Warning on mutual funds

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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