Editorial
Abdul Rahim Suriya, FCA President’s Page Zafar Iqbal Sobani, FCA Mutual Funds
Mutual Funds - Some Unique Issues Nasim Beg, FCA
Investing in Mutual Funds Altaf Noor Ali, ACA
Mutual Fund Nadeem Butt, A C A
Investing in Mutual Funds Rizwan Razzak, ACA Hedging Instruments
Hedging Instruments in the Petroleum Industry: A Brief Survey
Herald A. Osel Hedge Funds
Challenging Conventional Investment Management Mohammad Shoaib Jan Memon, ACA
Banking
Operational Risk Management in a Bank: Easier said than done!
Danish Ahmed Siddiqui, ACA Federal Budget 2005-06
Distortions in an Investor Friendly Budget? Adnan A. Mufti, ACA
Proposal to bring more services into GST Net Abbas, FCA
Information Technology
Flowcharting and Accountants Noor-ul-Huda Ashraf, FCA
Human Resource Management
Attributes of a Successful Manager Amirali Kassim Merchant, FCA
Institute News Obituary Sk. Hashmat Ali SAFA Conference
SAFA Conference Tasneem Yusuf, ACA IFAC News
IFAC eNews Health News
Constipation: Prevention and Treatment Dr. S. M. Wasim Jafri
Students’ Section
The Brilliant Scholar - Irfan Ghani Interviewed by Shakil Akhtar Qureshi, FCA P U B L I C ATIONS COMMITTEE
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Vol # 38
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Issue # 3 May - June 20053
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Editorial
Mutual Funds
Never in their wildest of dreams had the three Boston securities executives who pooled their money together to create the first official mutual fund in 1924 imagined how popular these would become for channelizing savings. Today, not only in the developed world where trillions of dollars are invested in these Funds, but also in developing countries like Pakistan mutual funds are growing at a galloping pace and have become an important vehicle for investing one’s savings.
People with small savings or those preparing for their retirements are particularly attracted towards these funds. It is not difficult to understand why mutual funds are so popular in these classes of investors. Empirical evidence indicates that these groups of investors are generally bad at picking stocks. Mutual Funds provide them with an easy way out. One is not required to be an expert on the hundreds of thousands of stocks that these funds own. Furthermore, they are easy to use, could be liquidated quickly in times of need, and have unique diversification capabilities that help in keeping the returns up and the risks down.
In Pakistan, the Government of Pakistan (GOP) ventured into this industry in 1960s by establishing the National Investment Trust (NIT) and the Investment Corporation of Pakistan (ICP). However, in 2002 the GOP decided to privatize the two funds. ICP is now operating in the private sector, and the privatization of NIT is slated for 2005. A number of private sector companies have also entered into this industry.
Privatization and the entry of the private sector have rejuvenated the mutual fund industry in Pakistan. Not only the number of funds has substantially increased but also a number of new products have been introduced, and the net assets value of the funds is estimated to have increased by five times in just three years.
The regulators too have been active, and have enacted rules and regulations to provide all the players a level playing field. However, Mr.Nasim Beg, FCA h a s highlighted in his article published in this journal a number of anomalies in these rules and regulations that need to be redressed.
Industry analysts are predicting a very bright future for these funds, and the interest of the general public is expected to increase manifold in them. It is therefore essential to strengthen the regulatory framework governing these funds and make it more effective. On its part the industry should not only follow religiously the code of corporate governance in Pakistan, but also voluntarily adopt the international best practices. This would boost the confidence of the investor in mutual funds, and in the capital markets of the country.
Abdul Rahim Suriya, FCA
President’s Page
Pakistan Accountant has been regularly bringing its issues on very interesting topic and the current issue on Mutual Funds in Pakistan perspective is a very important theme.
Mutual Funds are a vital component of the financial market for mobilization of savings Their incredible popularity in advanced countries is recognized, Mutual Funds have also progressed significantly in emerging economies and our neighboring country India is excellent example reflecting the gigantic growth in the regime of Mutual Funds in last few years. In Pakistan Mutual Funds have evolved at a cautious pace, however for the last three years the fund management industry has progressed at a very fast pace with the participation of private sector in this industry which was run exclusively in the public sector and was unfortunately working with lot of red tapism generally associated in the public sector.
Now the focus of the industry is tilting towards open end funds from closed end funds, several new products have been introduced and others are in the process of being rolled out. These Mutual Funds are now developing the quality man power resources who are working with them and this will result in the Mutual Fund industry poised for significant growth in the next few years. We have, on several occasions, witnessed the crisis in the Stock Exchanges and bleeding of the common investor who opted to enter in the highly bullish market for making some quick money. Mutual Fund industry development at fast pace will go in long way to facilitate these investors and they can use this vehicle to channelise their savings for achieving steady return. One important thing which should be borne in mind is the role of regulators and their efforts to evolve the Code of Corporate Governance and best practices for the mutual industry and it is heartening to note that at present all the players in the field are, by and large, playing proactive role which will add great value to mutual fund industry, it is also heartening that a few members of ICAP are associated with the mutual industry in key position and are contributing exceedingly well.
I C A P elections process which started in February was successfully completed in June with nail biting finish, the election also witnessed high turnout of members on electoral day which has been the hall mark of our last few elections and it reflects close attachments our members have with ICAP., the new Council will be meeting in due course as we have received the name of government nominees after which the two regional committees in South and North will
start their business. I congratulate the newly elected members and wish them great success. The current four years term of the council was a very challenging one as a result of the global events which brought accounting profession in the focus, these events have benefited the accounting profession in a big way as International Federations of Accountants took a lead in revisiting the issues relating to the profession and other accounting bodies followed it and this process is still going on. The accountancy profession in Pakistan under the lead of ICAP has also taken number of initiatives in this regard which are shared with our members through our publication and web site and I am thankful for the whole hearted support we have got from all of you .Our coordination with the front line regulators is excellent and has resulted in bridging the gap of trust to quite an extent. ICAP’s resources have been strengthened specially in the human resource area, the members are feeling this change and I am confident, in future, the results of the improvements which are taking place will be more visible to all the stakeholders, however this is not the end of story as the reform process will need to carry on to face the challenging of complexities in businesses. I will like to share, in this regard, that in last council meetings we have taken a few bold decisions in the area of education in order to attract the good entrants in the profession which will enable in increasing the size of membership which currently is not in line with the demand of our professionals in the country and outside Pakistan specially developed countries. The council has also recently allowed the professional firms engaged in auditing practice the use of foreign names in combination with their local name, these reforms will strengthen us to face the global challenges.
