The Systematic Investment Plan (SIP) has gained widespread attention in Nepal in recent years. From social media influencers and advertisements to discussions among small investors, this investment plan has captivated many. As part of open-ended mutual funds, SIP operates on principles of forced investment plan, compound interest and cost averaging. It enables small investors to invest modest, regular amounts toward long-term goals, such as retirement or a 20–25-year investment horizon.

Although SIP is a relatively new addition to Nepal's mutual fund market, the industry itself has roots going back to the early 1990s. Nepal's foray into mutual funds began in 1993 with the launch of the NCM Mutual Fund by NIDC Capital Market (now Laxmi Sunrise Capital). This open-ended fund initially raised Rs 100 million and saw strong performance but eventually declined, leading to its restructuring as a close-ended fund, NCM Mutual Fund, in 2002. Similarly, the Citizen Unit Scheme (CUS), introduced by Citizen Investment Trust (CIT) in 1995, became Nepal’s second collective investment scheme and is still managed by CIT. Interestingly, both of these early schemes were launched before any formal mutual fund regulations existed in Nepal. In fact, the mutual fund industry predates the Securities Board of Nepal (SEBON) and its regulatory framework. After Nepal’s first open-ended mutual fund was launched in 1993, SEBON introduced Mutual Fund Regulations in 2010 and Mutual Fund Guidelines in 2012.

While mutual funds have a three-decade history in Nepal, fund managers say early efforts were hampered by limited investment opportunities, leading to the underperformance of the first fund. “NIDC Capital Market, now Laxmi Sunrise Capital, is one of Nepal's oldest mutual fund issuers. When we launched the first mutual fund scheme, it was challenging to raise the issue size of Rs 100 million,” said Bijaya Lal Shrestha, CEO of Laxmi Sunrise Capital. “At that time, open-ended funds struggled, and the scheme was eventually converted to a close-ended one.”

Shrestha added that factors like the limited market size, few listed companies, restricted investment opportunities and limited knowledge among both the government and fund managers influenced the shift to close-ended funds. In 1994, according to the data of Nepal Stock Exchange (NEPSE), the capital market index stood at 226, with just 66 listed companies and a market capitalisation of Rs 13 billion.

The Surge

The introduction of regulations and guidelines paved the way for fund managers to launch mutual fund schemes, with Siddhartha Capital taking the lead post-2012. The first fund introduced after SEBON’s Mutual Fund Regulations in 2010 was the Siddhartha Growth Scheme 1 valued at Rs 500 million.

Before the regulations were introduced, only two mutual fund schemes were available in Nepal. However, 54 schemes have been launched since then. Of these, 11 have matured, with 36 closed-ended and seven open-ended schemes now in operation. The Covid-19 pandemic accelerated digital trading in Nepal, allowing thousands to trade online from home and driving the stock market to record highs amid economic uncertainty. Falling interest rates and accessible margin loans for investment in listed shares attracted retail investors to the secondary market. Merchant bankers capitalised on this trend by issuing 26 mutual fund schemes since the pandemic.

This momentum carried into 2020/21 with the launch of nine schemes totalling Rs 9.9 billion, followed by seven schemes in 2021/22 raising Rs 7.44 billion. The peak occurred in 2022/23 with 16 schemes valued at Rs 16.15 billion issued, reflecting rising investor interest and confidence on mutual funds.

According to Mukti Aryal, a capital market analyst, the concept of mutual funds in Nepal has been around for roughly 30 years, however, the sector has struggled with issues like limited expertise among fund managers, a small market and a lack of dedicated policies. “These factors initially forced many mutual funds to adopt close-ended structures. As a result, mutual funds have generally underperformed, failing to meet return expectations and discouraging retail investment.”

Close-ended Schemes Dominate

Globally, open-ended mutual fund schemes dominate, but in Nepal, approximately 80% of mutual funds remain close-ended, compared to just 1% globally. This imbalance reflects the limited immediate value close-ended funds provide, though there has been a recent surge in open-ended scheme issuance over the past two years.

"Globally, over 90% of mutual funds are open-ended, allowing investors to make smaller, regular investments, such as monthly contributions, instead of a large upfront sum," says Deepesh Kumar Vaidya, CEO of NMB Capital Limited.

The key difference between these fund types lies in flexibility and the ease of trading. Open-ended funds issue and redeem units directly based on the fund's net asset value (NAV), with no maturity date, providing continuous investment opportunities. Close-ended funds, however, launch through a new fund offering (NFO) and have fixed maturity period, typically spanning five, seven, or ten years, during which they offer dividends and a final payout upon maturity. They are termed 'close-ended' because they have a fixed number of shares with no additional shares issued post-NFO.

