil nil nil nil nil 3 3.3

Source: Annual Audited Accounts of Mutual Funds, SBP and MUFAP

The public sector open end mutual fund, NIT, by i ts sheer size continues

to have a significant share of 31.0 percent in the net assets of the sector.

As of endJune FY06, the mutual funds sector comprised of 66 funds with

47 opene nd f un ds a nd 1 9 c lo se de nd f un ds . T he n um be r o f f un ds

increased to 95 by endFY07. Openend funds dominate the sector , as

shown in Table 3.3, due to investors preference for ease of exit and the

flexibil i ty this investment option offers . By endFY07, the share of open

end funds in the net assets of the mutual funds sector was 86.0 percent as

compared to the share of closed end funds at 14.0 percent . Closed end

mutual funds are more suitable for long term investors. In the absence of

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the continuous sale and redemption of cert if icates by a closed end fund,

i nv es to rs c an o nl y e xit t he f un d a t t he g iv en m ar ke t p ri ce o f t he

shares/cert ificates in the stock market , which is generally at a discount to

the NAV per share/cert if icate. However, lack of redemption pressure has

i ts advantages for the closed end fund, par t icular ly wi th respect to the

abi l i ty to inves t in i l l iquid, but high potential small and mediumsized

companies to earn h igh returns, optimizing investment of as se ts by

maintaining low liquidity and saving on marketing and distribution costs.

Given the usefulness of closedend funds, necessary mechanisms may be

int roduced to faci l i tate inves tors who wish to exi t a closed end fund in

order to address their primary concern about ease of exit . Internationally,buyback of shares/cert ificates of a closedend fund by i ts fund manager,

prompted by trading of shares at a certain discount to the NAV, is widely

used to minimize the difference between the market price of

shares/certificates on the stock market and their net asset value (NAV), so

that the secondary market price is not disadvantageous to investors exiting

the closedend fund.

An encouraging development in the mutual funds sector is the increasing

diversi ty of categories of funds offered for public subscription (see type

of Mutual Funds), as also evident from the variety of entrants in the sector

dur ing FY07. By the close of the year , equi ty funds const i tuted almost

41.0 percent of the mutual funds sector , income funds const i tuted 23.9

percent, money market funds had a share of 16.2 percent, balanced funds

6 .5 per cent , I sl amic f unds 7 .9 per cent , whi le t he r es t consi st ed o f

miscel laneous types of funds such as t racker funds and fund of funds .

While, equity funds have the largest share in the mutual funds sector in

terms of the number of funds as well as the net assets under management,

however, the large assortment of options for investors is a reflection of

the abil i ty of fund managers to meet the investment needs and r isk profi le

of a variety of investors.

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3.7 Types of Mutual Funds in Pakistan

Each mutual fund has specific investment objectives that mould the funds

assets , investment options and strategy. At the most basic level , there are

three types of mutual funds: ( i) Equity funds, i i ) Fixed income funds, and

i ii ) Money Mar ke t f unds . A ll t he o ther k inds o f mut ua l f unds a re

var iat ions of these three bas ic types . The character is t ics of the var ious

types of funds are detailed below:

Growth Fund: A mut ua l f und whose f ocal a im i s t o ach ieve cap it al

appreciat ion primarily by investing in growth stocks. In pursuit of large

capital gains, these funds invest in companies with significant earnings or

revenue growth, rather than those with high pay

outs. In general , growthfunds are more volat i le than other types of funds. Direct correlat ion with

market is usually greater than 1.

Asset Allocation Fund : This type of mutual fund invests in a variety of

securities in multiple asset classes with the objective of carrying out asset

al location typically by i tself . The rat ionale is to provide investors with

sui tably divers if ied holdings and consis tent returns. Generally , asset

allocation funds are less volatile usually with correlation of almost 1 with

the market.

Money Market Funds: A mu tua l fun d wh ic h in ve sts in lo w risk

securi t ies , for the most part in government securi t ies , CoDs, commercial

paper of companies and other highly l iquid and low risk securi ties . These

funds have inherently low risks. Generally, these funds are least volat i le

with weak correlation with the market.

Tracker Fund: This type of fund, as i ts name sugges ts , fol lows the

performance of a part icular index. Theoretically, these types of funds are

as volatile as the market with a correlation of unity.

