EXPLAINING THE SIZE OF THE MUTUAL FUND

INDUSTRY AROUND THE WORLD

Ajay Khorana,a Henri Servaes,b,c Peter TuIanod,e,*
Abstract
This paper studies the mutual Iund industry in 56 countries and examines where this Iinancial
innovation has Ilourished. The Iund industry is larger in countries with stronger rules, laws,
and regulations, and speciIically where mutual Iund investors` rights are better protected. The
industry is also larger in countries with wealthier and more educated populations, where the
industry is older, trading costs are lower and in which deIined contribution pension plans are
more prevalent. The industry is smaller in countries where barriers to entry are higher. These
results indicate that laws and regulations, supply-side and demand-side Iactors simultaneously
aIIect the size oI the Iund industry.
1. Introduction
Over the past Iew decades, the mutual Iund industry, both in the U.S. and elsewhere, has exploded. While
the global Iund industry has Ilourished, academic studies oI mutual Iunds have remained geographically
narrow. Almost all oI the research has Iocused on the U.S., with the exception oI a Iew insightIul studies
oI national Iund markets.1 Even those who study the Iund industry are generally unaware that U.S.-
domiciled Iunds accounted Ior only 15 oI the number oI Iunds available globally and 60 oI the
world`s Iund assets in 2000 (see Investment Company Institute (2001)). Nor are they aware that the
nation which is home to the second-largest Iund industry (measured by Iund assets) is Luxembourg, with
6.5 oI world mutual Iund assetspart oI the large and growing so-called 'oIIshore market, or that
France and Korea oIIer the second-largest number oI mutual Iunds available worldwide (13 oI the
world total Ior each country).
The mutual Iund industry is among the most successIul recent Iinancial innovations. In aggregate,
as oI 2001, mutual Iunds held assets worth $11.7 trillion or 17 oI our estimate oI the 'primary
securities in their national markets. There is a recognizable mutual Iund 'style oI intermediation in
most countries, characterized by a transparent investment vehicle whose underlying assets are
identiIiable, with the value oI the Iund marked-to-market on a regular (usually daily) basis and reIlected
in the Net Asset Value oI the Iund, and with new shares created or redeemed upon demand. In contrast,
in a relatively opaque Iinancial intermediary (like a bank or insurance company), investors` claims are not
contractually linked to the underlying asset, marked-to-market, or created/redeemed upon demand.
Open-end Iunds have been around and visible Ior quite a long time. The Iirst open-end Iunds were
created in the early twentieth century in America and were soon thereaIter adopted in the Netherlands and
the U.K.2 The median national Iund industry in our sample is 36 years old, but this innovation was
adopted more quickly and vigorously in some countries than in others. By 2002, in some countries, the
industry was a Iormidable Iorce in the national economic landscape; in other countries, it was small or
nonexistent. What explains the diIIerent rates oI adoption oI this innovation? In this paper, we study a
combination oI Iundamental economic and regulatory Iorces that help explain where the open-end Iund
has Ilourished.
One set oI hypotheses, drawn Irom the ample literature on law and economics, suggests that laws and
regulations can explain diIIerences in the pace oI Iinancial development. Applying this logic to the Iund
industry, we would expect that Iunds would prosper when laws and regulations make this sort oI
investment attractive to investors, Ior example by protecting investor rights. A second set oI supply-side
hypotheses Iocuses on competitive dynamics to explain diIIerent adoption rates. For example, a
concentrated banking sector could plausibly encourage or discourage the Iormation oI a strong Iund
industry, depending on whether banks saw the Iund business as a complement or substitute to their
traditional deposit-taking activities. A third set oI demand-side hypotheses Iocuses on characteristics oI
the potential buyers oI mutual Iunds in terms oI, Ior example, their degree oI wealth and education, to
explain these diIIerences. We might expect that more economically well-oII and sophisticated national
populations would be quicker to adopt the innovation in place oI the older, more opaque methods oI
investing. Finally, the characteristics oI the country`s securities trading environment may be relevant in
that the production technology available to Iund promoters can inIluence the attractiveness oI the ultimate
investment vehicle. At the outset, it important to appreciate that these are not mutually exclusive classes
oI hypothesesrather, all may help explain worldwide patterns in the Iund industry.
Our goal is to study a broad sample oI countries. We gather data Ior 56 nations and measure the size
oI each country`s mutual Iund industry relative to the country`s assets in primary domestic securities
(which includes equities, bonds, and bank loans). For completeness, we also examine the size oI national
Iund industry assets relative to each country`s GDP and population. We study the industry as a whole,
and equity and bond Iunds separately, because certain hypotheses apply only to one oI the two subsectors.

