Mutual Funds: 'Peace of mind' or 'Nightmare', the need for education

Frank van Lerven Jakarta

The Indonesian mutual funds industry is suddenly faced with a crisis in confidence. This time not caused by the stock market but by the fixed interest market, also knows as the "bond market" (obligasi).

It all started with the significant hikes in interest rates by Bank Indonesia over the last couple of months as it attempted to protect the rupiah and keep inflation in check in the wake of higher fuel prices. Simply said: A few months ago "money in the bank" would produce about 6 percent in interest, now we are looking at approximately 10 percent.

Holders of a 7 percent fixed interest security (bond) which was attractive a few months ago (earning 1 percent more than "money in the bank"), now start to wonder whether it would not be better to liquidate the 7 percent bond, and just keep their money in the bank, earning 10 percent.

One may think that the relationship between bond prices and interest rates is easy to comprehend, and so should not be "such a big deal". The truth is that the intricacies of fixed interest securities, and their complexities are widely underestimated! Bonds are difficult to understand, and even in the U.S. and the UK, where there is a long history of investing in financial markets, most investors will readily admit that they do not fully understand how bonds operate.

So, many Indonesian investors were in for a surprise this summer, to find out when instructing to sell their bonds, they suddenly were looking at losses. Were not bonds to be "safe", "secure" and low-risk or no-risk?

Where these dropping bond prices seemed to have hit most was not with individual investors owning bonds outright, but with investors owning bond funds: Mutual funds investing in fixed interest securities.

Mutual funds! Do we have mutual funds in Indonesia? Oh, yes we do! A quick look at one of the financial pages in Bisnis Indonesia daily will tell us that 24 insurance companies offer mutual funds or reksadana, and another 80 banks & investment companies, comprising together to well over 400 funds! Banks market funds, sometimes using the American word "mutual fund" as everyone traveling south down Jl. Sudirman can witness everyday.

Virtually every bank now has a "wealth management" department, and a quick review of their services will undoubtedly reveal an offering of various reksadana. Stock funds, fixed interest funds, money market funds. The "new kid on the block" is sharia funds, and it will not be long before hedge funds make their entry.

Mutual funds, as one of the leading international banks here in Indonesia correctly states on its website, are "A pool of money invested in stocks, bonds and money market instruments, managed by an independent fund manager in order to maximize returns and diversify risk for investors".

Mutual funds are common in the U.S. (an estimated one out of every three American families own mutual funds), and also widely owned in the UK (an estimated one out of four UK families own "unit trusts" the equivalent of the American mutual funds). Mutual funds are widely marketed as the "common man's tool" to invest in financial markets. This refers to the fact that investors can participate with small amounts in the financial markets, receiving "management by an expert" and "diversification".

So, are Mutual funds as an investment concept easy to understand? Well, in fact the answer again is no! How units are priced, what happens when you want to sell, who "guards" the fund, who is responsible for investment results, are among the topics that are far from straightforward, let alone trying to understand the markets in which these funds invest.

When reading marketing material on mutual funds, we see pictures of "happy and satisfied" people at retirement, enjoying the fruits of "years of investing" in mutual funds. The words "professional", "expertise", "management" are all over the pages, and the heading "Peace of Mind" is not just used by Indonesian mutual fund companies, but is widespread worldwide.

The facts are that mutual funds are as risky as their underlying assets. Mutual funds can be totally speculative, high risk, medium risk or low risk: It all depends on how risky the market is in which the fund invests! This risk factor, unfortunately, is not properly understood by investors and too often also not by the people who sell these funds.

When one puts two fairly complicated concepts together, "fixed interest securities" and "mutual funds", we find ourselves at the outset of a potentially diabolic mix! An example of this is the fact that one of Indonesia's leading banks has seen the total asset value of one of its bond funds collapsing from Rp 8 trillion to Rp 1.5 trillion in a matter of two months! Indonesian investors, for various reasons, tend to take a short-term view as regards investing in the financial markets and, in addition, demand high returns. This forces the hand of financial institutions wanting to sell mutual funds and looking for quick sales. Asked for high returns with little risk, it is easy to overemphasize the return and underemphasize the risk.

This leaves investors ill-informed about what they are investing in. As said before, the sellers of mutual funds, especially in the case of fixed interest funds, often do not fully comprehend these investment vehicles themselves

This leads me to one of the main contributors to the mess we are currently facing: The lack of proper knowledge on the part of the people who market mutual funds to the public!

Some elements of a learning curve are unavoidable, but we can, and must, learn from experience elsewhere. Initiatives currently undertaken to introduce financial diplomas and qualification standards for "introducers of financial products" deserve full support by governmental authorities and financial institutions. One of them is the introduction of the CFP certification in Indonesia by the FPAI (Financial Planning Association Indonesia), which is expected to materialize in late 2006.

In the meantime, mutual fund companies and life insurance companies should take it upon themselves to increase the knowledge of their sales staff as regards investment instruments and the financial markets, recognizing that truly professional selling is a long-term winner, where all will benefit.

The writer is CFP and FPC qualified financial planning professional.