In the end, I would like to place on record admirable support from all the council members specially the Vice Presidents from South and North and the Regional Committees members. I would also like to thank the ICAP management team for their admirable support to me and I am very confident that this new team under the leadership of Executive Director will be able to cope with the challenges of future.
Mutual Funds
Mutual Funds
Some Unique Issues
Most readers of this journal are reasonably well informed about the advantages of investing through mutual funds. However, there are some issues unique to mutual funds that should be of special interest for professional accountants.
Income Tax
Most professional accountants will know that mutual funds are not taxed provided they distribute 90% of their income. However, what is generally not realised is that this is not an ‘exemption” but simply a mechanism for avoidance of double taxation. A person investing directly in the market would pay tax on dividends received. If, however, the person went through a mutual fund and the fund suffered tax on the dividend received by it and in turn the investor also were to suffer tax on the income distributed by the fund, it would amount double taxation of the same income. The tax law is designed to avoid this anomaly.
Net Asset Based Accounting
The Net Asset Value (NAV) is an important aspect of mutual funds. An investor buying or selling a share (unit or certificate) of a closed-end mutual fund through the stock exchange needs to know the underlying true market value of the share so as to make an informed decision. In the case of open-end funds, the units are issued and redeemed on NAV based prices.
The NAV is the market value of the portfolio of assets/securities less any liabilities; and the NAV per unit is the NAV of the fund divided by the number of its units in issue. The point to note is that the assets of a mutual fund are valued at market and not at “cost or market whichever is lower”, which is what is considered prudent for most other situations. The reason for using market value is that anyone buying into or exiting from a mutual fund must be treated fairly with respect to the true value of the portfolio. The significance of this is illustrated by the example in the following paragraph.
If we assume a fund was set up a few years ago and it continues to hold the shares bought by it then and that the market value of the shares today is three times the original cost. If we also assume that the original size of the fund was Rs. 1,000,000,000 and it had issued 100,000,000 units at Rs. 10 each, the market value of the portfolio today will be Rs. 3,000,000,000 and the NAV Rs. 30 per unit. In the event we valued the portfolio at historic cost and consequently the price of Rs. 10 per unit, a person joining the fund today with say Rs. 1,000,000 would get 100,000 units instead of 33,333 units (if market value was applied). In other words, this new investor would get an undue benefit by paying a lower price and becoming a 1.0% owner of the portfolio instead of 0.33% owner at
the market value. This would be at the cost of the rest of the investors in the fund as their interest will be diluted. A similar logic will apply for someone leaving the fund, where the person must be paid fair market value rather than historic cost.
Daily Financial statements: The NAV based accounting makes it a
must to draw up daily financial statements with full accruals so as to ensure determination of accurate NAV. Some mutual funds subject themselves to a continuous audit throughout the year so as to ensure accuracy, as errors cannot be undone once units have been issued or redeemed.
Element of Profit or Gains included in NAV
Having addressed the matter of the importance of issuing and redeeming units of an open-end fund on the basis of an accurate marked-to-market NAV, another interesting aspect from the accounting view point is of the treatment of certain elements included in the NAV.
Each time new units are issued one could simply take the entire proceeds of the issue to the capital account of the fund as this would be new capital coming into the fund. However, this would pose a problem as, at any point in time, a fund will have some realised and unrealised income and gains (or losses), thus the distributable amount of income per unit (if any) at that point in time, will be diluted by the new units that are issued (albeit at NAV and therefore not impacting the overall worth per unit).
The way to manage this is to work out the break-down of the net assets. Assuming that some new units are being issued at this point in time but there has been no issue or redemption since the beginning of the financial year prior to this, then the net assets at this point in time will comprise of the capital at the beginning of the financial period, some amount in the Income Statement (profit or loss resulting from realised gains or losses, income such as dividends etc., less expenses) and an unrealised surplus or deficit on the valuation of the assets (being marked to market). The NAV per unit applicable to the new entrant will be apportioned between the Income Statement and the Capital Account in proportion to their relative weight in the net assets.
Thus if an investor comes into an open-end fund on the last day of the financial year, the person will buy into the income (or the loss) accrued for the financial year and will be entitled to get some portion of this back by way of dividend that may be declared after the close of the year. Nasim Beg, FCA
Mutual Funds
This new entrant will be entitled to the dividend distribution for the year (at par with other unit holders) and the Income Statement will have the capacity to accommodate this new entrant’s entitlement as it would have been credited with the element of income this person has bought while coming into the fund. Once the dividend is paid out, the NAV will drop to the extent of the dividend. Thus a person remains indifferent as to when he or she enters or exits an open-end fund (expect to the extent of tax impact, if any, on dividend). On the other hand, the dividend distribution capacity of the fund is not impacted by dilution.
Element of income at redemption stage:
Similar to the principle applied at the entry stage, a person exiting the fund gets full NAV and takes the accrued earnings with him or her. This means that the dividend distributable out of the Income Statement is reduced in proportion to the number of units redeemed, thus the amount distributable per unit remains undisturbed.
Timing of NAV based prices
The NAV based prices are designed to ensure that all unit holders of a fund are treated fairly at the time of any investor joining or leaving the fund. Since the NAV based price reflects the marked-to-market valuation of the portfolio of the fund, one expects that the by using this price we will achieve the objective. However, in view of the price volatility of the underlying assets, by the time we act in the market after an investor comes in, the prices in the market may have moved up, thus the fund would pay more than it has recovered from the new investor. This would be at the cost of the rest of the unit holders. The best way would be to charge the new entrant the exact purchase cost and not the historic NAV, however this is not practical, thus the next best way is to charge the NAV based price next fixed after the person joins the fund. In this manner the new entrant cannot deliberately attempt arbitrage against the fund by trying to buy units at a historic price when the market may have moved up. Similarly, a person exiting the fund is best paid off at the price determined after the application to redeem has been
lodged so as to avoid deliberate arbitrage by exiting at the historic price when the market may have fallen. Mutual funds can favour some clients by bending the rules in this regard, something we must guard against.
Transaction Costs
Having dealt with various issues in trying to ensure that we have a fair (to everyone) system for allowing entry into and exit from a mutual fund, there still remains one important issue which is not widely recognized. This relates to the transaction costs of buying or selling securities in the market such as brokerage and custodian’s movement charges etc. When some new entrant comes into the fund on an NAV based price, it is assumed that the fund will be able to buy more securities out of the new entrant’s money by buying these at the prices used for working out the NAV. Even if the fund is able to, (we assume that some times it will pay more and at times less, thus averaging out over time), it will still have to suffer transaction costs that would not have been included in the NAV, as the N AV reflects market prices without brokerage etc. These transaction costs should be ideally be recovered from the new entrant. Funds following best industry practices estimate these transaction costs as a percentage of the NAV and add these on to the NAV for determining the issue price of the units. The transaction costs are separate to any sales load a fund may c h a rge for paying towards distribution costs. The sales load recovered in the issue price is retained by the management company and paid out in form of selling commissions etc. However, the transaction costs that are recovered are paid to the fund enabling it to offset the costs it will suffer.