We analyze the cross-sectional diIIerences in the size oI national Iund industries in 2001, as well as the
size and growth oI national industries over the Iive-year window Irom 1996 to 2001.
For the countries in our sample, the mutual Iund industry holds 17 oI the nations` primary Iinancial
assets, on average, with a median oI 4. This large diIIerence between the mean and median is largely
driven by two national outliersthe so-called oIIshore Iund industries in Luxembourg and Ireland hold
assets that are 484 and 82 oI their country`s domestic primary assets.3 The nave inclusion oI these
countries in multivariate analyses can produce misleading results. However, given these are two
interesting data points in our analysis, it would be inappropriate to just treat them as outliers. Hence, we
analyze the drivers oI the Iund industry Ior the remainder oI our countries and separately discuss the
Iactors driving the growth oI these two oIIshore hubs.
For 'on-shore industries, we Iind that laws and regulation are related to a more robust mutual Iund
sector, i.e., one that controls a larger Iraction oI the nation`s primary securities. In general, countries with
stronger judicial systems, and more speciIically, nations with more stringent regulatory approval and
disclosure requirements Ior Iunds, tend to have a larger Iund industry. This latter result indicates that
stronger regulation that speciIically protects Iund investors may be beneIicial to the Iund industry.
Furthermore, Ior equity Iunds, the enIorcement oI insider trading rules has an adverse eIIect on the size oI
the mutual Iund industry, consistent with the view that Iailure to enIorce these rules discourages investors
Irom purchasing equities directly and encourages them to rely on proIessional intermediaries such as
Iunds instead.
When considering supply-side Iactors, we study characteristics oI the Iinancial sector that would
inIluence the speed oI adoption oI mutual Iunds. We examine the eIIect oI bank concentration,
restrictions placed on banks to enter the securities business, the number oI distribution channels available
Ior Iunds, the presence oI an explicit deposit insurance system Ior banks, and the time and cost to set up a
new Iund. We Iind that nations that restrict banks Irom entering the securities business have smaller
equity Iund sectors, whereas countries with a more concentrated banking industry have smaller bond Iund
sectors. Nations whose barriers to entry are higher have smaller Iund industries; in particular, the costs
required to set up a new Iund are negatively related to industry size.
When considering demand-side Iactors, we Iind that wealthier countries, as measured by GDP per
capita, and countries with a more educated population have larger mutual Iund industries. These eIIects
are particularly pronounced Ior the equity Iunds, which may require a higher level oI investor
sophistication. Internet penetration is also positively related to the size oI the mutual Iund sector, but it is
highly correlated with the other demand-side variables. In addition, mutual Iunds control more national
assets in countries in which a larger Iraction oI pension plans are deIined contribution plans. The age oI
the national Iund industry is also positively related to its size and recent growth rate. Finally, we Iind that
countries whose trading costs are lower have a more developed Iund industry, which indicates that the
ability to oIIer liquidity at a low cost is important Ior the industry`s growth. Overall, these results suggest
that mutual Iunds thrive in more developed economies.
Our ability to draw sharp conclusions that distinguish among these various hypotheses is hampered
by the high correlation among a number oI the independent variables in our sample. For example, the
correlations oI GDP per capita with education level and judicial system quality are 0.63 and 0.89,
respectively. Stepping back Irom the individual regressions, it appears that the Iund industry is stronger
in countries that are more economically developed (as measured by variables such as education and per
capita GDP) and that have stronger legal systems. However, Iund-speciIic investor protection plays an
independent role in explaining national Iund industry success.
We interviewed experts to explain the growth oI Luxembourg and Ireland. Tiny Luxembourg grew to
be a European mutual Iund hub Iueled by Iavorable bank secrecy and tax laws as well as its central
location. Experts attribute the growth oI Ireland (Dublin in particular) to its educated workIorce and the
tax advantage given to management companies. In particular, Iund management companies set up beIore
July 1998 pay a tax oI only 10 on their income until 2005, substantially less than most other corporate
tax payers, and they are allowed extra deductions Ior rental payments.