Fund of Funds: A type of mutual fund which inves ts in other mutual

funds , also known as mul t i management funds . These types of funds

enable inves tors to achieve a broad divers if icat ion and an appropr iate

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asset al location with investments in a variety of fund categories that al l

are wrapped up into one fund. Due to diversif ication, these funds are less

volatile with moderate correlation with market.

Income Fund: A type of mutual fund that emphasizes current income,

either on a monthly or quarterly basis , as divergent from targeting capital

appreciat ion. These funds hold a var iety of government , municipal and

corporate debt obligations, preferred stock, money market instruments and

dividend paying s tocks . Generally , these funds are least volat i le wi th

weak correlation with market.

Balanced Fund: Mutual funds that combine investments in shares, short

t erm a nd l on g t er m b on ds i n p urs ui t o f i nc om e g ai ns a nd c ap it al

appreciat ion while avoiding excessive r isk. These are also called hybrid

funds. The idea behind this concept is to provide investors with a single

mutual fund that combines income and growth objectives, by investing in

both stocks and bonds. Due to diversification, these funds are less volatile

with moderate correlation with market.

Equity Fund: A mutual fund that inves ts pr incipal ly in s tocks is cal led

equity fund. It is also known as a stock fund.

This type of fund can be fur ther ca tegor ized into two ca tegor ies , i .e .domestic and international , depending on the nature of investments of the

fund. Generally, these funds are very volat ile with strong correlation with

the market.

Sector Fund: A mutual fund that inves ts ent i rely or predominant ly in a

speci f ied (s ingle) sector i s a sector speci f ic fund. These funds usual ly

exi st i n ene rgy, gol d, and o ther p reci ous met al s s ec to rs . The r is k

associated with these funds depends on the specif ied sector . These types

of funds are less diversif ied. The volati l i ty and correlat ion with market

also depends on the specified sector.

Is lamic Funds: A t yp e o f f un d w hi ch e nt ir ely i nv es ts i n S ha ri ah

compl iant i ns tr umen ts . I sl amic f unds exi st i n a lmos t a ll t he f or ms

discussed earl ier . Each fund inves ts in i t s respective areas of interes t

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keeping in view the rules of shar iah compl iance. The volat i l i ty of each

kind of Islamic fund depends on its category and also the relationship with

the market in which it operates.

A significant regulatory development during FY06 was the discontinuation

of SECPs requirement for asset management companies to seek foreign

collabora t ion in managing openend f unds . The condi ti on had been

imposed at the initial stage of development of the mutual funds industry in

Pakistan to facil i tate transfer of technical knowledge and expert ise from

overseas fund management companies to loca l fund managers. I t was

considerably successful in enabling local asset management companies to

o bta in t ra in in g, k no w h ow a nd r es ou rc es f ro m t he ir in te rn at io na l

aff i l iates. The condit ion was removed once SECP was sat isf ied with the

pace of development of the mutual funds sector and the abi l i t ies of the

a sset man ag emen t c omp an ie s to ma na ge th eir re spe ctiv e fun ds

profess ional ly and prof ic iently. On the posi tive s ide , r emoval of the

condition for mandatory foreign affiliation has helped to lower barriers to

entry of new fund managers. However, a greater responsibil i ty now lies

wi th SECP in s tr engthening i ts l icens ing cri te r ia for fund managers ,

monitoring their performance and taking appropriate enforcement actions

in order to prevent market abuse. In discharge of this responsibility, SECP

since August 2005 requires asset managers and investment advisers to

obtain f rom credi t rat ing agencies in Pakis tan rat ings speci f ic to their

fund management quali ty as well as rat ings specif ic to the performance of

the mutual funds managed by them. The rat ings must be disseminated for

public information and disclosed in the accounts and advert isements of

mutual funds and fund managers . SECP has also s tar ted inspect ions of

fund managers, focusing on the quali ty of their systems and procedures,

subsequent to the close of FY06.

During FY07, SBP allowed mutual funds to make overseas investments up

to 30 .0 percent of the aggregate funds mobi li zed ( inc luding foreign

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currency funds) subject to a cap of US$ 15 mill ion, whichever is lower.5

Pr ior approval of SBP i s r equi red by a mutual fund seeking to inves t

outside Pakis tan. In order to manage associated r isks , SECP generally

re qu ire s fun d ma na ge rs to o bse rv e certain c on dition s visvis

in ternat ional investments . The permission to invest abroad has been

welcomed by the mutual funds sector as i t would enable them to diversify

investments outside Pakistan.