“In Nepal, confidence in the mutual fund market was low about 15 years ago. At that time, close-ended funds were more common as they were listed on NEPSE and traded in the market, providing liquidity for investors. This allowed investors to buy and sell their units on the stock exchange, which helped build trust in the system," said Ramendra Rayamajhi, CEO of NIC ASIA Capital Ltd. "Consequently, close-ended funds became more popular in Nepal compared to open-ended funds during that period.”

Open-ended funds allow buying and selling at any time, offering small investors the flexibility to invest or redeem units as desired. Unlike close-ended funds, open-ended schemes have no maturity period, allowing investors to stay invested indefinitely. In the past two years, seven such schemes have entered the market, including NMB Saral Bachat Fund – E, NIC Asia Dynamic Fund, and Siddhartha Systematic Investment Scheme. Open-ended funds are gaining popularity in Nepal, with dozens more awaiting SEBON’s approval. One key advantage of open-ended funds is the option for small, periodic investments — monthly, quarterly, or bi-annually — attracting retail investors who prefer low-risk, growth-oriented savings. “Open-ended funds offer two options: a one-time purchase of units, or an initial investment followed by monthly contributions. This approach lets investors benefit from fund managers’ expertise, and over time, their wealth compounds,” explained Vaidya.

Typically, close-ended funds are valued at Rs 1 billion which can be expanded to Rs 1.25 billion if oversubscribed. Open-ended funds, however, begin with SEBON-approved sizes of Rs 500 million, with additional approvals needed to grow. Nepal’s mutual fund market currently stands at approximately Rs 52 billion.

The Current Status

When Siddhartha Growth Scheme 1 launched in 2012 at Rs 500 million, it marked the start of a new era for Nepal’s mutual funds. Twelve years later, the market has expanded to Rs 50 billion — a remarkable 100-fold increase. But is this growth enough? "Not quite," said Rayamajhi of NIC Asia Capital. Despite over a decade of development and 54 funds in the market, mutual funds still account for only 1.3% of NEPSE’s market capitalization and a mere 0.9% of Nepal’s GDP. Institutional investors dominate, holding around 65% of the mutual fund market, while retail investors make up about 40-45%, roughly Rs 22-24 billion.

Experts say there is a misconception in the Nepali market that mutual funds offer low returns. In reality, data from fund managers show that Nepali mutual funds, including those that have matured or surpassed five years, have provided average annual returns of 15%, including both capital gains and dividends.

This misconception about mutual fund returns, according to experts, is influenced by speculative practices in the stock market. “When some investors achieve 15% returns in just a few weeks, the 15% annual return from mutual funds can seem less appealing, leading more people toward the secondary market. Though the concept of ‘higher risk, higher return’ applies in the capital market, poor advice and failure to properly analyse the market often lead to losses,” they say.

Rayamajhi added that market performance also affects buying behaviour. "When the market performs well, investor confidence strengthens," he said, referring to varying performance of NIC Capital’s funds. fluctuating fund performance. While the first two funds were undersubscribed, the third saw a 25% oversubscription, the fourth 28%, the fifth 115%, and the latest achieved a 92% subscription rate.

“A confident market makes selling investments easier, but raising capital is challenging in a market that lacks confidence,” Rayamajhi added.

Deepesh Kumar Vaidya of NMB Capital said Nepali investors expect unrealistic returns of 25-30%, despite the economy’s growth rate of under 6%. "A sustainable long-term target is around 15-16%," he said. “While stock market investments carry higher risks, mutual funds offer a more stable alternative, through its expertise of managing risks and finding rightly valued stocks, aiming for a consistent return of 15%, which is attractive for those seeking long-term growth with moderated risk.”

Limited Investment Opportunities

In Nepal, mutual funds are permitted to invest in a limited range of sectors as outlined by SEBON’s regulations. After pooling funds from investors to maximise returns, fund managers build a diversified portfolio, typically comprising equities, bonds and fixed-income securities. Fund managers primarily invest in listed securities registered with SEBON, as well as bonds, debentures, IPOs, FPOs, rights shares, fixed deposits and savings with banks. Regulatory guidelines cap investments at 15% for fixed deposits and 10% for other mutual funds, though there are no limits for debentures. For example, if a fund manager collects Rs 100 for a mutual fund scheme, up to Rs 15 can be allocated to fixed deposits, Rs 10 to other mutual funds, and the remainder to debentures or bonds as needed.

