The last thing Japan's struggling mutual fund industry needed was a scandal, but that's what it got. The trigger came as a surprise: the collapse of US energy trader Enron. But it struck at an area long known to be vulnerable by the industry and regulators: managed money funds (MMFs), unregulated portfolios widely believed by investors and many asset management companies to be as safe as bank deposits.

But there's no such thing as a free lunch. Japanese investors, both retail and institutional, enthusiastically poured money into MMFs, eager to reap the higher yield while everyone - investors, regulators, industry organizations, distributors and fund managers - revelled in the delusion that such returns could come without additional risk. At their peak in autumn of 2001, MMFs accounted for nearly Y19 trillion of assets, almost a third of total mutual fund assets under management.

Their appeal was that they were considered risk-free, or at least fully guaranteed by fund managers. This illusion was based partly on the verbal association with US money market funds, which are indeed pretty safe investments, but because they are heavily regulated. US money market funds do have Japanese equivalents called money reserve funds, but they are a negligible part of the industry.

So there were no safety controls on a product aimed at retail investors, and too many institutions trading in and out of a product designed for stable, long-term retail investments.

Foreign asset management firms via the American Chamber of Commerce in Japan (ACCJ) and the European Business Council had publicly pointed out these dangers, but no one - not the Financial Supervisory Agency (FSA), not the Investment Trust Association of Japan (ITAJ), and certainly not distributors or fund managers - paid much attention.

Signs of trouble appeared early in 2001. Most MMF assets were invested in short-term domestic and international bonds, including those of Xerox and Japan's Mycal, two financially troubled blue chips. A few corporate investors began phasing out of MMFs but no one realized that these wobbles demonstrated the actual exposures of MMFs.

Then came Enron, which revealed the extent to which Japanese fund managers were asleep at the wheel. As early as August, 2001, Enron's problems came to light and American investors began dumping shares, leading to a steady decline in Enron's share price until the final debacle in November.

Enron's collapse caught Japanese portfolio managers unawares. It also revealed poor diversification, for the fall of Enron blew several MMFs out of the water. Nikko Asset Management's MMF, for example, saw its price fall below its par value of Y10,000 on November 29.

This sparked an exodus out of MMFs. In the months of November and December, some Y11 trillion fled MMFs, nearly a sixth of all mutual fund assets, according to the ITAJ. Among fund management companies, Nikko Asset Management, a subsidiary of Japan's third-largest brokerage, Nikko Cordial, suffered the worst: its MMF assets under management fell from nearly Y4 trillion to a mere Y280 billion at the end of December.

Its top executives were forced to step down and its future as an independent fund manager is in doubt. Its new president, Masafumi Hikima, declined an interview request.

This has come at a time when the mutual fund industry in general is struggling in Japan. From a high of nearly Y60 trillion in 1999, total mutual fund assets in Japan had fallen to around Y45 trillion in late 2001 - before the exodus from MMFs.

Moreover, while overall assets had stagnated, distribution through bank channels had been growing, providing a bright spot in a tough industry. Bank customers are more stable and long-term than those of brokers, giving fund managers hope for instilling a long-term investment culture. Although most MMF products were pushed through brokers, some fund houses worry this will cool risk-averse bank customers to mutual funds.

"This is one of the worst things that could have happened to the mutual fund industry," says Scott Gilman, chairman of the ACCJ's investment subcommittee. "This was an asset class that people should have felt most confident about, and it blew up in their face. So why would they invest money in asset classes that carry more risk?"

Adds Christopher Wells, a partner at White & Case: "This episode proves to investors that nothing is safe. There's a sense that 'we can't trust 'em'. It's a black eye for the mutual fund business, and it means another four or five years of hard selling for any collective investment product."

The MMF disaster also demonstrates the critical need by fund managers and distributors to work on investor education, says Yuji Miyachi, executive officer at Nomura Asset Management's fixed-income investment division. This goes even for institutions, most of which realized MMFs were not guaranteed but continued to invest due to a perceived lack of short-term, liquid alternatives.

Indeed, improved disclosure was one item of new MMF guidelines issued in February by the ITAJ in response to the disaster. Among other things, it outlines what kind of securities MMFs can invest in, what credit rating they must have and for what maturity; it also stipulates portfolio diversification, requires securities be marked to market, suggests distribution be limited to retail investors and asks mangers to implement monthly disclosures about MMF portfolio composition.

Yoshiaki Kaneko, vice chairman at the ITAJ, says the most important aspect about these rules is that, simply, there are rules now for MMFs. Second, it introduces for the first time rating requirements. "We are still working on increased disclosure rules," he says.

But he does not feel the ITAJ or regulators are at fault for what happened to MMFs. "In principle, we think fund management should be as free of regulation as possible. The MMF case is different because it is for individual investors."

This begs the question of why, after warnings from foreign fund managers, such rules were never instituted on MMFs. Here the ITAJ as well as the FSA has little to say, except that institutions were aware of the risks.

"The industry itself has recognized the problem with MMFs," says Teruyoshi Yamazaki, director of the FSA's market division planning bureau. "People have to learn about risk, although not this way, it should be gradual. The FSA asked the ITAJ to make improvements. After financial reform [ie the Big Bang] we did not think more regulation was going in the right direction, so we asked the industry to regulate itself. The ITAJ has done the right thing. We hope confidence in the MMF market recovers."

Yamazaki adds that some fund managers such as Nikko asked the FSA for help during the crisis, but the FSA has spurned all such attempts at a bailout. He does not see the need for further action.

Kaneko adds, "Asset management companies now realize the existence of risk. Investors and asset management companies have paid a high price to learn this, and now fund managers are reorganizing their management. But there is no role for us, it is up to each company."

Some market participates are less sanguine. For example, Miyachi doubts boosting disclosure will help without broader changes to improve investor education (which is also a major objective for ITAJ). "We are improving disclosure, but 99% of our clients never read our reports," he says. He applauds measures by the ITAJ to make disclosure easier to understand and more simple, but adds, "Nearly 90% of investor assets in MMFs have stayed. I hope they believe in Nomura's MMF product and brand name, but I'm afraid they didn't understand the real problems of MMFs and still think it is guaranteed."

Wells says the MMF debacle highlights other issues. "There is no disciplining by the industry, no industry watchdogs, no warnings by market analysts. In the US there is a long history of companies like Morningstar that analyse funds not just for performance but for risk management, and the industry cooperates with them. Here in Japan fund analysis is still young and few fund companies are transparent to companies like Morningstar."

Although the mutual fund industry has taken a hit, some fund managers are optimistic that the MMF trauma will force investors to think more realistically about risk and return. Minoru Mukai, executive director at UBS Asset Management, notes institutional investors are seeking new alternatives for short-term, liquid vehicles, and are increasingly willing to look at offshore credit. They are discovering that US corporate credit as well as agency paper such as mortgage-backed loans can offer better yields for the same credit rating, even after the costs of hedging back into yen.

Moreover, says Bill Wilder, president at Fidelity Investments in Japan, asset management is becoming increasingly important to Japanese financial institutions. The MMF experience has been a shock that some will learn from. Moreover, the total size of the mutual fund industry remains so tiny - he reckons it is smaller than Fidelity's US flagship, the Magellan Fund - that the MMF crisis will not have a lasting impact on its fortunes.

Several fund managers, in fact, say the MMF disaster is a one-off setback that will help investors think about emerging products such as real-estate investment trusts, exchange-traded funds and variable annuities.

It is possible that the MMF collapse represents the darkness before the dawn, but one thing is for sure: when it comes to Japan's mutual fund industry, investors, regulators and practitioners alike seem to learn lessons only the hard way.