Developments in the regulatory and operat ing environment indicate a

s tr ong pot en ti al f or t he mut ua l f unds s ec to r t o con ti nue i ts g rowt h

momentum albeit the challenges faced by the sector need to be addressed

expeditiously.

3 .8 GROS S DOMES TI C PROD UCT GD P

The gross domestic product (GDP) or gross domestic income (GDI) is a

measure of a country 's overall economic output. I t is the market value of

al l f inal goods and services made wi thin the borders of a country in a

year. I t is often posit ively correlated with the standard of l iving, though

its use as a stand-in for measuring the standard of l iving has come underincreasing cri t icism and many countries are actively exploring al ternative

measures to GDP for that purpose.

GDP can be determined in three ways , al l of which should in pr inciple

give the same result . They are the product (or output) approach, the

income approach, and the expenditure approach.

The mos t d i rec t of the three i s the product approach, which sums the

outputs of every class of enterprise to arr ive at the total . The expenditure

approach works on the principle that al l of the product must be bought by

somebody , therefore the va lue of the total product must be equal to

people's total expenditures in buying things. The income approach works

on the principle that the incomes of the productive factors ("producers,"

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colloquially) must be equal to the value of their product , and determines

GDP by finding the sum of all producers' incomes.

Example: the expenditure method:

GDP = priva te consumption + gross investment + government

spending + (exports imports), or

In the name "Gross Domestic Product,"

"Gross" means that GDP measures product ion regardless of the var ious

uses to which tha t product ion can be put . Product ion can be used for

immediate consumption, for investment in new fixed assets or inventories,

or for replacing depreciated f ixed assets . If depreciation of f ixed assets is

subtracted from GDP, the result is cal led the Net domestic product; i t is a

measure of how much product is available for consumption or adding to

the nat ion 's weal th. In the above formula for GDP by the expendi ture

method, if net investment (which is gross investment minus depreciat ion)

is substituted for gross investment, then net domestic product is obtained.

"Domestic" means that GDP measures production that takes place within

the country 's borders . In the expendi ture-method equat ion given above,t he expor ts -minus -i mpor ts t er m i s neces sa ry i n o rder t o nul l out

expenditures on things not produced in the country ( imports) and add in

things produced but not sold in the country (exports).

E co no mists (sin ce Ke yn es) h av e p refe rre d to split the g en eral

consumption term into two parts; private consumption, and public sector

(or government) spending. Two advantages of dividing total consumption

this way in theoretical macroeconomics are:

Private consumption is a central concern of welfare economics. The

private investment and trade portions of the economy are ultimately

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directed ( in mainstream economic models) to increases in long-term

private con sumption.

I f separated f rom endogenous pr ivate consumption, government

consumption can be treated as exogenous,[ci tat ion needed] so that

di fferent government spending levels can be considered wi thin a

meaningful macroeconomic framework.

Gross domest ic product comes under the heading of nat ional accounts ,

which is a subject in macroeconomics. Economic measurement is called

econometrics.

3.9 DETERMINING GDP

PRODUCTION APPROACH

Usually in this approach the producer units (corporate and unincorporated

enterprises which together form the business sector , "pure" households,

gover nmen ts and non-p ro fi t i ns ti tu ti ons s er vi ng househo lds) o f an

e co no my a re c la ss if ie d in to c la ss es o f in du st rie s: a gr ic ult ure ,

construction, manufacturing, etc. Their outputs are est imated largely on

the basis of surveys which businesses f i l l out , but also the services from

dwellings owned by households are counted towards production. To avoid

"double-count ing" in cases where the output of a producer uni t i s not a

f ina l good or serv ice , but serves as intermedia te input ( in termedia te

consumpt ion) into another producer unit , e ither only f ina l goods and

services outputs must be counted, or a "value added" approach must be

taken, where what i s counted is not the total value output of a producer

uni t , but i t s value added: the di f ference between the value of i t s gross

output and the va lue of i ts intermedia te consumption . Value added i s

obtained as a balancing i tem in the product ion account of the nat ional

accounts.

Gross Value Added (GVA) = Sum of g ross val ue added by a ll

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producer units = Gross output - intermediate consumption of goods

and services to produce the output.