Based on this rationale the transaction costs should also be recovered from exiting unit holders so that the fund does not suffer these costs while selling securities to pay off the exiting unit holder. This would be achieved by deducting the estimated costs from the NAV. However, if a fund is at a growing stage, i.e., it has net inflows, it is not likely to be selling securities to pay off exiting unit holders, thus it need not recover this cost. In fact it may have some
surplus left over from the transaction costs recovered from new entrants as there will be some redemptions and therefore somewhat lesser amount of securities to be p u rchased as a result of the net cash received from the proceeds of issues less redemptions.
Valuation of Debt Securities
As has been elaborated earlier, it is extremely important that all securities in the portfolio of a mutual fund are valued at market. However, the NBFC Rules, which govern mutual funds, have their origin in a set of earlier rules which were structured with listed shares in mind. The Rules require listed securities to be valued at the price at the stock exchange and unlisted securities at cost or break-up value. Corporate bonds (TFCs) are listed but rarely traded at the exchanges. Thus the last price recorded at the exchange can be quite outdated and at times does not even account for in part redemption of the TFC. These prices are therefore not representative of true market value at which these are traded at between financial institutions outside the exchange. Government bonds are not listed and it would be totally inappropriate to value these at historic cost. Most mutual funds value these at true market but in violation of the Rules, thus the audit reports of such funds get qualified by their auditors. On the other hand some funds are known to have treated government bonds as “Held to maturity” under IAS 39, thus totally flouting the NAV principle and yet their accounts do not get qualified – Perhaps the accountant community needs to be a bit more alive to the matter and propose some remedial measures for having the Rules and the IAS brought in line with ground realities.
About the Author:
Mr. Nasim Beg is a Fellow Member of the Institute of Chartered Accountants of Pakistan. He is the Founder and Chief Executive Officer of Arif Habib Investments. Readers are welcome to contact him at:
Mutual Funds
Investing in Mutual Funds
Altaf Noor Ali, ACA
Think of a group of people who collectively decide to contribute funds with an intention of making a return by investing the pool prudently in financial securities - primarily in shares of companies listed on stock exchange.
The above is a practical illustration of what ‘mutual funds’ are all about. In a slightly sophisticated way, it is simply a legal arrangement where by a group of investors contribute funds with the specific objective of investing it in securities. You may be wondering why should one be bothering about ‘mutual funds’ when you can just about walk in any bank and deposit almost immediately your entire funds there in any of the so-called ‘attractive’schemes such as certificate of investments etc. A l t e r n a t i v e l y, you may also invest in National Saving Schemes, which offers Khas Deposit Certificates, or Defence Saving Certificates. The advantage of doing so is that you can go for whoever is offering you the best ‘rate’ and lock your funds. It is easy and relatively risk-free. Isn’t it?
Panel -1
Net Asset Value:
To compute NAV of a close-end mutual fund, we simply take the total of ‘shareholders’equity’and divide it by the number of shares.
For example, the total of shareholders’ equity of Al-Meezan Mutual Fund at 30 June 2004 was Rs. 1,127,312,058 (the same as net assets). On that date, there were 77,500,000 shares outstanding (Note 12).
This means on that date its NAV was 1,127,312,058 divided by 77,500,000 = Rs. 14.54 per share.
True. However, you need to see what happens after you lock your funds. Whoever has promised you to pay a certain ‘rate’, whether it is an established bank or a government saving institution, they would not sit on your money. They need to invest funds where it earns a return not only to keep Johnnies like us happy but also to make something above it to keep making all those high-rise buildings and immaculate offices. And where do you think they invest? They either loan it out to businesses who promise to pay them even higher, or invest it in capital market. And its in the capital markets (of which stock exchange is an example), where you find ‘close-end’and ‘open-end’ mutual funds in which these institutions invest heavily, hoping that at the end of the day they will pay
peanuts to depositors like us and keep the cake for themselves.
You do not have to believe me. We will discuss only one representative example. Just pick up the Annual Report 2004 of Al-Meezan Mutual Fund Limited, a close-end mutual fund listed on the Karachi Stock Exchange, and go to ‘Categories of Shareholders as of 30 June 2004’ on page 33.
You will find that on 30-6-04, the general public held 21% only of its shares, whereas banks, development finance institutions, insurance companies and other institutions held 79%. Specifically, these included names like Meezan Bank Limited (2%); Meezan Islamic Fund (12%); A l - M e e z a n Investment Management Ltd. (14%); NIT & ICP (4%); Pak Kuwait Investment Company (Pvt) Ltd. (19%); State Life Insurance Corporation of Pakistan (3%); and 10% held by Union Bank Ltd, Faysal Bank Ltd., Muslim Commercial Bank Ltd., Prime Commercial Bank Ltd., PICIC Commercial Bank Ltd., and Dawood Leasing Company Ltd. The last 15% was held by provident funds, corporate bodies etc.
The bottom line here is that if you are a little ambitious than a conservative deposit holder, to start with, you may as well consider investing a part of your funds in a mutual fund in your quest for finding better ‘returns’ than a bank deposit. As time goes by, with an experience of couple of accounting cycles, you are likely to grow in confidence. Investing in Mutual Funds may sound a bit risky to a new comer as there is no promise of a pre-determined ‘rate’, but you can be sure that the level of risk you are accepting is no different then that of the banks who invest in them.
Assuming that you feel confident enough to explore this topic further, remembering the difference between ‘close-end’ and ‘open-‘close-end’ mutual funds can be helpful.
As a rule, you will find a ‘close-end’ mutual fund only to be listed on stock exchanges in Pakistan, primarily because the holders of its shares or certificates can buy and sell it without any reference to the company (except for registering change in ownership), just like any other security traded on the stock exchange. For example, if you wish to buy 1000 shares of Al-Meezan Mutual Fund Limited, only a holder who has already got it can sell it to you. The funds involved in the transaction would not go to the Fund directly. Does it mean that all mutual funds listed on Stock Exchanges in Pakistan are close-end Funds? Certainly!
