Let Portfolio Managers Eat Their Cooking, But Don’t Force-Feed Them

It has been reported in the media that Kotak Mahindra Asset Management Company (AMC) has ruled that its employees who wish to invest in mutual funds, shall henceforth do so only in the AMC’s funds. The reports also suggest that employees will be penalized if they make fresh investments in funds from other AMCs after the policy comes into place. 

The rationale behind the move is to introduce the concept of ‘skin in the game’. The concept is far more common in the West, than in India. For instance since 2005, the U.S. Securities and Exchange Commission has required AMCS to annually disclose how much portfolio managers invested in the funds they run. 

To clarify, Kotak Mahindra AMC is not the first Indian AMC to institute a ‘skin in the game’ policy. While some AMCs pay (a part of) bonuses to their investment teams in the form of mutual fund units, others pledge that their top brass invest in funds from the AMC. What differentiates Kotak Mahindra AMC’s guideline is that perhaps for the first time, employees across the board who wish to invest in mutual funds, have been told to compulsorily do so, in the AMC’s funds. 

Why ‘skin in the game’ matters 

From an investor’s perspective, is Kotak Mahindra AMC’s guideline necessarily a positive one? I don’t think so.

To clarify, I have been a propagator of portfolio managers eating their cooking i.e. investing in funds they run for a while now; also, I believe there is a case for disclosing managers’ investments in funds they run. To understand why I am not convinced of the guideline in question, let’s delve further into the ‘skin in the game’ concept. 

At its core, portfolio managers investing in mutual funds they run is all about inspiring confidence in investors. Portfolio managers who invest alongside their investors show a conviction in their investment approach and a confidence in their investment acumen. It’s a classic example of putting one’s money where the mouth is.

Coercion versus free will

The trouble with Kotak Mahindra AMC’s policy is that there is an element of coercion. Employees (including portfolio managers and analysts) who wish to invest in mutual funds, will invest in funds from the AMC because they are being forced to do so, not because they want to. For an act to inspire confidence, it must be voluntary and not compulsory. Even if managers claim that they have invested in funds from the AMC voluntarily, that argument is unlikely to find many takers, given the existence of a policy which dictates such investments.

What AMCs must do

  

If Indian AMCs are serious about building investor confidence, they must adopt the ‘skin in the game’ concept in letter and spirit. Apart from voluntary investments by portfolio managers, AMCs can explore avenues such as offering a part of the compensation in locked-in units from the AMC’s funds, or periodically disclose investments made by managers in funds they run. 

Most importantly, AMCs must appreciate the importance of free will for ‘skin in the game’ to have the desired effect.

SEBI misses a trick or two

In its February 2014 board meeting, the market regulator approved a ‘Long Term Policy for Mutual Funds in India’. The policy has both tax and non-tax related proposals. Some of the latter are particularly interesting. For instance, there is a proposal to introduce the concept of seed capital whereby asset management companies (AMCs) will invest 1% of the amount raised (capped at Rs 5 million) in any open-ended fund they launch. Clearly the regulator wants to ensure that AMCs eat their own cooking which is a positive. Such a move can incentivize AMCs to put in due effort while running a fund since they will have skin in the game. More importantly in the larger scheme of things, it can help build investor confidence.

That in turn makes one wonder, why restrict a step which has the potential to be a game changer to just new fund offers (NFOs). How about existing funds which are open to investors for subscription; would it not be fair for AMCs to display the same commitment to existing funds. Make no mistake; there are quite a few funds out there which AMCs have conveniently lost interest in. Several of these funds were in vogue at the time of launch. However over time, their weak investment propositions have caught up leading to poor performance and dwindling assets. Should fund houses be forced to invest in their open-ended funds across the board, it will make for some interesting watching. It should come as no surprise if AMCs merge and close a record number of funds to circumvent the regulation.

And while we are on the topic, how about asking portfolio managers to disclose their investments in funds they run. In effect, while AMCs mandatorily invest in all their open-ended funds, managers are only required to disclose their investments (if any) in funds they helm. Wouldn’t these two steps go a long way in reinforcing investor confidence?

Another proposal suggests that the minimum net worth of AMCs be increased to Rs 500 million (from Rs 100 million at present). This one has been in the news for a while. Apparently the thinking is that increasing the net worth threshold is a surefire way to ensure that only ‘serious’ players operate in the mutual fund business. Mildly put, this rationale is ludicrous. A ‘large’ AMC doesn’t necessarily become better or even more investor-friendly than a ‘small’ AMC. While the importance of having serious players cannot be disputed, suggesting that an entity which can put together substantial monies automatically qualifies as one is inane. Let’s not forget that mutual funds operate as ‘pass-through’ structures; simply put, AMCs charge a fee and manage monies on behalf of investors who in turn enjoy/incur the profits/losses made. AMCs are certainly not expected to take losses on their books, thereby necessitating a higher net worth.

Furthermore if history is any indicator not all ‘large’ AMCs have distinguished themselves. Let’s not forget that some of them were among the worst offenders when it came to launching trendy NFOs (in rising markets) and transferring illiquid fixed income securities from debt funds to equity funds (during the 2008 meltdown). On the other hand, a ‘small’ AMC was the first to launch direct-to-investor funds thereby reducing the cost of investment for investors.

This regulation could well turn the Indian mutual fund industry into a big boys’ club, which is certainly not desirable. While SEBI must take all steps to ensure that ‘fly-by-night’ operators don’t enter the mutual fund business, it should certainly not elbow out niche players. Eliminating potential competition from smaller players with a differentiated offering might result in hurting investors’ interest rather than protecting it.

Don’t get me wrong. I’m not a SEBI-basher. If anything, I have by and large favoured most regulations instituted by the market regulator to protect investors’ interests. However this time around, SEBI has missed a trick or two: While the market regulator has failed to do enough in its proposal to introduce seed capital for mutual funds, the regulation to increase net worth for AMCs is a case of misguided righteousness.