For market producer sales i s usually the l arges t part of output. But

producer unit s may a lso produce output for own f ina l use (own f ina l

consumption or own gross f ixed capital formation) or add their output of

goods to their inventories.

Depending on how gross va lue added has been ca lcula ted , i t may be

necessary to make an adjustment to i t before i t can be considered equal to

GDP. This is because GDP is the market value of goods and services the

price paid by the customer but the price received by the producer may

be different than this if the government taxes or subsidizes the product.

For example, if there is a sales tax:

Producer's price + sales tax = market price

If taxes and subsidies have not already been computed as part of GVA, we

must compute GDP as:

GDP = GVA + Taxes on products - Subsidies on products

EXPENDITURE APPROACH

In contemporary economies, most things produced are produced for sale,

and sold. Therefore, measuring the total expenditure of money used to buy

things is a way of measuring production. This is known as the expenditure

method of calculat ing GDP. Note that if you knit yourself a sweater , i t is

product ion but does not ge t counted as GDP because i t i s never so ld .

Sweater-knit t ing is a small part of the economy, but if one counts some

major activi t ies such as child-rearing (generally unpaid) as production,

GDP ceases to be an accurate indicator of production.

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COMPONENTS OF GDP BY EXPENDITURE

GDP (Y) i s a s u m o f Consumption (C) , Investment (I) , Government

Spending (G) and Net Exports (X - M) .

Y = C + I + G + (X M)

Here is a description of each GDP component:

C (consumption) i s normally the largest GDP component in the

economy, cons is ting of priva te (household f ina l consumption

expenditure) in the economy. These personal expenditures fall under

one of the following categories: durable goods, non-durable goods,and services. An example includes food, rent, jewelry, gasoline, and

medical expenses but does not include the purchase of new housing.

I ( investment) inc lude business investment in equipments for

e xa mp le a nd d oe s n ot i nc lu de e xc ha ng es o f e xi sti ng a ss et s.

E xa mp le s i nc lu de c on str uc tio n o f a n ew m in e, p ur ch as e o f

[software], or purchase of machinery and equipment for a factory.

Spending by households (not government) on new houses i s also

inc luded in Investment. In cont rast to i ts co lloquia l meaning,

'Investment ' in GDP does not mean purchases of f inancial products.

Buying f inancia l products i s c lassed as ' saving' , as opposed to

investment. This avoids double-count ing: i f one buys shares in a

company, and the company uses the money received to buy plant ,

equipment, etc. , the amount wil l be counted toward GDP when the

company spends the money on those things ; to also count i t when

one gives i t to the company would be to count two t imes an amount

that only corresponds to one group of products . Buying bonds or

s tocks i s a s wapp ing o f deeds , a t rans fe r o f c la ims on f ut ur e

production, not directly an expenditure on products.

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G (government spending) is the sum of government expenditures

on final goods and services. I t includes salaries of public servants,

p ur ch as e o f w ea po ns f or t he m il it ary , a nd a ny i nv es tm en t

expendi ture by a government. I t does not inc lude any t ransfer

payments, such as social security or unemployment benefits.

X (exports) represents gross expor ts . GDP captures the amount a

country produces, including goods and services produced for other

nations' consumption, therefore exports are added.

M (imports) represents gross imports. Imports are subtracted since

imported goods wil l be included in the terms G, I, or C, and must

be deducted to avoid counting foreign supply as domestic.

A fu lly equivalent defini tion i s that GDP (Y) is th e su m o f final

consumption expenditure (FCE) , gross capital formation (GCF), and net

exports (X - M) .

Y = FCE + GCF+ (X M)

FCE can then be fur ther broken down by three sec tor s (households ,

governments and non-profi t inst i tut ions serving households) and GCF by

f ive s ec to rs ( non- fi nanc ia l cor pora ti ons, f inanci al cor pora ti ons,

households, governments and non-profit inst itut ions serving households) .

T he ad van ta ge of th is sec on d de fin ition is tha t ex pe nd itu re is

s ys te ma ti ca ll y b ro ke n d ow n, f ir stl y, b y t yp e o f f in al u se ( fi na l

consumption or capital formation) and, secondly, by sectors making the

e xp en dit ur e, w he re as t he f ir st d ef in it io n p ar tl y f oll ow s a m ix ed

delimitation concept by type of final use and sector.

Note that C, G , a n d I are expendi tures on f inal goods and services ;

e xp en diture s o n in termed ia te go od s an d serv ic es do n ot c ou nt.