Mutual Funds
On the other hand, for open-end mutual fund, no buying or selling in its securities can take place without direct reference to the Fund. For example, National Investment Trust is an open-end mutual fund. If you wish to buy its 1,000 certificates, you may do so only by going to one of its designated branches or dealers; whatever agreed price you pay would go directly to NIT on whose behalf a certificate of ownership will be issued to you. This is also true for the rest of open-end mutual funds like Al-Meezan Islamic Fund, for which you need to contact the Fund or its authorised dealer directly.
You may be longing to figure out: which type of Fund would be suitable for you? Well, I personally like ‘close-ends’ and the reason is that most of them are available at a discount to their Net Asset Value (see panel-1) whereas open-ended mutual funds are normally quoted at their NAV or at a slight premium. So, if I can buy a close-end at a discount of almost 20 to 35%, what is the need of going for an open-end fund, each with its own way of working, especially when the returns are also quite competitive?
Secondly, you can invest relatively smaller amounts in close-ends. For example, on 24 August 2005, Abamco Composite Fund Limited, another close-end fund, was traded between Rs. 6.45 and Rs.6.85 per certificate. Buying 500 or 50,000 of
Facts about Close-end Mutual Funds:
Market capitalisation = Number of shares x Closing price. Example: PICIC Investment Fund had 284.125 million shares and its closing price on 24-8-05 was Rs. 13.95. Therefore, its market capitalisation was = 284.125 x 13.95 = Rs. 3.963 billion.
Similarly, the market capitalisation of close-end mutual fund as a whole on 24-8-05 was Rs. 31.4 billion.
its certificates can be as easy as calling my stockbroker and within ‘seconds’ he can confirm the purchase transaction to me. I need less than Rs. 3,500/= to buy its 500 certificates. On the other hand, I would only get less than 7 units of Atlas Income Fund, an open-ended fund whose offer price that day was Rs. 516.54 plus a time consuming trip to its offices and filling out some forms.
Let us now try to gain some idea about the close-end mutual funds listed on the Karachi Stock Exchange. You will find stock quotes in almost all newspapers and you will have no difficulty in finding the headline ‘close-end mutual funds’ under which all such funds are listed. On 24-8-05, there were around 22 Funds listed there. Panel-2 shows the close-end mutual funds listed on Karachi Stock Exchange on 24-8-05.
Mutual Funds
Panel 2: Additional Notes
1. Price behaviour of last 52 weeks. We take PICIC Growth Fund (PGF) as an example and see that during last 52 weeks, its price oscillated between Rs. 37.50 and Rs. 79.95 – a fluctuation of 2.13 times from its lows (during this time PGF declared an interim stock bonus of 25%; it may have touched Rs. 79.95 with 25% stock dividend included in that price). The lesson here is that market gives an opportunity to invest at a reasonable price to a patient long-term investor. Buying it ex-bonus ex-interim around Rs. 45 would give you a gain of Rs. 5 per certificate at 24-8-05 closing and gross final dividend of Rs. 3.50. Total gain=Rs.8.50 or 17.8% of Rs. 45. Not bad!
2. What is EPS? Earning per Share is computed by taking the profit after tax for the year and dividing it by the number of outstanding shares. Example: Meezan Balanced Fund MBF earned Rs. 146.636 m for the year ended 30 June 2005. On that date, it had 120 m shares. Its EPS 2005 was = 146.636 divided by 120 = Rs. 1.22.
3. What is P/E? Price Earning ratio is computed by taking the closing price and dividing it by EPS. The P/E for MBF on 24-8-05 = 8.80 divided by 1.22 = 7.25 times. It can be said that its present price equals its current earnings of 7.25 years. Buying good stocks at lowest P/Es is a goal of every sensible investor.
Where is the NAV?
Earlier, I said that most close-end mutual funds are available at a discount to its NAVs. Let us validate this point and have a look at Panel-2 to see if you can spot the NAVs?
You may be thinking of a misprint, since the column for NAV information of each Fund is missing in the Panel. The truth is that there is no misprint. Simply put, the NAV of close-end mutual funds is not a part of the daily stock quote. Infact, NAV of each Fund is notified by the management of the Fund to the Stock Exchange on a weekly basis but you may not find such information readily available in the newspapers [The daily NAV of Abamco and Al-Meezan related close-end (and open-end) funds can be found from their websites w w w.abamco.com and www. a l m e e z a n g r o u p . c o m respectively. ‘The News’daily, also prints NAV of some funds in its business section].
I could not access the latest NAV of all the Funds, of those with me follows. Panel-3 shows that most of close-end mutual funds are available at a discount.
What are the 2005 yields?
The close-end mutual funds yield is an important matter for an investor. Panel-4 shows how they fared for the fiscal year 2005.
It is a valid question to find out if the close-end funds will continue to perform similarly in 2006. For this, the investors need to understand the direct relationship between the close-end mutual funds and the stock market. When market performs better, so do most mutual funds. The reverse is also true. The market goes down and the returns are anaemic.
Panel 3: Additional Notes
1. NAV = Net Asset Value = Total of Shareholders Equity. This is actually NAV per share. To find it you take Shareholders Equity and divide it by number of outstanding shares. 2. Discount. The closing price of Abamco Composite on 24-8-05 was Rs. 6.45. On that date, its NAV was Rs. 10.54. The NAV was higher than Market Value by Rs. 4.09. This means it was selling at a discount = 4.09/10.54 = 0.388 or 38.8%. Buying at scrip at a discount from NAV is ‘safe’ for the investor.
However, investor should be alert about too steep discount. In this case, no final dividend for 2005. It paid 12.5% as interim dividend, reasonable given its price.
Mutual Funds
Panel 4: Additional Notes
1. Distributions = Cash Dividends, Stock Bonus, or Right shares issued during last three years. Example: In 2004, Pakistan Premier Fund announced a 12.5% Cash Dividend, 25% Stock Bonus, and 50% Rights (an option to subscribe an additional share for every two shares held).
2. Net Dividend = For individuals there is a 10% at source deduction hence the difference between dividend and net dividend. Example: Pakistan Strategic Fund declared a cash dividend of Rs. 1 but an individual investor would only get Rs. 0.90.
3. Average = The average of high and low prices during last 52 weeks. Example: Abamco Growth Fund = high + low divided by 2 = Rs. 31+ Rs. 19 divided by 2 = Rs. 25. 4. Yield = Net Dividend divided by Average Price. Example: Golden Arrow = 1.80 divided by 6.65 = 0.2707 or 27.07%.
Conclusion:
In this article, we have explored values of close-end mutual funds through NAV and Yield approaches. Feel free to use the format here to update position.
As a courtesy to my readers, I must also disclose that I own some of the close-end funds mentioned in this article and that I carry out investment research for my clients.