“The returns for fund managers mainly stem from stock market trading due to limited investment instruments,” says Bijaya Lal Shrestha, CEO of Laxmi Sunrise Capital. “Expanding regulations to allow Nepali mutual funds to invest in foreign stocks would open international market opportunities and stimulate growth.”

In Nepal, a minimum of 5% of shares offered for public issuance by institutions is reserved specifically for mutual funds. However, these funds are prohibited from selling their allotted IPO shares for six months post-allotment. This SEBON regulation aims to prevent mutual funds from capitalising on peak market prices immediately after listing.

The limited range of investment instruments available to fund managers in Nepal poses significant challenges, industry insiders say. Currently, fund managers are primarily required to invest in equities, leading to a high-risk environment.

“A major challenge for fund managers is the lack of diverse investment instruments which leads to inconsistent returns across funds. While some have delivered satisfactory returns, many have fallen short of investor expectations,” said Aryal.

According to Rayamajhi of NIC Asia Capital, mutual funds perform well during market upswings but face similar downturn impacts due to their heavy reliance on stock market performance. “The lack of diversification options leaves mutual funds vulnerable,” Rayamajhi explained, adding that while sourcing investments is crucial, finding diverse opportunities for effective capital allocation remains a challenge. "Expanding investment options could significantly enhance growth and diversification," said Shrestha of Laxmi Sunrise Capital.

Currently, Nepali mutual funds can only invest in listed stocks, whereas mutual funds abroad enjoy broader investment options, including real estate and investments in other mutual funds through a “scheme of schemes” structure. In Nepal, fund managers are limited to allocating only 10% of their portfolios to other mutual funds.

Regarding the reservation of shares for mutual funds in IPOs, Rayamajhi has a critical perspective. “While the reservation of shares may seem beneficial, it primarily serves fund operators rather than individual investors. There should be introduction of more comprehensive investment instruments for fund managers,” he said. “Implementing a forward market, along with futures and options, as well as mechanisms for short selling, would provide fund managers with better tools for risk management and diversification, ultimately benefiting the mutual fund landscape in Nepal.”

Attracting Retail Investors

Of the 36 closed-ended mutual fund schemes in Nepal, 27 have been introduced in the last four years. However, the appeal to small investors is declining. In the fiscal year 2020/21, when nine mutual funds issued their IPOs, 66.39% of the investments came from institutional investors, while individual or retail investors contributed only 33.61%. This trend shifted slightly in the following fiscal year (2021/22), with seven mutual funds showing that 37.21% of investments were from retail investors, and 62.78% from institutions. However, this trend took a sharp decline in the fiscal year 2022/23, when 16 mutual funds saw only 11.13% of investments from retail investors, leaving a staggering 88% from institutional sources.

Historically, individual investors were the main contributors when mutual funds first launched. Now, retail investors hold around 40-45% of the mutual fund market, equivalent to approximately Rs 22-24 billion. Rayamajhi said that despite the growth of mutual funds, attracting investments from retail investors remains a challenge. In contrast, India has effectively drawn substantial mutual fund investments due to tax incentives, such as rebates and deductions that encourage participation. According to Ramesh Hamal, a former chair of Sebon, Nepal has made strides in enhancing retail investor access, with an increase in open-ended funds to support broader participation. "However, institutional investors—primarily commercial banks as sponsors—dominate the sector, which somewhat conflicts with the mutual fund concept that aims to empower retail investors."

In Nepal, retail investors face a 5% tax on total dividends received, while institutional investors pay 15%. Additionally, a 10% capital gains tax is imposed on retail investors. Conversely, in India, capital gains from mutual funds are not taxable, and the net income of the fund is also exempt from tax. Experts say that these tax benefits make investing in mutual funds more attractive in India. Fund managers say that many Indian investors prefer entering the stock market through mutual funds rather than direct investments. “I believe similar tax exemptions in Nepal could attract more retail investors to mutual funds, leading to larger fund sizes, a broader stock market, and ultimately benefiting the economy,” said Shrestha.

Vaidya added that many countries incentivise mutual fund investments through tax rebates, a strategy currently lacking in Nepal. Implementing such incentives, according to Vaidya, could drive greater investment in mutual funds and foster sector growth.

Rayamajhi also said Nepal could consider introducing tax incentives for mutual fund investors, similar to India's Equity-Linked Savings Scheme (ELSS) which helps investors reduce their taxes while pursuing long-term financial goals. “In India, insurance companies are also permitted to operate mutual funds, which broadens the scope for investment. To enhance long-term investment and market stability in Nepal, frozen or inactive investors could be re-engaged by offering tax benefits,” he said, adding that investors could be required to commit to a minimum three-year investment period within a seven-year mutual fund cycle.