(Intermediate goods and services are those used by businesses to produce

other goods and services within the accounting year)

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According to the U.S. Bureau of Economic Analysis , which is responsible

for calculat ing the national accounts in the United States, : In general , the

source data for the expenditures components are considered more rel iable

than those for the income components.

EXAMPLES OF GDP COMPONENT VARIABLES

C , I , G , and NX (net expor ts ) : I f a person spends money to renovate a

hot el t o i nc reas e occupancy r at es , t he s pend ing r ep resent s p ri va te

i nv es tm en t, b ut if h e b uys s ha re s in a c on so rt iu m to e xe cu te t he

renovation, i t is saving. The former is included when measuring GDP (in

I) , the lat ter i s not . However , when the consor t ium conducted i t s own

expenditure on renovation, that expenditure would be included in GDP.

If a hotel is a private home, spending for renovation would be measured as

consumption, but if a government agency converts the hotel into an office

for civi l servants , the spending would be included in the publ ic sector

spending, or G.

I f the renovation involves the purchase of a chandelier from abroad, that

spending would be counted as C , G , or I (depending on whether a private

individual , the government , or a bus iness i s doing the renovat ion) , but

then counted again as an import and subtracted from the GDP so that GDP

counts only goods produced within the country.

If a domestic producer is paid to make the chandelier for a foreign hotel ,

the payment would not be counted as C, G, or I , but would be counted as

an export.

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INCOME APPROACH

Another way of measur ing GDP is to measure total income. I f GDP is

calculated this way i t is sometimes called Gross Domestic Income (GDI),

or GDP ( I) . GDI should provide the same amount as the expendi ture

met hod des cr ibed above . ( By def in it ion, GDI = GDP. I n p ract ice,

however, measurement errors wil l make the two figures sl ightly off when

reported by national statistical agencies.)

Total income can be subdivided according to various schemes, leading tovarious formulae for GDP measured by the income approach. A common

one is:

GDP = compensat ion of employees + gross operat ing surplus +

gross mixed income + taxes less subsidies on production and

imports

GDP = COE + GOS + GMI + TP & M - SP & M

C om pe nsat io n o f e mp lo ye es (COE) measures the total

remunerat ion to employees for work done. I t includes wages and

salar ies , as wel l as employer contr ibut ions to social secur i ty and

other such programs.

Gross operating surplus (GOS) i s the surplus due to owners of

incorporated businesses. Often called profits, although only a subset

of total costs is subtracted from gross output to calculate GOS.

Gross mixed income (GMI) is the same measure as GOS, but for

u ni nc or po ra te d b us in es se s. T hi s o ft en i nc lu de s mo st s ma ll

businesses.

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The sum of COE, GOS and GMI is cal led total factor income; i t is the

income of all of the factors of production in society. It measures the value

of GDP at factor (basic) prices. The difference between basic prices and

final prices ( those used in the expenditure calculat ion) is the total taxes

and subsidies that the government has levied or paid on that production.

So adding taxes less subsidies on production and imports converts GDP at

factor cost to GDP (I).

Total factor income is also sometimes expressed as:

Total factor income = Employee compensation + Corporate profits +

P ro pr ie te r s in co me + R en ta l i nc om e + N et

interest

Yet another formula for GDP by the income method is:

GDP = R + I + P + SA + W

where R : rents

I : interests

P : profits

SA : statistical adjustments (corporate income taxes, dividends,

undistributed corporate profits)

W : wages

Note the mnemonic, "ripsaw".

==a "production boundary" that delimits what will be counted as GDP.

"One of the fundamental quest ions that must be addressed in preparing the

national economic accounts is how to define the production boundary that

i s , wha t par ts o f the myr iad human act iv it ie s a re to be inc luded in o r

excluded from the measure of the economic production."

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All output for market is at least in theory included within the boundary.

Mar ke t out pu t i s def ined as t ha t whi ch i s s ol d f or " economical ly

significant" prices; economically significant prices are "prices which have

a significant influence on the amounts producers are wil l ing to supply and

purchasers wish to buy." An exception is that i l legal goods and services

are often excluded even if they are sold at economically significant prices

(Australia and the United States exclude them).

This leaves non-market output. I t is part ly excluded and part ly included.