About the Author:
Mr. Altaf Noor Ali is Chartered Accountant practicing in his own name.
Readers are welcome to contact him at: [email protected]
Mutual Funds
MUTUAL FUND
Nadeem Butt, ACA
A fund operated by an investment company that pools / raises money from shareholders and invests in a variety of securities, including stocks, options, bonds and money market instruments.
A mutual fund stands ready to buy back (redeem) its shares at their current net asset value, which depends on the total market value of the fund's investment portfolio at the time of redemption. The US name for mutual fund is “Unit Trust”.(refer table attached)
The two principal types are closed-end and open-end mutual funds.
Shares in closed-end mutual funds, some of which are listed on stock exchanges, are readily transferable on the open market and are bought and sold like other shares. Open-end
funds sell their own new shares to investors, stand ready to buy back their old shares, and are not listed.
Closed-End Fund - A type of investment company that has a
fixed number of shares that are publicly traded. The price of a closed-end fund share fluctuates based on investor supply and demand. Closed-end funds are not required to redeem shares and have managed portfolios.
As open-end investments, most mutual funds continuously
offer new shares to investors. These funds offer investors the advantages of diversification and professional management and enables its shareholders to pool their funds for professional management as a single investment account. A mutual fund, or an open-end fund, sells as many shares as investor demand requires. As money flows in, the fund grows. If money flows out of the fund the number of the f u n d ’s outstanding shares drops. Open-end funds are sometimes closed to new investors, but existing investors can still continue to invest money in the fund. In order to sell shares an investor usually sells the shares back to the fund. If an investor wishes to buy additional shares in a mutual fund, the investor must buy newly issued shares directly from the fund. Mutual Funds have a low minimum investment amount, can be bought or sold any business day.
Each shareholder ’s investment is priced at a net asset value representing that share’s portion of the collective investments of the fund and at which price shares may be purchased or redeemed (sold).
Professional portfolio investment managers, usually called the AMC ( Asset Management Company), decide to buy, sell or hold securities in an attempt to take advantage of current and future market conditions. Investors profit through increases in the fund's share price (appreciation) and through the distribution of dividends. All owners in the fund share in the gains or losses of the fund.
How the fund invests is determined by the fund's objectives. The mutual fund's prospectus details this type of information plus information on any fees, the management company and other relevant data.
They offer investors a variety of goals, depending on the fund and its investment charter. Some funds, for example, seek to generate income on a regular basis. Others seek to preserve an investor's money. Still others seek to invest in companies that are growing at a rapid pace.
Funds can impose a sales charge, or load, on investors when they buy or sell shares. Many funds these days are no load and impose no sales charge.
If you wish to invest in a mutual fund you should get answers of the following:
1. What area or instruments does the fund invest in? 2. What has been the long-term rate of return? 3. How much return has been varied in the past?
4. How does the fund’s performance compare with that of the underlying market?
5. Is the fund seeking income or capital growth? *Past performance is not indicative of future results.
And before selecting a fund to invest in you should learn:
1. How to read a fund prospectus
2. How to assess a fund manager's investment style and its impact on your returns
3. How to evaluate fees and expenses 4. How to evaluate risks
Mutual Funds
1.HOW TO READ A
FUND PROSPECTUS
Key Elements of a Mutual Fund Prospectus are:
Date of issue—First, verify that you
have received an up-to-date edition of the prospectus. A prospectus must be updated at least annually.
Minimum investments—Mutual funds
differ both in the minimum initial investment required, and the minimum for subsequent investments.
Investment objectives — The goal of
each fund should be clearly defined — such as income with preservation of principal or long-term capital appreciation. Be sure the fund’s objective matches your objective.
Investment policies — A prospectus
will outline the general strategies the fund managers will implement. You’ll learn what types of investments will be included, such as government bonds or common stock. The prospectus may also include information on minimum bond ratings and types of companies considered appropriate for a fund. Be sure to consider whether the fund offers adequate diversification.
Risk factors—Every investment involves
some level of risk. In a prospectus you’ll find descriptions of the risks associated with investments in the fund. Refer to your own objectives and decide if the risk associated with the fund’s investments matches your own risk tolerance.
Performance data— You’ll find selected
p e r-share data including net asset value (NAV) and total return for different time periods since the fund’s inception. Remember that past results do not guarantee future performance. When evaluating performance, look at the track record of a fund over a time period that matches your own investment goals.
Fees and expenses — Sales and
management fees associated with a mutual fund must be clearly listed. The prospectus will also display the impact these fees and expenses would have on a hypothetical investment over time.
Tax information — A prospectus will
include information on the tax status and implications of a fund’s distributions, and whether they will be treated as dividend income or capital gains.
Investor services — Shareholders may
have access to certain services, such as automatic reinvestment of dividends and systematic withdrawal plans. Be sure to read the prospectus and ask questions about items that you are not sure about before investing.
2. HOW TO ASSESS A
FUND MANAGER’S
INVESTMENT STYLE AND
ITS MPACT ON
RETURNS:
Some fund managers follow an investing "style" to try and maximize fund performance while meeting the investment objectives of the fund. Fund styles usually fall with in the following three categories.
Fund Styles:
w Va l u e : The manager invests in stocks believed to be currently undervalued by the market. w G r o w t h : The manager selects
stocks they believe have a strong potential for beating the market. w Blend: The manager looks for a
combination of both growth and value stocks.
To determine the style of a mutual fund, consult the prospectus as well as other sources that review mutual funds. Don't be surprised if the information conflicts. Although a prospectus may state a specific fund style, the style may
c h a n g e . Value stocks held in the portfolio over a period of time may become growth stocks and vice versa. Other research may give a more current and accurate account of the style of the fund.
3. HOW TO EVALUATE
FEES AND EXPENSES:
Mutual funds charge some amount for their services. Of course, these charges will affect the amount of money you’ll have someday. The secret is to evaluate the full potential of an investment—the amount you keep after paying the fees. Here’s a simple strategy to help you get started: 1.Understand fees and expenses. 2.Compare charges that apply to
mutual funds.
3.Consider redemption fees or rates (difference of buying selling)
Shareholder Fees
These fees are paid directly from the share-holder's account and may include:
Sales Charge
This fee, also called a "load," is paid to the shareholder's investment professional as compensation for acting as the intermediary between the fund company and the investor.
Front-end Load
This load is imposed at the time of the purchase. It is shown as a percentage of the fund's offering price (the fund's price per share, which includes the front-end sales charge).
Exchange Fee
This fee is levied to help defray the administrative costs associated with exchanging from one fund to another within the same family, within the same class of shares. Often, a fund will allow a certain number of free exchanges before imposing this fee.
