Mutual funds are the investment equivalent of a frozen dinner. Rather than go through the hassle of walking the supermarket aisles, picking out individual ingredients, packing them all home and then cooking a meal, you can buy a frozen dinner and get everything you want in one convenient package. However, just as we wouldn't expect a frozen dinner from Hong Kong or Belgium to be the same as one from the local supermarket, we can't expect foreign mutual funds to look the same as those based in the United States.
A mutual fund based in Europe falls under a different regulatory environment than a fund that is certified for investment accounts in Hong Kong. Each country has its own rules and "tastes" for how a mutual fund is constructed, and it's important to understand how these regulations shape the funds from each country. This article will give a quick tour of mutual funds and their regulators around the globe.
A mutual fund is a vehicle for individuals to invest their money in the stock or bond market. It is ideal for the individual investor with limited funds, as they can gain access to diversification benefits even though they may have a modest amount to invest. Going back to our frozen dinner example, it is expensive and inconvenient to buy all the ingredients separately for a full meal; convenience and cost savings are why both mutual funds and frozen dinners exist. Investors don't have to make decisions about which individual stock to buy, they simply decide what portfolio suits them best.
Can You Buy a Fund from Another Country?
If you are an investor in the U.S., you can only buy funds that have registered with the Securities and Exchange Commission. This acts as a protection for U.S. investors, as a fund that is registered with the SEC is regulated according to U.S. securities law. Likewise, if you are a Hong Kong resident looking to invest for your retirement, your choice of funds would be limited to those regulated by Hong Kong's Mandatory Provident Fund Schemes Authority (MPFSA).
A mutual fund from another country is not the same as a global fund or international fund. A global fund invests in assets from around the world, including the investor's home country. Meanwhile, an international fund includes the entire world except for the investor's home country. Both of these funds still have to be registered with the SEC before U.S. investors could buy them.
Common Traits of All Mutual Funds
Before we can delve into the differences, it is important to first describe some basic mutual fund truths. All mutual funds pool the many smaller deposits of individual investors so they can make large purchases in stocks or bonds. Most mutual funds are available to both the retail clients (individual investors) and institutional clients (large companies, foundations, etc.). There is usually a wide selection of funds, both by company and style in each country, including a good variety of stock, bond, money market and balanced funds (blends of stocks and bonds in the same fund).
Another commonality among mutual funds throughout the world is that every major economy has specific rules pertaining to the registration, marketing, and sale of funds. The mutual fund industry is a highly regulated space, but those regulations differ by country or region. Regulations are in place to protect the consumer; this helps to ensure that asset managers are keeping the interests of the investor above their own, and that the investor does not get taken advantage of. It is very important that the investor feels confident that the proper authority is monitoring the industry as a whole so that they will entrust their savings in a mutual fund. If investors lacked confidence, the industry would likely falter.
Differences Around the Globe
The mutual funds that are available for investment differ depending on where the investor is domiciled. Let's look at some of the regulators and the regulations to see how the rules shape the funds.
The U.S. Market
All mutual funds marketed to U.S. retail investors must be registered with the SEC and must abide by the rules set forth under the Investment Company Act of 1940, commonly referred to as the '40s Act. Some of the rules under the '40s Act deal with diversification issues. Specifically, Section 12 limits the amount of fund assets that can be invested in other investment companies. In other words, the rule prohibits a mutual fund from concentrating too many of its holdings in the stock of an investment company.
Another rule, 35d-1, commonly referred to as the "name test," makes sure that most (80%) of the mutual fund's holdings are reflective of the fund's name and prospectus. So, if a fund calls itself an "International Equity Fund," 80% of its holdings should be equities, and they need to be international equities.
The European Union
Mutual funds authorized for sale in Europe are governed by regulations from the Undertakings for Collective Investment in Transferable Securities, or UCITS. The most recent iteration of the rules is called UCITS III, which differs from the previous rules by paying more attention to the risk monitoring of derivative positions. The rules cover many areas, but like the 1940s Act some deal with making sure the fund does not concentrate its holdings to ensure diversification.
To market your fund across all member countries of the European Union, you need only register your fund in one EU country under the authority of that country's financial regulator. For example, in Ireland, it is the Irish Financial Services Regulatory Authority. In turn, the IFSRA is part of the Committee of European Securities Regulators, which is in charge of coordinating the securities regulators of all the EU countries.
The Hong Kong Market
Hong Kong's rules are the most restrictive. There are two fund governing bodies in the Hong Kong market: the Securities and Futures Commission (SFC) and the MPFSA. The SFC's rules are broader and not as specific or restrictive as the rules set forth by the MPFSA. They apply to all funds marketed in Hong Kong, no matter what type of mutual fund they are. In contrast, MPFSA only governs funds that are marketed for use in the retirement accounts of its residents. This means that funds suitable for investment in retirement accounts have two regulatory bodies to worry about—they must abide by both SFC and MPFSA rules. However, as the MPFSArules are more restrictive than SFC rules, fund managers can usually concentrate on the MPFSA rules, knowing that compliance with these rules will usually ensure compliance with the broader rules as well.
The MPFSA's rules are more restrictive partly because the authority wants to make sure that the nest eggs of its residents are protected and not invested in funds of a speculative nature. The MPFSA takes compliance with its rules very seriously. Some of the more restrictive rules deal with unrated, or below-investment grade, securities, and unlisted securities. The MPFSA requires that bond mutual funds sell bonds that have been downgraded below investment grade, even if they were investment grade at the time of purchase. The rules also place emphasis on approved exchanges. The MPFSA provides its own list of approved stock exchanges. No more than 10% of a mutual fund's securities may be allocated to contain stocks not listed on one of these approved exchanges.
Markets other than the three mentioned above, have their own structure and regulations. In Canada, for example, mutual funds are subject to provincial securities laws as well as national rules known as NI 81-102. The NI stands for "National Instrument." For example, dealers who sell mutual funds must be registered with the securities regulator of their province, while the mutual fund asset manager must ensure that the fund they manage abides by the NI 81-102 rules.
Another market that is currently opening up to outside fund managers is Taiwan. In Taiwan, the regulator is the Financial Supervisory Committee (FSC). There are only about 20 rules specific to mutual funds marketed in Taiwan, but this is still an evolving market.
The Bottom Line
Understanding the differences among the financial regulators is very important for a mutual fund manager. A manager may have different funds registered among these different regulatory environments, and they need to make sure that they understand what they can and cannot do in each of the countries. Breaching a rule, especially a major one, can give a fund and its manager a bad reputation, a fine, or both.