“This would encourage long-term participation, stabilise the market, and provide investors with tax rebates. Fund managers would benefit from more stable inflows, while investors would gain from both tax relief and potential long-term returns. The government, in turn, would collect taxes when the market thrives.”

Since open-ended schemes are popular in Nepal, industry insiders believe that fund managers should consider launching more open-ended schemes to attract previously frozen investments. Rayamajhi said that in the past, mutual funds were not well understood by the public, resulting in closed-ended funds being dominated by institutional investments. “Although institutional investors remain major participants in closed-ended funds, the scenario is markedly different for open-ended funds. In these schemes, approximately 95 percent of participants are retail investors, indicating a significant shift towards individual investment,” he added.

“Nepal has made strides in enhancing retail investor access, with an increase in open-ended funds to support broader participation. However, institutional investors—primarily commercial banks as sponsors—dominate the sector, which somewhat conflicts with the mutual fund concept that aims to empower retail investors,” said Hamal, former chair of Sebon.

Revisiting Regulation

One ongoing challenge in Nepal's mutual fund sector is the seed capital requirement for fund managers, currently set at 15%. The Mutual Fund Regulations mandates that fund managers invest a minimum of 15% of the total assets of their first scheme as seed capital, with similar requirements for subsequent schemes. While discussions have occurred regarding a potential reduction of this percentage by the SEBON, no concrete decisions have yet been made. Industry insiders say that this requirement significantly limits the growth potential of mutual funds. With the mutual fund market’s size expanding to approximately Rs 50 billion, the existing regulation effectively locks up around Rs 8 billion of the capital of fund managers and its sponsors.

Rayamajhi said that this seed capital requirement might have been needed when the mutual fund market was relatively small, between Rs 500 million and Rs 5 billion. According to him, SEBON should revisit this regulation as adjusting the seed capital requirement could unlock new growth opportunities, enabling fund managers to innovate while ensuring market integrity.

Vaidya agreed with Rayamajhi, saying that the current seed requirement necessitates continuous reinvestment, further slowing growth potential. In contrast, India benefits from a much lower seed requirement. Fund managers in India are required to invest seed capital of one percent of amount raised subject to a maximum of INr 50 lakhs in all opened schemes.

“The requirement for seed capital which mandates that 15% of the corpus fund must be contributed by either the fund managers or the sponsors has limited the growth of mutual funds in Nepal. If an open-ended fund reaches Rs 1 billion, for example, fund managers would need to contribute Rs 150 million which limits scalability. This conservative policy, combined with a narrow selection of investment instruments, makes the seed capital mandate overly restrictive,” said Aryal.

Lowering the seed capital requirement in Nepal could encourage similar growth in the sector, allowing mutual funds to make a more substantial contribution to the overall market. To bolster the establishment of mutual funds, sponsors — typically commercial banks — should be encouraged to invest more heavily, making a more vibrant and robust mutual fund environment in Nepal.

Following a study by the Securities Board of Nepal (SEBON) some months ago, new regulatory measures, including a six-month lock-in period, were introduced. The regulation, according to Hamal, former Sebon chair, was brought as fund managers were engaged in share dumping.

“Previously, mutual funds would sometimes sell stocks immediately after listing, creating instability and negatively affecting small retail investors. While mature markets generally do not require such restrictions, SEBON implemented the lock-in period to safeguard market stability, despite initial resistance from mutual funds.”

Introducing a wider range of financial instruments, including forward markets, futures, options, and short-selling mechanisms could help Nepal's mutual fund industry to thrive. Currently, the limited tools available to fund managers restrict growth opportunities. Enhanced options would help fund managers employ varied strategies, attracting a broader investor base and stabilising returns in both bullish and bearish markets. The introduction of such financial tools would require regulatory reform and collaboration between SEBON, merchant bankers and other stakeholders. By diversifying investment options, Nepal could align closer with mature global markets, giving fund managers the flexibility needed to foster a more resilient and dynamic mutual fund industry.

“Another problem is the rigid closing period of close-ended funds. If a fund is set to close after five years but the market is down, investors may incur losses. Allowing more flexible holding periods could better safeguard returns, as opposed to rigidly adhering to predetermined closing dates regardless of market conditions,” concludes Aryal.

(This report was originally publihsed in November 2024 issue of New Business Age magazine.)