First , "natural processes wi thout human involvement or di rect ion" are

excluded. Also , there mus t be a per son or ins t i tu t ion tha t owns or i s

enti t led to compensation for the product. An example of what is includedand excluded by these cr it er ia i s g iven by the United States ' na tional

accounts agency: " the growth of t rees in an uncul t ivated fores t i s not

included in production, but the harvesting of the trees from that forest is

included."

Within the l imits so far described, the boundary is further constr icted by

"functional considerations." The Austral ian Bureau for Stat is t ics explains

t his : " Th e n at io na l a cc ou nts a re p ri ma ri ly c on st ru ct ed t o a ss is t

governments and o thers to make market -based macroeconomic poli cy

decis ions , including analys is of markets and factors af fect ing market

performance, such as inf la tion and unemployment. " Consequently,

production that is, according to them, "relatively independent and isolated

from markets ," or "diff icult to value in an economically meaningful way"

[i .e. , diff icult to put a price on] is excluded. Thus excluded are services

provided by people to members of their own families free of charge, such

as child rearing, meal preparation, cleaning, transportat ion, entertainment

of family members , emot ional suppor t , care of the elder ly . Most other

product ion for own (or one 's family's ) use i s also excluded, wi th two

notable exceptions which are given in the list later in this section.

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Non market outputs tha t a re inc luded within the boundary are l is ted

below. Since, by definition, they do not have a market price, the compliers

of GDP must impute a value to them, usually ei ther the cost of the goods

and services used to produce them, or the value of a similar i tem that is

sold on the market.

Goods and s er vi ces p rovi ded by gover nmen ts and non-p ro fi t

organizations free of charge or for economically insignificant prices

are included. The value of these goods and services is est imated as

equal to their cost of production.

Goods and s er vi ces p roduced f or own-use by bus ines ses a re

at tempted to be included. An example of this kind of product ionwould be a machine constructed by an engineering f irm for use in

its own plant.

Renovations and upkeep by an individual to a home that she owns

and occupies are included. The value of the upkeep is est imated as

the rent that she could charge for the home if she did not occupy i t

hersel f . This i s the larges t i tem of product ion for own use by an

individual (as opposed to a business) that the compilers include in

GDP.

Agr icul tu ra l p roduct ion f or consumpti on by onese lf o r one 's

household is included.

Services (such as chequeing-account maintenance and services to

borrowers ) provided by banks and o ther f inancia l ins ti tu t ions

without charge or for a fee that does not reflect their full value have

a va lue imputed to them by the compi ler s and are inc luded. The

financial inst i tut ions provide these services by giving the customer

a less advantageous interes t rate than they would i f the services

were absent; the value imputed to these services by the compilers is

the d if ference be tween the in teres t r ate of the account with the

services and the interest rate of a similar account that does not have

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the services. According to the United States Bureau for Economic

Analysis, this is one of the largest imputed items in the GDP.

GROSS DOMESTC PRODUCT vs. GROSS NATIONAL PRODUCT

GDP can be cont rasted wi th gross national product (GNP) or gross

national income (GNI) . The d if ference i s that GDP defines i ts scope

a cc or din g t o lo ca tio n, w hi le GN P d ef in es it s s co pe a cc or di ng to

ownership. GDP is product produced within a country 's borders; GNP is

product produced by enterprises owned by a country 's ci t izens. The two

would be the same i f al l of the product ive enterprises in a country were

owned by i t s own ci t izens , but foreign ownership makes GDP and GNP

non-identical . Production within a country's borders, but by an enterprise

owned by somebody outside the country, counts as part of its GDP but not

i t s GNP; on the other hand, product ion by an enterpr ise located outs ide

the country , but owned by one of i t s ci t izens , counts as part of i t s GNP

but not its GDP.

To take the United States as an example, the U.S. 's GNP is the value of

output produced by American-owned firms, regardless of where the f irms

are located.

Gross nat ional income (GNI) equals GDI plus income receipts f rom the

rest of the world minus income payments to the rest of the world.

In 1991, the United States switched from using GNP to using GDP as i ts

primary measure of production. The relat ionship between United States

GDP and GNP is shown in table 1.7.5 of the National Income and Product

Accounts.

