Should SEBI be so concerned about size?

Admittedly, “does size matter?” is one of the more tricky questions to answer. Depending on where and when that question is posed, it could evoke different responses from the same individual.

However (and on a more serious note), market regulator SEBI seems to have an unambiguous view on the subject. It is seemingly convinced that bigger is indeed better. Not too long ago, it mandated that the minimum net worth of asset management companies (AMCs) be increased to Rs 500 million (from the erstwhile minimum of Rs 100 million). If recent media reports are to be believed, SEBI has written to AMCs asking them to merge or close debt funds with an asset size of less than Rs 200 million. Reports further suggest that equity funds with an asset size of less than Rs 100 million will be dealt with likewise.

Yet again SEBI seems convinced that investors’ interests will be better served by investing in larger funds. To be fair, larger funds offer certain advantages: all things being equal, they are structured to be more competitive on the price (read expense ratio) front versus smaller sized funds. In certain segments of the debt market, the minimum lot size is on the higher side, in turn necessitating that the fund have a reasonable asset size to be able to operate efficiently.    

But doesn’t it strike as being odd that the market regulator is now even dictating what a fund’s minimum asset size should be? Clearly, there’s more to it than meets the eye. For some time now, SEBI has been trying to make mutual fund investing less complicated for investors. Remember the risk-based colour-coding for funds, or even asking AMCs to disclose fund performance versus an appropriate benchmark index across specified time periods. To my mind, SEBI recognizes that there are too many funds available out there which makes fund selection a difficult task for investors. With this move, SEBI is in fact trying to rationalize the number of funds.

In India, AMCs have displayed a penchant for recklessly launching new fund offers (NFOs), since NFOs do act as tools of asset mobilisation. In this context, while the regulator’s intent cannot be flawed, the approach needs to be questioned. A fund’s asset size in isolation cannot be the barometer of its worthiness. Just as there are several small funds which perform and serve investors well, there are several large ones which are laggards and hurt investors’ interests.

Disallowing smaller funds en masse hardly seems like the right solution. Instead what the regulator must do is force (since they seem incapable of doing so voluntarily) accountability on AMCs. And here’s how:

1.   Make AMCs invest in all their open-ended funds:   

Extend the scope of the recent regulation whereby the concept of seed capital in open-ended NFOs has been introduced to all open-ended funds. Simply put, it should be mandatory for AMCs to invest their personal monies in all their open-ended funds. Apart from boosting the fund’s asset size, this move will (more importantly) also reveal an AMC’s true commitment to its funds. It should come as no surprise if a number of funds are voluntarily closed or merged irrespective of their asset size.

2.   Make the Board of Trustees accountable

The Board of Trustees (BoT) is required to sign off on NFOs authenticating that they are different from the AMC’s existing funds. Truth be told, not all boards have distinguished themselves, else we wouldn’t have had a proliferation of like NFOs. It’s time SEBI makes the BoT accountable by getting them to audit all existing funds on an ongoing basis with a view to weed out both weak and similar funds. The audit report, recommendations made and action taken should be a part of the annual statutory disclosure.

3.   Enhance quality of distributors

This is admittedly a long-term initiative: the Indian mutual fund industry needs more informed and better-equipped distributors. Sadly, there are a large number of well-meaning distributors who would like to do what’s right for the investor, but are ill-equipped to do so. For instance, when an AMC offers them a fund with a poor investment proposition, they are unable to see through it. The answer lies in re-visiting the criteria for empanelling distributors. Also, SEBI should mandate that a part of the monies meant for ‘investor education’ initiatives (we all know how that is really utilised J) be used for training distributors.

Finally, the market regulator must recognize that if it wishes to attract investors and build investor confidence, there is a need to make systemic changes in the mutual fund industry. Targeting smaller sized funds is unlikely to help on either count.