Mutual Funds
Redemption Fee
In an attempt to discourage frequent trading in and out of a fund, a redemption fee may be imposed. This fee may be eliminated after the shares are held within a fund for a certain amount of time, such as 30 or 60 days. This fee can apply to redemptions as well as exchanges out of a fund.
Account Fee
This may be applied to help cover the administrative costs of maintaining an account. For example, some funds may charge an annual fee.
Annual Fund Operating Expenses
These expenses are deducted from the fund's assets and typically cover ongoing costs associated with running the fund itself. These may include the following:
Management Fee
This is often the largest operating expense and it covers the costs associated with the professional management of a fund's portfolio.
Other Expenses
These include miscellaneous custodial, legal, accounting, and other administrative expenses associated with operating a mutual fund.
Adding it up — Total Annual Fund Operating Expenses
Now that you know what your fund is paying for and how you're being charged, you need a way to evaluate and compare these costs. The tool for this job is the expense ratio and it generally appears in the "To t a l Operating Expenses" line at the bottom of the Annual Fund Operating Expenses table in the prospectus. Simply defined, the expense ratio is the percentage of a fund's average net assets (assets minus liabilities), which is spent on operating expenses during a fiscal year. For instance, if a fund has assets of Rs.500 million and annual operating expenses of Rs.10 million, the expense ratio in this case would be 2%.
The expense ratio excludes shareholder fees and some other charges such as portfolio trading costs. Because portfolio transaction costs are not always paid separately from the cost of buying or selling securities, they do not appear in the fund's expense ratio.
Anything that affects operating costs can have a bearing on the expense ratio. When you're examining expense ratios among funds, be sure you're comparing apples-to-apples — because the average costs of managing different types of investments can vary d r a m a t i c a l l y. And, while expense ratios make it easy to evaluate the costs of similar funds, don't forget to compare a figure that's even more important in your investment decision: total return.
"No Load" Doesn't Mean "No Fees"
Although mutual funds labeled as "no load" don't have an up front sales charge that does not mean they are free of other charges. No-load funds may carry purchase fees, redemption fees, exchange fees, and account fees. And, of course, shareholders of almost all funds are subject to the indirect costs associated with annual operating expenses.
4. HOW TO EVALUATE
RISKS
Different mutual funds have inherently different risk characteristics and should not be compared side by side. A bond fund with below-average risk, for example, should not be compared to a stock fund with below average risk. Even though both funds have low risk for their respective categories, stock funds overall have a higher risk/return potential than bond funds.
Mutual funds face risks based on the investments they hold.
Following is a glossary of some risks to consider when investing in mutual funds.
Call Risk. The possibility that falling
interest rates will cause a bond issuer to redeem—or call—its high-yielding bond before the bond's maturity date.
Country Risk. The possibility that
political events (a war, national elections), financial problems (rising inflation, government default), or natural disasters (an earthquake, a poor harvest) will weaken a country's economy and cause investments in that country to decline.
Credit Risk. The possibility that a bond
issuer will fail to repay interest and principal in a timely manner. A l s o called default risk.
Currency Risk. The possibility that
returns could be reduced because of a rise in the value of the currency against foreign currencies. Also called exchange-rate risk.
Income Risk. The possibility that a
fixed-income fund's dividends will decline as a result of falling overall interest rates.
Industry Risk. The possibility that a
group of stocks in a single industry will decline in price due to developments in that industry.
Inflation Risk. The possibility that
increases in the cost of living will reduce or eliminate a fund's real inflation-adjusted returns.
Interest Rate Risk. The possibility that
a bond fund will decline in value because of an increase in interest rates.
Manager Risk. The possibility that an
actively managed mutual fund's investment adviser will fail to execute the fund's investment strategy effectively resulting in the failure of stated objectives.
Mutual Funds
Market Risk. The possibility that stock
fund or bond fund prices overall will decline over short or even extended periods. Stock and bond markets tend to move in cycles, with periods when prices rise and other periods when prices fall.
Principal Risk. The possibility that an
investment will go down in value, or "lose money," from the original or invested amount.
5. HOW TO CALCULATE
RETURN ON
INVESTMENTS
You make money from mutual fund investment when:
w The fund earns income on its investments, and distributes it to you in the form of dividends.
w The fund produces capital gains by selling securities at a profit, and distributes those gains to you. w You sell your shares of the fund at a
higher price than you paid for them The average annual return for a mutual fund is stated after expenses. The expenses include fund management fees. Average annual returns are also factored for any reinvested dividend and capital gain distributions. To compute this number, the annual returns for a fixed number of years (e.g., 3, 5, life of fund) are added and divided by the number of years, hence the name "average" annual return. This specifically means that the average annual return is not a compounded rate of return. In addition to this appreciation in the sale price of the fund share / unit over that period is also part of the profit.
ARE UNIT TRUSTS
DIFFERENT FROM
MUTUAL FUNDS?
From an investment perspective, there are no major differences between unit trusts and mutual funds. Both are professionally managed portfolios which invest in a wide variety of financial instruments.
The key difference between the two lies in the legal structure:
Unit Trusts Mutual Funds
Form of establishment Trust Limited liability company
Beneficiary Unit holder Shareholder
Governing law Trust law Company law
Legal document in which the rules Trust deed Company's articles/ bye laws &
are laid down custodian agreement
Who protect investor interests Trustee Custodian (but according to the custodian
agreement and articles / bye laws).
Who owns or holds the fund assets Trustee holds the The mutual fund company
assets for the owns the assets and benefit of the Investors are shareholders
investors of the company.
Who is liable Trustee The company has limited
liability; directors can be liable.
About the Author:
Mr. Nadeem Butt, ACA qualified from Gardezi & Co., Lahore in 2001. Presently he is working as Head of Internal Audit & Budget Depts. at TAQ Logistics. Readers are welcome to contact him at: [email protected]
Mutual Funds
Investing in Mutual Funds
Looking for income and some growth from your investments?
Who isn’t?
The big problem: You typically can’t have your cake and eat it too. The higher the return on an investment, the greater the risk. Mutual Funds are the tools to diversify risk and earn decent returns.
Thanks to the break of the bear spell over the stock market that catalyzed the rebirth of mutual funds in Pakistan. It now promises to be one of the fastest growing industries in the financial sector. The economic overturn of the country after 9/11 has played significant role in the boost of this sector. Once reluctant corporate giants are now the leading investors in the mutual funds. The concept of mutual fund is very simple. It replicates a prudent single individual by pooling the resources to exploit the underlying asset class more efficiently and effectively.