International standards

The internat ional s tandard for measur ing GDP is contained in the book

S yste m o f Nation al A cco unts (19 93 ), wh ic h w as pre pa red by

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representatives of the Internat ional Monetary Fund, European Union,

Organiza tion for Economic Co-operat ion and Development, United

Nations and Wor ld Bank. The publ icat ion i s normal ly r efer red to as

SNA93 to d i st ingui sh i t f rom the previous edit ion publ ished in 1968

(called SNA68)

SNA93 provides a set of rules and procedures for the measurement of

national accounts. The standards are designed to be f lexible, to al low for

differences in local statistical needs and conditions.

National measurement

Within each country GDP is normally measured by a national government

s tat i s t ical agency, as pr ivate sector organizat ions normal ly do not have

access to the information required (especial ly information on expenditure

and production by governments).

Interest rates

Net interes t expense i s a t ransfer payment in a ll s ector s except the

financial sector . Net interest expenses in the f inancial sector are seen as

production and value added and are added to GDP.

ADJUSTMENTS TO GDP

When comparing GDP figures from one year to another, i t is desirable to

compensate for changes in the value of money inflation or deflation. The

raw GDP figure as given by the equations above is called the nominal , or

historical , or current , GDP. To make i t more meaningful for year-to-year

comparisons, it may be multiplied by the ratio between the value of money

in the year the GDP was measured and the value of money in some base

year. For example, suppose a country 's GDP in 1990 was $100 million and

its GDP in 2000 was $300 mill ion; but suppose that inflat ion had halved

the value of i t s currency over that per iod. To meaningful ly compare i t s

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2000 GDP to i ts 1990 GDP we could mult iply the 2000 GDP by one-half ,

to make i t relat ive to 1990 as a base year . The resul t would be that the

2000 GDP equal s $300 mil li on x one -hal f = $150 mil li on , i n 1990

monetary terms. We would see that the country 's GDP had, realis t ical ly,

increased by 1.5 t imes over that per iod, not 3 t imes , as i t might appear

from the raw GDP data. The GDP adjusted for changes in money-value in

this way is called the real, or constant, GDP.

The factor used to conver t GDP from current to constant values in this

way is called the GDP deflator . Unlike the Consumer price index, which

measures inf la tion (or deflat ion r are ly !) in the pr ice of household

consumer goods, the GDP deflator measures changes in the pr ices a lldomes ti ca lly produced goods and services in an economy inc luding

i nves tmen t goods and gover nmen t s er vi ces, a s wel l a s househo ld

consumption goods.

Constant-GDP figures allow us to calculate a GDP growth rate, which tells

us how much a country 's product ion has increased (or decreased, i f the

growth rate is negative) compared to the previous year.

Real GDP growth rate for year n = [ (Real GDP in year n) - (Real

GDP in year n - 1)]/ (Real GDP in year n - 1)

Another thing that i t may be des i rable to compensate for i s populat ion

growth. If a country 's GDP doubled over some period but i ts population

tripled, the increase in GDP may not be deemed such a great

accomplishment: the average person in the country is producing less than

t hey wer e bef or e. Per -cap it a GDP i s t he measure compens at ed f or

population growth.

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CROSS-BORDER COMPARISON

The level of GDP in different countries may be compared by convert ing

their value in national currency according to ei ther the current currency

exchange rate, or the purchase power parity exchange rate.

Current currency exchange rate is t he e xc ha ng e ra te in t he

international currency market.

Purchasing power parity exchange rate is the exchange rate based

on the purchas ing power par i ty (PPP) of a currency relat ive to a

selected standard (usually the United States dollar).

The ranking of countries may differ s ignificantly based on which method

is used.

The current exchange rate method converts the value of goods and

services using global currency exchange rates. The method can offer

better indications of a country's international purchasing power and

relat ive economic s t rength. For ins tance, i f 10% of GDP is being

s pent on buy ing h i- tech f or ei gn a rms, t he number o f weapons

purchased i s en ti re ly governed by current exchange rates, s ince

arms are a traded product bought on the international market . There

is no meaningful ' local ' price dist inct from the international price

for high technology goods.

The purchas ing power pari ty method accounts for the r e la tive

effective domest ic purchas ing power of the average producer or

consumer with in an economy. The method can provide a be tt er

indica tor of the l iv ing s tandards of l es s developed countr ies,

because i t compensates for the weakness of local currencies in the

internat ional markets. For example, India ranks 12th by nominal

GDP, but four th by PPP. The PPP method of GDP convers ion i s

more relevant to non-traded goods and services.

