--By Sushil Maharjan

 

The country’s only stock exchange, the Nepal Stock Exchange (NEPSE), has been thriving and attracting capital market investors. 

 

The Securities Board of Nepal (SEBON) received approval from the Nepali government under the Securities Act, 2007 to establish Mutual Fund Regulations, 2010 as well as the power to issue licences for mutual funds to be sold in Nepal.  In 2010, the first two mutual fund companies were licenced by SEBON and more are in the pipeline.  Nepal’s first mutual funds have since become well-established businesses that have successfully launched other mutual fund schemes.  In this brief period, SEBON has made new provisions to open secondary markets for non-resident Nepalis by making necessary amendments to Mutual Fund Regulations, 2010.  I strongly believe, in the next five to ten years, there will be more diversity in the Nepalis capital market as the mutual fund industry continues to mature.

 

We have seen the NEPSE reach a historical low of approximately 375 points back in 2006, and a high of approximately 1180 points in 2008, only for the index to reach an all-time low of approximately 292 points back in 2011. Although the NEPSE has had its share of bear and bull markets, however the index is on the brink of surpassing its highest point for 2013.  Capital markets affect portfolios of mutual fund holdings, as the (net asset) values of these portfolios increase and decrease according to the direction of capital markets.  Thus, the portfolio net asset 

value affects mutual fund unit prices on a daily basis. 

 

The NAV of a mutual fund is derived from the value of the underlying securities held in the fund’s portfolio, which is equal to the mutual fund’s assets, less all of its liabilities.  Many mutual funds use this number to determine the trading price for units of the fund. When investors buy and sell mutual funds, firms typically do so at the NAV; there is no secondary market in mutual fund units as the fund itself issues and redeems them.

 

We know confident Nepali investors are a big boost to the capital market, though increased trading volume doesn’t necessarily indicate that there is growing interest in the stock market; this may be because of reasons such as the improving political stability of Nepal, regulatory changes or available investment opportunities.  Value investors see how well companies or stocks are performing within their mutual fund portfolios and measure the performance and returns of all funds across all mutual fund asset classes as well as of market indices. 

 

In this changing and high-paced investment world, there are reasons to be concerned about mutual fund companies’ failure to adopt fair value pricing, which would help to avoid losses due to market timers and to manage emerging risk and market trends.  Compliance plays a very big role in capital markets and investments, especially with Nepal’s new mutual funds.  Compliance is the strict following of a requirement, such as specific regulations, policies, standards or laws.  The goal of regulatory compliance is to ensure that corporations or public agencies are made fully aware of relevant laws and regulations and take the necessary steps to follow them; this is vital in for Nepal’s capital market and mutual industry to thrive.  An increasing number of regulations and need for operational transparency will require that institutions that offer mutual funds adopt and consolidate their compliance controls, as this will ensure that all the necessary governance requirements can be met without duplication or inefficiency.  Mutual fund trade processing, recordkeeping, and transaction flows strengthen mutual fund oversight programs and operations. We know that compliance rules have the potential to improve mutual fund company operations and that the independence of the compliance function is key to preventing violations and/or abuses of securities laws, regulations and mutual fund policies. 

 

One has to be very conscious of the various risk types associated with mutual funds.  Operational risk cannot be overlooked; this arises from the individual systems and processes through which Nepal’s mutual fund companies operate.  Operational risk is stated in the Basel II regulations as the risk of loss resulting from inadequate or failed internal processes, people and systems or from any external events.  As an investor, one must recognize that the people, processes and systems of any given company are imperfect, and that losses can occur due to errors and ineffective operations.  Generally speaking, the volume of global financial transactions, combined with solid compliance reduces operational risk.  However, I want to focus on mutual fund valuation risk and trading abuse.  We know that assets can be overvalued or worth less than expected whenever they mature or are sold before then by brokers or dealers.  Initiating institutions, brokers, custodian banks, fund administrators, transfer agents and auditors currently share their information electronically and their processes are already automated, thus raising the potential risks with respect to data management and valuations.  As valuation risk affects transactions processing, front and back office operations, distribution, investment management as well as the private wealth and advisory services areas of mutual fund firms, I strongly believe that straightforward processes and trading strategies, dating and valuation techniques must be consistent throughout the trade processing cycle.  

 

 

From a mutual fund trade processing and recordkeeping standpoint, investors generally purchase, transfer in (or out), or sell fund units through multiple channels - either directly from the fund companies, or through various intermediaries, such as broker-dealers, financial advisors, banks and insurance companies.  Settlement risk occurs when the counterparty does not deliver a mutual fund’s value in cash as per its trading agreement with the other party upon the execution of trade instructions.  This is particularly true for assets that have low liquidity and are not easily tradable in public exchanges. Moreover, issues associated with valuation risks go beyond the firm itself. Mitigating risks as much as possible will provide transparency and ensure the integrity and consistency of the data, models and processes used in making and reporting calculations in the valuation of mutual funds.

 

(Maharjan has extensive financial services industry experience and is currently with CIBC Mellon, Canada’s Leader in Asset Servicing, jointly owned by Canadian Imperial Bank of Commerce and The Bank of New York Mellon.  This is not an official publication of CIBC Mellon. The views expressed are those of the author and are not necessarily those of CIBC Mellon or New Business Age.)