Of Sangakkara, Yuvraj, and Prashant Jain…

In the recent World T20 final, southpaw Kumar Sangakkara’s blistering knock helped Sri Lanka triumph over India. Playing his last international T20 match, Sangakkara had had a rather indifferent run coming into the final. But on the day, his batting display meant that all skepticism surrounding him vanished and the clichéd maxim “form is temporary, class is permanent” was back in circulation.

In the same match, another southpaw Yuvraj Singh had a bad day at the office. To put it mildly, he was woefully out of sorts with the bat. As a result, he found himself at the receiving end of a barrage of criticism; even as I write this post, critics are busy writing his cricketing career’s obituaries. Though Yuvraj has proven credentials as a match winner, not many seem willing to offer the “form is temporary …” defense in his favour, at present.

To my mind, the diverse reactions can be attributed to a recency bias. The accolades for Sangakkara and criticism for Yuvraj have more to do with their performance in the final match, rather than an accurate evaluation of their cricketing prowess. Both Sangakkara and Yuvraj are unquestionably talented batsmen with impressive careers to show for. But for now, most believe that Yuvraj is a 'has-been', while Sangakkara is a 'class act'. And what’s driving this belief—the players’ showing in the most recent match.

The recency bias can manifest itself in investments as well. If markets have been on an upswing in the recent past, investors are more likely to believe that they will continue to move northwards going forward as well, rather than otherwise. Likewise, a stock or sector which has hit a purple patch lately will often inspire more confidence in investors rather than one that has underperformed recently.

O Prashant, Where Art Thou?

In the latter part of 2013, I was addressing a gathering of mutual fund distributors, advisors and investors. Things became interesting when the conversation veered towards funds run by portfolio manager Prashant Jain i.e. HDFC Top 200 and HDFC Equity. To clarify, I thought (and continue to think) highly of those funds and the manager in question. But then, I was in a minority. The funds were having a terrible run in 2013, underperforming both their respective benchmark indices and comparable peers. The audience was at its vitriolic best: Theories such as the manager doesn’t churn the portfolios enough, the funds are too large to perform, and the manager is a spent-force were put forth by the audience to rationalise the underperformance.

Prashant Ahoy!

Oddly, at present (i.e. roughly six months later), Jain and his funds are being eulogized by the same set of distributors, advisors and investors. And what has changed between then and now–the funds have clocked a strong showing and emerged among the best performers in a peer-relative sense. Is that surprising? Not really. Broadly speaking, the manager has been betting on a turnaround for a while now and had positioned his portfolios accordingly. Expectedly, while the funds struggled for a better part of 2013, they staged a comeback of sorts in the present market upturn.

Is it Heads or Tails?

Here’s what makes the funds tick: Jain easily ranks among the best portfolio managers in the country; he plies a robust investment process and is backed by a fund house which has a reputation for safeguarding investors’ interests.

The aforementioned factors existed when the funds were underperforming, and they continue to be present now too, when the funds are outperforming. All things being equal, a year or so of underperformance doesn’t turn a good fund into an inferior one; likewise, outperformance over a six-month period doesn’t convert a mediocre fund into a superior fund.

Yet, we have seen the manager and his funds go from vilification to glorification in a six-month period. This is irrational behavior at its best which can be attributed to the recency bias. I shudder to think of the reactions that will follow, if Jain’s funds were to underperform over the ensuing six months.      

What investors must do

Resist succumbing to the recency bias while investing. Think about it: you might exit a sound investment avenue with solid long-term prospects because of short-term underperformance. Conversely, by blindly chasing an investment which has fared well you may run the risk of making an overpriced buy or even one that is unsuitable for you. Maintain a long-term orientation while investing; it will help you block out all the noise which prevails in the near-term.

Also, learn to look beyond just performance while making investment decisions. Rather focus on what makes the investment avenue tick to better understand when it is likely to fare well and otherwise. This in turn will help you make informed investment decisions, independent of recent performance.

On a lighter note, a word of caution for those writing off Yuvraj based on one poor showing—the humble pie isn’t particularly palatable!