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There is a clear pattern of the purchasing power pari ty method decreasing

the dispar i ty in GDP between high and low income (GDP) countr ies , as

compared to the current exchange rate method. This f inding is called the

Penn effect.

For more information, see Measures of national income and output.

STANDARD OF LIVING AND GDP

GDP per capi t a i s not a measurement of the s t andard of l iv ing in an

economy. However, i t is often used as such an indicator , on the rat ionale

that al l c i t izens would benef i t f rom thei r country 's increased economic

product ion . S imilar ly , GDP per capi ta i s not a measure of personal

income. GDP may increase while incomes for the majori ty of a country 's

ci t izens may even decrease or change disproportional . For example, in the

US from 1990 to 2006 the earnings (adjusted for inflat ion) of individual

workers, in private industry and services, increased by less than 0.5% per

year whi le GDP (adjus ted for inf lat ion) increased about 3.6% per year

over the same period.

The major advantage of GDP per capi ta as an indicator of s tandard of

l iving is that i t i s measured f requent ly, widely and consis tent ly . I t i s

measured frequently in that most countries provide information on GDP

on a quar ter ly bas is , which al lows a user to spot t rends regular ly . I t i s

measured widely in that some measure of GDP is avai lable for almost

every country in the wor ld, al lowing compar isons to be made between

countries. I t is measured consistently in that the technical definit ion of

GDP is relatively consistent among countries.

The major disadvantage is that i t i s not, s t rictly speaking, a measure of

s tandard of l iving. GDP is intended to be a measure of part icular types of

economi c act iv it y w it hi n a par ti cu la r count ry . Not hi ng about t he

defin it ion of GDP suggest s i t i s necessari ly a measure of s tandard of

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l iving. For instance, in an extreme example, a country which exported 100

per cent of i t s product ion and impor ted nothing would s t i l l have a high

GDP, but a very poor standard of living.

The argument in favor of using GDP is not that i t is a good indicator of

the standard of l iving, but that , al l other things being equal , the standard

of l iving tends to increase when GDP per capita increases. As such, GDP

can be a proxy for the standard of living, rather than a direct measure. The

sometimes use of GDP per capita as a proxy of labor productivity is also

problematic.

LIMITATIONS OF GDP TO JUDGE THE HEALTH OF AN ECONOMY

GDP is widely used by economists to gauge the health of an economy, as

i ts variat ions are relat ively quickly identif ied. However, i ts value as an

indicator for the standard of l iving is considered to be l imited. Not only

t ha t, but i f t he a im o f economi c act iv it y i s t o p roduce eco logi ca ll y

sus tainable increases in the overal l human s tandard of l iving, GDP is a

perverse measurement ; i t t reats loss of ecosys tem services as a benef i t

instead of a cost. Other criticisms of how the GDP is used include:

Wealth distribution GDP does not t ake d i spari ty in incomes

between the r ich and poor into account. However, numerous Nobel-

prize winning economists have disputed the importance of income

inequali ty as a factor in improving long-term economic growth. In

fact , shor t term increases in income inequal i ty may even lead to

long term decreases in income inequali ty. See income inequali ty

metr ics for discuss ion of a var iety of inequal ity-based economic

measures.

Non-market transactions GDP excludes act ivi t ies that are not

provided through the market, such as household production and

volunteer or unpaid serv ices . As a r esult , GDP i s unders ta ted .

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Unpaid work conducted on Free and Open Source Software (such as

Linux) cont ributes noth ing to GDP, but i t was es timated tha t i t

would have cos t more than a bi l l ion US dol lars for a commercial

company t o devel op . A ls o, i f F ree and Open Source Sof twar e

became identical to i ts proprietary software counterparts , and the

nation producing the propr iety software s tops buying propr ietary

software and switches to Free and Open Source Software, then the

GDP of t hi s nat ion wou ld r educe, however t he re wou ld be no

reduction in economic production or standard of living. The work of

New Zealand economis t Mar i lyn Waring has highl ighted that i f a

concerted attempt to factor in unpaid work were made, then it would

in par t undo the in jus t i ces of unpaid (and in some cases , s l ave)

labor, and also provide the political transparency and accountability

necessary for democracy. Shedding some doubt on thi s c la im,

however , i s the theory tha t won economist Douglass North the

No be l P rize in 19 93. N orth argu ed th at the cre atio n an d

project on mutual funds (2)

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