Indonesia's mutual funds industry: Down but not out

Martin Jenkins, Jakarta

It has not been a good year for Indonesia's mutual funds industry. Still reeling from the Bank Global fiasco at the end of 2004, the industry has seen huge redemptions in 2005 as investors fled to safer havens on fears that mutual funds would continue to post negative returns. The size of the redemptions has indeed been staggering: At the beginning of the year Rp 111.13 trillion (US$ 11.1 billion) was invested in mutual funds, but by the third week of September the amount had plummeted to just Rp 33.9 trillion.

Most of the redemptions have been in fixed income mutual funds, generally mutual funds holding government bonds. These funds had earlier attracted many investors since they offered much higher returns than time deposits or other money market instruments. Indeed, fixed-income bonds had become so popular that they accounted for the vast majority of funds under management at the beginning of 2005. Of the Rp 111.13 trillion in funds under management in mutual funds at that time, bond mutual funds represented more than 80 percent of the total. Money market funds, mixed mutual funds, and equity mutual funds accounted for the remainder.

But this skewed distribution should have set the alarm bells ringing. Why had bond mutual funds become so popular in the first place?

To answer this question is not difficult. First of all, it should be appreciated that Indonesian investors are, generally speaking, risk adverse. This is unsurprising really: In a low trust society, where investment scams are not uncommon, caution is a wise policy. As such, Indonesian investors are generally attracted to safe investments in which future returns are more or less guaranteed. Time deposits are a good example of a safe investment.

But earlier in the year there wasn't much incentive to hold time deposits or other money market instruments since domestic interest rates were low and falling, and returns were therefore low. So what did investors do? They placed their funds in fixed income mutual funds, many of which invested in so-called "risk free" Indonesian government bonds. Investors were happy: Not only were they enjoying significantly higher returns, but they also weren't taking any major risks. Or so they thought.

But like all things too good to be true, there was a catch: Government bonds are not actually free of risk. Although bond returns are generally fairly stable it's true, this isn't always the case -- especially when economic variables change. And bond prices, being highly sensitive to inflationary expectations, started to come under great pressure early in the year as inflationary pressures intensified, partly because of the anticipated impact of surging oil prices on domestic prices of goods and services. As a result, returns on fixed income bonds turned negative as the loss on the principal investment outweighed the interest received. Investors subsequently panicked and sold off their holdings.

Given their losses, investors were understandably angry. Some of them even blamed their fund managers for their predicament, alleging that they had not been given appropriate advice. If they had known of the risks in advance, they claim, then they would have been far more cautious.

For their part, however, investment managers said that investors should have known of the risks. After all, despite the complexities of investment theory, the basic rule of investing is actually remarkably simple: the greater the level of risk you take, the greater the return you should expect. The fact that the potential returns on bond mutual funds was considerably higher than on time deposits should have signaled to investors that they were taking greater risks. This simple fact was implicit the investment managers claim.

But while this may be true, the fact that investors lost faith in mutual funds should be of great concern to investment managers. The investment business is basically a business of trust. Thus, if investors lose their confidence in what they are investing in, or if they believe that the value of their investment will drop, then they will be out in a shot.

A business of trust should be grounded in effective communication. After all, had investors been better informed, they wouldn't have stampeded into bond mutual funds in the first place.

The problems faced by the mutual funds industry this year also highlight the need for effective regulation of the industry.

First of all, effective regulation should oblige fund managers to warn investors of the potential risks and rewards inherent in any investment. In essence this is that past performance is no guide to future performance and that the value of an investment can go down as well as up. And such statements should be made explicitly clear to investors in all advertisements and promotional material, and not just hidden away in a tiny disclaimer.

Moreover, fund managers should be obliged to provide suitable investment advice to their clients. For instance, investors with short-term horizons should not be encouraged to place their funds in higher risk -- although potentially more lucrative -- investments.

Finally, effective regulation of the mutual funds industry should also help to maintain market confidence. This is very important as investors are a fickle bunch. Just like customers rush a bank in a herd mentality on signs that a bank is not doing too well, holders of mutual funds are also prone to panic when market conditions change adversely.

But although damage has been done to the mutual funds industry, investors are likely to return in the longer run. Because while bank deposits are safe, placing your money in them is not really investing. Indeed, investors who place money in bank deposits are likely to lose out in the long run as returns will be much lower than returns on riskier investments such as bonds and stocks.

And investors who choose not to invest in stocks and bonds via mutual funds may be forgoing huge potential gains. At the beginning of 2003, for example, the Jakarta Composite Index (JCI) stood at just 409.12. Today it stands at around 1,100, indicating average returns of around 168 percent on Jakarta stocks over that time period!

Currently, in a bid to lure investors back into mutual funds some investment managers are now offering "protected" funds -- funds with a guaranteed rate of return. But although there is no downside, there is of course a catch: Potential gains are limited compared to other mutual funds. Even so, these mutual funds may be attractive to the very risk adverse.

The writer is Market Analyst at the Danareksa Research Institute. He can be reached at martin@danareksa.com.