Tue, 02 Dec 2003

Warning on mutual funds

The rush by investors in Jakarta last month to redeem their fixed-income mutual funds should serve as an early warning signal to the capital market watchdog (Bapepam) to establish safeguard measures for this rapidly-growing, yet largely unregulated, investment instrument.

Traders and analysts estimated that about Rp 30 trillion (US$3.5 billion) worth of fixed-income mutual funds were redeemed in the first half of last month due to confusion over the method of pricing mutual funds (net asset value). However, Bapepam put redemptions during the minor panic only at around Rp 4.5 trillion net, after taking into account new purchases of funds during that period.

Irrespective of the different estimates of the fund redemptions, the rush should have rudely awakened Bapepam to introduce clear-cut rules regarding this financial product, which has expanded from Rp 8.5 trillion in January 2002 to a Rp 90 trillion mutual fund-industry today.

It appeared simply to be a coincidence that the short-time panic in Indonesia was preceded by the uncovering of a scandal in the $7 trillion mutual-fund industry in the United States whereby Putnam Investment Fund traders were found to have conducted improper trading practices.

While the problems in the U.S. mutual-fund industry were related mostly to improper trading of mutual funds invested in stocks traded overseas, the small panic in Indonesia was caused by the confusion over the method to price fixed-income mutual funds, which account for almost 90 percent of total mutual funds in Indonesia.

Each mutual-fund share (unit) ideally should represent the value of the stocks or securities (bonds) held in portfolio, meaning that the funds should be priced on the basis of the prevailing market value of their underlying assets. This is called marked-to-market pricing, which is considered the most fair value pricing method.

However, the capital market watchdog in Indonesia has not yet set clear-cut procedures for fair value-pricing of mutual-fund assets. In the absence of such procedures, most fixed-income mutual funds managers have thus far set their net asset value according to what they perceive to be the fair value of the government bonds in their portfolio, not on the basis of actual daily market prices of the bonds.

So when one of the largest fund managers recently changed its pricing method by fixing its net asset value according to the daily market prices of their underlying assets, most of its investors panicked because the net asset value of their funds fluctuated in line with the daily movements of the bond prices.

Many investors, who had previously been accustomed only to a steady rise in their fund's net asset value, rushed to redeem their fund shares, thereby forcing fund managers to sell bonds at big discounts to raise funds.

However, this panic should also be blamed partly on the market perception, which fund managers had unconsciously inculcated among fixed-income fund investors when they promoted their funds through commercial banks.

Mutual-fund managers often mislead investors to believe that, like time-deposits at banks, fixed-income mutual funds generate fairly stable rates of returns. The major differenceand this is the main bait used to attract investorsis that fixed-income mutual funds now produce higher returns as they are tied to fixed-rate government bonds, while time deposit interest rates are declining steadily in line with the fall in the central banks short-term interest rate.

This flaunted advantage, combined with the income tax exemption granted to mutual funds in the first five years after their floating, the steady decline in time deposit interest rate and the expanding market of government bonds, has been responsible for the explosive growth of the fixed-income mutual- fund industry.

However, fund managers apparently forgot to educate investors that the prices or value of mutual funds, though tied to fixed- rate government or corporate bonds as their underlying assets, may also fluctuate daily according to the market value of the bonds in the secondary market.

Moreover, many investors seem not aware that mutual funds are basically a long-term investment which, like other investment instruments, has its own risks of price fluctuations.

Many investors may also not realize that mutual funds, even though marketed mostly through banks, are not covered by the government blanket guarantee on bank deposits and claims because they are simply not a bank product.

The wrong perceptions among investors about mutual funds as an investment vehicle and the confusion over the method of pricing mutual fund shares are some of the issues the capital market watchdog have to address soon.

Bapepam also needs to issue clear-cut rules on mutual-funds as an investment instrument and on mutual-fund trading, while the central bank should see to it that commercial banks do not take unnecessary risks by deceptively packaging mutual funds into their financial products.

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