Indonesia's mutual funds industry: Down but not out

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.