Mr. Portfolio Manager: It’s About Conviction, Not Guarantees

Over the years, in my several interactions with portfolio managers most have claimed to be big investors in funds they run. Perhaps it was politically correct to do so. Then again, there was no way to independently verify their claims. However, with market regulator SEBI mandating that investments made by managers and the fund company's top brass be disclosed, the scenario has changed.

The disclosures have been startling to say the least. Several long-tenured managers running large diversified funds have nominal investments to show for, while others have chosen not invest in their funds. It can be safely stated that the principle of having ‘skin in the game’ hasn’t been embraced by many managers.

Recently, a manager who has no investments in his funds came up with a novel justification. He stated that a ‘manager investing in his own fund doesn’t guarantee performance’; hence, his investments (or lack of them) are immaterial. To clarify, he isn’t the only manager to have taken that stand. In my opinion, this line of thought is both naive and flawed.

Given their market-linked nature, mutual fund investing entails taking on risk. While the degree of risk may vary depending on the kind of fund chosen, risk is pervasive nonetheless.

So how do investors mitigate risk? By performing an evaluation. For instance, some may focus on quantitative parameters such as past performance, risk-return showing, while others emphasize on qualitative factors—manager skill, investment process et al. It isn’t uncommon for investors to combine the two either.

The portfolio manager’s investments in funds he runs is yet another evaluation tool. A manager investing substantial monies in his funds demonstrates conviction in his investment approach and acumen. It’s a classic example of putting one’s money where the mouth is.

None of the evaluation parameters can guarantee performance. But that in no way diminishes their relevance. Of all people, a portfolio manager should be aware that there are no guarantees in his domain. Investing in markets akin to a business of risk, not a business of guarantees. Does the fact that there is no guarantee of returns, prevent the manager from exhorting investors to invest in funds he runs?

I have no doubt that some managers will continue to steer clear of investing in funds they run. But they would do well not to trivialise the importance of having ‘skin in the game’ using inane arguments. As for investors, I am certain that like me, most will be wary of the chef who doesn’t eat his own cooking.

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.