Securities and Exchange Commission of Pakistan introduced Investment Companies and Investment Advisers Rules, 1971 and Asset Management Companies Rules, 1995 to regulate open and close end funds. Although not comprehensive, however these were the initial steps in regularising the fund management industry in Pakistan.
Later in 2003 The Non-Banking Finance Companies (Establishment and Regulation) Rules, 2003 were introduced that not only combined scattered regulations governing non-banking financial sector but also tried to be more comprehensive then the predecessors individual laws. This shows progression and commitment of the regulators for the sector. However still the issues of benchmarks for fund return, addressing accounting and reporting issues and standardised risk control measures for investment in other than stock sectors are few of the concerns that need proper attention.
In Pakistan, at present 14 open end and 20 close end funds are under operation. Many more are in pipeline and several are in conceptual phase. Most of them are plain vanilla funds investing purely in capital markets or money markets and a
few of them calling them as balanced fund. However, as the market grows we may witness products with complex and sophisticated investment strategies and overlapping asset classes.
We appreciate regulators recognition of the sensitivity of the i n d u s t r y. In accordance with the NBFC Rules, a fund manager cannot advertise in any form unless the proof of advertisement is approved by the regulators. However, there is still a lack of awareness about the concept of mutual funds among the masses that needs to be taken up by the regulators and the industry players.
Scaring from the past experience of investment companies scams, most of us still conceive mutual funds as the new version of such companies. Mutual Funds are different from
our nightmare investment companies in terms of their regulations, supervision and professional management. Nevertheless, the investments in mutual funds are not free from risk. Before you invest in any mutual funds, be it stocks or bonds, it is important understand all the risks. The greater the risk, the greater the potential return. Unfortunately, there are quite a few types of risks to consider.
Market risk is the risk that your individual stock, bond or mutual fund will decline if the stock or bond market declines.
There is the risk that bad news about a single company will tumble its stock price. Similar there may be a situation wherein a rumour or the social or political issues nosedives the market. In such a situation the fund manager would not be able to prevent the loss however; if the asset class of a fund is adequately diversified you may witness reduction of loss in comparison with its benchmarks and peers.
On the bond side, you face interest rate risk. Bond prices move in opposite directions to interest rates. So when rates rise, bond prices fall.
There also is inflation risk. The income you get from your bonds through the years, may not keep pace with rising costs.
Credit risk is the danger that the issuer of a money market instrument could go bankrupt.
Mutual Funds
Due to influx of new and giant corporate and financial sector players in the market, there is a sign of good healthy competition in the industry. However, on the other hand this would also be a test of investors’ preference. Although the fund’s return would top the investors’ choice however, it is not as simple as it appears; there are a few things that require deeper digging especially in our nascent market:
WHAT DOES THE FUND
INVEST IN?
Does the fund invest in stocks or bonds? Does it invest in larg e , medium-size or small companies? Does that fund invest in growth stocks or undervalued stocks? Does the fund invest in bonds for income? These all questions have relevance to your investment goals and risk preferences. Stock funds tend to involve more risk then the bond funds and trading stock funds riskier then the stock funds having strategy to invest in undervalued and growth stocks.
WHAT ARE THE FEES?
The level and method of charging load may also have impact on your choice. Do you have a choice of a front-end or back-end load, or is there an ongoing level load? A load is a commission. The higher the load the longer it would take to make your absolute returns in line with the fund returns.
PRICING METHODOLOGY:
Is the fund has forward pricing mechanism or it announces the offer and redemption prices in advance? Generally, stock funds or the funds having significant equity asset class follow forward pricing mechanism to avoid arbitrage against the fund. On the other hand, bond funds may advance pricing mechanism as the underlying market is not volatile and any expected move in the interest rates may already being digested over in the
market before its official announcement. The fund having pricing policy protecting the interest of the unit holder is the preferred choice.
FUND RETURNS:
The past performance of the fund reflects the fund manager’s capability of rowing the boat. Stable returns over a longer period is more important then peaks of a short period followed by trough.
The asset class of the fund may perform well due to some alien conditions and in turn the fund may perform well. However, as soon as the triggering conditions are no longer in the field the fund’s return may show nosedive effects. Take an example of from our markets, if a fund having asset concentration in PSO Stock, its returns shoot up as soon as we hear the announcement of its privatisation due to market expectations of having its pricing over its fair value. However, as soon as the government put off the decision of its privatisation or the company is sold off below the expected market price, the market would dilute its price to its fair level. Although quiet riskier, this also give rise to an opportunity to earn good returns by playing with the market. Nevertheless, focusing too much on a mutual fund's past performance is also not advisable. While it's easy to get swept up in the latest investment trend, relying solely on past results rarely leads to success. Instead, ask yourself, "Is this a good investment right now?" There may be situations where bond funds may be outperforming the stock returns.
The advisable thing is to review a fund's return against the return of its stated benchmark and its peer group over the most recent three- year period. Then consider how the asset class as a whole has fared during this period. If the asset class has performed well recently, consider whether now is the right time to invest.
Harvesting the field in the favourable conditions is not a big task. Anyone can reap the benefits in bull markets. You may be looking for one who can sail your boat during tumbling times. One should also take into account the f u n d ’s performance during down markets. How much the fund asset shrinks during such period? Do the funds NAV falls in line with the market index or its peers or it falls more rapidly then the market index or its peers? Naturally, the one who can provide you decent returns in all weathers would be the preferred choice.
PAYING TOO MUCH IN
EXPENSES
Costs matter. Fund expenses - the costs of running a fund, measured by its expense ratio - come directly out of the fund's income and can significantly dampen your return. Over time, a seemingly small difference in expenses can have a big effect on your nest egg. Managers of high-cost funds have to earn higher returns in light of expenses just to outperform their low-cost peers. Mind it there might be some expenses whose dilution effect to the fund’s earnings could not be picked from the naked eyes, you might require to go deep into the waters to see such effects. All else being equal, it is recommended to avoiding funds with high expenses.
ACCOUNTING
TREATMENT FOR THE
INCOME AND EXPENSE
ITEMS:
Being new and specialised industry, lack of standardised accounting treatments / pronouncements may have significant impact on the fund returns. Book returns may not correspond to the implicit returns and may result in enronimism.
Mutual Funds
Mutual funds being specialised industry require standardisation of accounting procedures for its major class of transactions. In certain cases, generally accepted accounting principals may provide flexibility for presentation however, from mutual fund's perspective it may not be the case. Like a fund may not defer the valuation of its securities for the year end as it has to announce the net asset value of the underlying asset frequently or it may not adopt a certain IAS in toto to avoid distortion in the net asset values of the underlying assets. In such a scenario, the fund that adopts the accounting policy that fairly reflects the net asset value of the assets would be the preferred choice in comparison with the book return. Further, the matter should not be left in abeyance. We should not wait for the eruption of accounting scam. Being the involvement of people hard earned money, issues should be taken up by the SECP and ICAP more proactively.