DLSCkI1ICN CN MU1UAL IUNDS
MuLual fund ls a LrusL LhaL pools Lhe savlngs of a number of lnvesLors who share a common flnanclal
goal 1hls pool of money ls lnvesLed ln accordance wlLh a sLaLed ob[ecLlve 1he [olnL ownershlp of Lhe
fund ls Lhus MuLual" le Lhe fund belongs Lo all lnvesLors 1he money Lhus collecLed ls Lhen lnvesLed ln
caplLal markeL lnsLrumenLs such as shares debenLures and oLher securlLles 1he lncome earned Lhrough
Lhese lnvesLmenLs and Lhe caplLal appreclaLlons reallzed are shared by lLs unlL holders ln proporLlon Lhe
number of unlLs owned by Lhem 1hus a MuLual lund ls Lhe mosL sulLable lnvesLmenL for Lhe common
man as lL offers an opporLunlLy Lo lnvesL ln a dlverslfled professlonally managed baskeL of securlLles aL a
relaLlvely low cosL A MuLual lund ls an lnvesLmenL Lool LhaL allows small lnvesLors access Lo a well
dlverslfled porLfollo of equlLles bonds and oLher securlLles Lach shareholder parLlclpaLes ln Lhe galn or
loss of Lhe fund unlLs are lssued and can be redeemed as needed 1he funds neL AsseL value (nAv) ls
deLermlned each day
lnvesLmenLs ln securlLles are spread across a wlde crosssecLlon of lndusLrles and secLors and Lhus
Lhe rlsk ls reduced ulverslflcaLlon reduces Lhe rlsk because all sLocks may noL move ln Lhe same
dlrecLlon ln Lhe same proporLlon aL Lhe same Llme MuLual fund lssues unlLs Lo Lhe lnvesLors ln
accordance wlLh quanLum of money lnvesLed by Lhem lnvesLors of muLual funds are known as unlL
holders

kLCLN1 1kLNDS IN 1nL MU1UAL IUND INDUS1k
1he mosL lmporLanL ln Lhe muLual fund lndusLry ls Lhe aggresslve expanslon of Lhe forelgn owned
muLual fund companles and Lhe decllne of Lhe companles floaLed by Lhe naLlonallzed bank and smaller
prlvaLe secLor players Many naLlonallzed banks goL lnLo Lhe muLual fund buslness ln Lhe early nlneLles
and go off Lo a good sLarL due Lo Lhe sLock markeL boom prevalllng Lhen 1hese banks dld noL really
undersLand Lhe muLual fund buslness and Lhey [usL vlewed lL as anoLher klnd of banklng acLlvlLy lew
hlred speclallzed sLaff and generally choose Lo Lransfer sLaff from Lhe parenL organlzaLlon Some
schemes had offered guaranLeed reLurns and Lhelr paLenL organlzaLlon had Lo ball ouL Lhese AMCs by
paylng large amounL of money Lhe dlfference beLween Lhe guaranLeed and acLual reLurns 1he servlce
level was also bad MosL of Lhese AMCs have noL been able Lo reLaln sLaffs floaL and new schemes eLc
and lL ls doubLful wheLher barrlng a few expecLaLlons Lhey have serlous plans of conLlnulng Lhe acLlvlLy
ln a ma[or way
1he experlence of some of Lhe AMCs floaLed by prlvaLe secLor lndlan companles was also very slmllar
1hey qulckly reallzed LhaL Lhe AMCs buslness ls a buslness whlch makes money ln Lhe long Lerm and
requlres deep pockeLed supporL ln Lhe lnLermedlaLe years Some have sold ouL Lo forelgn owned
companles some have merged wlLh Lhe oLhers and Lhere ls general resLrucLurlng golng on
1he forelgn owned companles have deep pockeLs and have come ln here wlLh Lhe expecLaLlon of a long
haul 1hey can be credlLed wlLh lnLroduclng many new pracLlces such as new producL lnnovaLlon sharp
lmprovemenL ln Lhe servlce sLandards and dlsclosure usage of Lechnology broker educaLlon eLc ln facL
Lhey have forced Lhe lndusLry Lo upgrade lLself and servlce levels of Lhe organlzaLlon llke u1l have
lmproved dramaLlcally ln Lhe lasL few years ln response Lo Lhe compeLlLlon provlded by Lhese