FUND SIZE
Every fund category has a range of assets under management where, all other factors being equal, fund managers have their best chance to compete against their peers. In general, it's best to avoid funds with really small asset bases. And, it's generally best to avoid small cap funds with l a rge amounts of assets under management. Selecting the right-size fund is no guarantee of success, but it can enhance your prospects for a better return.
PUTTING TOO MUCH IN
FOCUSED FUNDS
Focused funds concept is new to our environment due to limited market size. However, as the size of the market grows we would witness emergence of focused funds. Focused funds are limited to a single sector or
even in the case of very large market cap companies limited to a single company.
Investing too much in the focused fund is exposing you to volatile returns. Focused funds are subject to greater volatility than diversified funds because they fail to completely diversify security and sector risk.
RISK CONTROLS
Risk controls are policies such as limits on stock or sector weights. Although, NBFC Rules address this issue to a basic extent however, it is really an internal risk control policy and its effective implementation that provides security and disciplined returns to the investors. They set the playing field for a fund and ensure that the portfolio manager seeks to generate returns in an efficient manner.
Being the investor in the fund you have the fullest right to learn about what types of risk controls portfolio managers use while exercising options to buy or sell specific securities. The more risky or volatile the investment category, the more important it is to have these controls in place.
NOT KNOWING WHO IS
MANAGING YOUR
MONEY
How long has the fund manager been running the fund? If the fund manager is new, you might want to go with a manager with a longer-term track record. After all, your hard earned savings should be in the safe hand. A loss of profit is bearable as against the loss of capital.
A fund's prospectus should clearly identify who makes the investment decisions. Be wary of investing in a fund with a novice manager or a faceless team whose compensation
might not be aligned with the performance of your fund. In some scenarios, committees manage some funds. So if one of the co-managers leaves, it‘s not that big a deal.
OVERLOOKING
EXCESSIVE DEMANDS ON
YOUR MANAGER'S TIME
The next issue is that a successful fund manager could be promoted to run multiple funds or chair multiple committees, or become chief investment officer for the firm. It's important to revaluate whether the manager is going to be focused enough on your fund. Start by reviewing how many funds your manager is managing, and in what roles. The better money management firms give their best managers ample support so they can devote sufficient time to managing your money.
THE BOTTOM LINE:
No doubt mutual funds are the best tool for earning decent return with risk diversification. Entrance of new fund managers and growth of the sector would witness a number of opportunities knocking your door. With a number of mutual funds to choose from, the selection process can be overwhelming. Being aware of these issues, should help narrow the field.
About the Author:
Mr. Rizwan Razzak is an Associate Member of Chartered Institute of Management Accountants, UK and the Institute of Chartered Accountants of Pakistan. He is presently serving as Chief Financial Officer of RUSD Investment Bank Inc, Labuan, Malaysia.
Readers are welcome to contact him at: [email protected]
Hedging Instruments
Hedging Instruments in the
Petroleum Industry: A Brief Sur v e y
A basic building block for economic success of every company is the management of the risks inherent to its business activities. Risk is closely associated with uncertainty and the extent to which probabilities could be attributed to the occurrence of future developments FN1. With respect to prices the magnitude of risk could be expressed in terms of price volatility.
The prices of primary importance to each economic enterprise are the interest rate in the capital market, prices for goods and services sold and received, exchange rates, as well as the market value of the company (e.g. expressed in terms of the market capitalization of the company’s shares). Techniques to manage the risk associated with the fluctuations of these prices have further been developed, which resulted in the creation of a variety of hedging instruments.
Hedging
A hedge basically aims at initiating a market transaction in order to dispose of the risks of price volatility. The company’s philosophy and attitude towards risk management, trading and hedging is typically reflected in its Risk Management Policies and Procedures FN2. An integrated oil company for example with the entire upstream production of crude being processed in the refinery experiences two offsetting price risks – i.e. a natural hedge - and might opt not to use additional hedging instruments. Alternatively the oil company might run its up- and downstream divisions as completely independent profit centers, which are requested to hedge its relevant price risk. The oil company might go for an alternative scenario and hedge only a fraction of the total production but not 100%, which could again form part of the Risk Management Policies and Procedures.
A competitive spot market for the underlying commodity as well as an associated market for derivative securities forms the basis for applying hedging technology.
Markets for hedging instruments could be highly organized such as in an exchange for stocks and commodities or otherwise be governed by individual over-the-counter (OTC) transactions.
The basic concept of hedging is to hedge risks originating from a present transaction in the physical market by simultaneously initiating an equal and opposite position for a future transaction in the futures market.
In case price fluctuations of the hedged position (e.g. oil) could be fully offset via price fluctuations of the hedging instrument (futures, options and others) a perfect hedge would have been achieved. In reality a perfect hedge often represents only a theoretical possibility. One reason for this being that the price of the hedged position respectively
underlying commodity and the price of the hedging
instrument do not move in tandem. That difference between the price in the physical, cash market and the price of the hedging instrument is called the basis and the risk associated with it is known as the basis risk.
Crude oil, refined products and natural gas represent the underlying commodities in the Petroleum Industry for which hedging instrument could be used.
Futures, options and swaps, as well as forward contracts represent the standard hedging instruments.
(1) Forward Contracts
Forward contracts represent over-the-counter transactions with a varying degree of standardization. Forward contracts essentially represent an agreement to buy or sell a commodity such as oil at a specific future date. Physical delivery of the oil traded is required upon agreed terms as stipulated in the contract. Forward contracts could be further indorsed and traded on to other market participants, which could result in a large number of transactions known as
Strings and Daisy Chains. As forward contracts are traded
over-the-counter the risk of non-fulfillment of the contract remains. In case of a hedging instrument that trades on an exchange a clearinghouse would guarantee fulfillment, which provides additional liquidity for that hedging instrument.
(2) Futures
Futures are standardized contracts, offered to the general public while being traded over an exchange. Buyers and sellers are connected at this exchange via a clearinghouse, which matches the longs (buyers) and the shorts
( s e l l e r s ).The clearinghouse charges a margin for its services
but guarantees the fulfillment of the futures contract, which makes futures a much easier negotiable asset. Companies interested in trading futures contracts often interact with the clearinghouse via a clearing broker. Conversations between the client and broker are regularly recorded.
