When The Portfolio Manager Exits…

Last week, it was reported in the media that portfolio manager Manish Gunwani has quit ICICI Prudential AMC. The recent past has witnessed a fair degree of churn among managers; media reports suggest that more exits are on the cards.

A portfolio manager’s exit is an eventuality that mutual fund investors are bound to encounter at some point. Given that the manager helms the fund, expectedly, his exit can have a bearing on investors.

On their part, investors must evaluate how the manager’s exit will impact the fund. More importantly, they must determine if the fund should continue to find place in their portfolios.

Sadly, investors’ task tends to be complicated by rather diverse perspectives.

Perspectives

From a fund company’s perspective, a portfolio manager’s exit is often treated as a non-event. Typically, the reaction will be: “we have robust investment processes in place; hence manager XYZ’s exit will have no impact on our fund’s performance”.

To be fair to the fund company, it is in its interest to say so. One can’t expect a fund company to admit that a manager leaving is a loss, and that investors could be in for troubled times.

On the other end of the spectrum is the portfolio manager-centric perspective. The latter stems from the belief that the manager is the be-all and end-all for the fund. Hence, all bets are off.

As is often the case, the truth lies between the two extremes.

Individual Brilliance versus Institutionalised Skill

Let’s understand how the investment process works at a typical fund company. The investment team comprises of products specialists, risk management professionals, research analysts, and portfolio managers. Each group performs a specialised task utilising an array of tools and resources.

Investment ideas are originated, debated and vetted before making it to the fund company’s ‘approved’ investment universe. Paper portfolios (also referred to as model portfolios) are created and tracked as an internal guideline. Often each fund is backed by a unique template listing guidelines.

Though the portfolio manager is the first among equals when it comes to running a fund, at times, investment committees also have secondary oversight on funds.

As is evident, a fund company deploys considerable resources to institute investment processes. Hence their typical reaction in response to every manager exit.

So does that make the portfolio manager redundant? Can investment processes eliminate the need for a manager? The answer is--No!

To begin with, not every investment process is necessarily robust. It takes a skilled manager to capitalise on available resources and process. Indeed, in some cases, the manager’s individual brilliance can deliver pleasing results, despite the presence of a less-than-robust investment infrastructure.

The truth is that if processes in isolation could have guaranteed success, then every buy and sell decision would have been made using algorithms, and the portfolio manager would have been an extinct species.

Conversely, those who believe that the manager is the be-all and end-all, must not forget that without the fund company’s resources and instituted processes, a manager could find himself disadvantaged, and perhaps unable to play to his potential. Though the manager is the face of the fund, the forces behind the scenes shouldn’t be overlooked.

Simply put, both investment processes and the manager’s skill contribute to the fund’s success. It would be imprudent to discount either of them.

One Size Doesn’t Fit All

Each fund company has in its arsenal, different investment processes and managers possessing varied skills. Hence the key is to determine which factor contributes more to the fund’s success.

For instance, a combination of a robust process plus a skilled incoming manager can make a manager exit, a non-event. Conversely, if a fund’s success can be largely attributed to the manager’s presence, then his exit should raise a red flag, irrespective of what the fund company claims. In other words, the impact of a manager exit needs to be evaluated on a case-by-case basis.

Admittedly, understanding the nuances of a fund company’s internal workings can be difficult for an investor. That’s where the investment adviser has a part to play in helping the investor make an informed decision.

All in all, a manager’s exit merits consideration, and investors’ response should be based on an in-depth understanding of the facts of the case.

Do Indian Portfolio Managers Eat Their Own Cooking?

For some time now, The Association of Mutual Funds in India (AMFI) has been running an ad campaign “Mutual Funds Sahi Hai”, to propagate the cause of mutual funds. Incidentally, these are good times for Indian asset managers with industry’s assets soaring to record highs. Clearly, investors have taken to mutual funds in a big way.

I thought it will be interesting to find out if portfolio managers who run mutual funds have taken to them as well. To my mind, a manager investing in his fund speaks volumes about both, his commitment to the fund, and confidence in his abilities.

In 2016, market regulator SEBI made it mandatory for fund companies to reveal information about investments made in each fund, by the fund’s portfolio manager, and other key personnel.

I compiled a list of the 50 largest equity funds (excluding hybrids) to study portfolio manager investment patterns. These funds account for roughly 61% of the industry’s equity mutual fund assets, making them a representative sample.

Some disclosures are in order: In the hunt for most recent information, I have perused various documents—Scheme Information Document, Statement of Additional Information, and Key Information Memorandum. However some fund companies continue to disclose information as on 2016, while others have released updated numbers.

Another area of inconsistency is the investment figures. It is apparent that several fund companies have disclosed the current value of manager investments, rather than the sum invested (which is evidently more relevant). The only fund company which stands out in this aspect is SBI Mutual Fund, for having unambiguously disclosed both—the sum invested and current value of investment. This is an area where SEBI needs to step in, to ensure that manager investment are disclosed in a uniform manner across the board.

To analyse the data more efficiently, I broke down investments into the following ranges: 0, INR 1—INR 20,00,000, INR 20,00,001—INR 40,00,000, INR 40,00,001—INR 60,00,000, INR 60,00,001—INR 80,00,000, INR 80,00,001—INR 100,00,000 and over INR 100,00,000. The results are interesting:

Indian Portfolio Managers Don’t Eat Their Own Cooking

Out of the top-50 funds, 20% have no investments from their portfolio managers.

The INR 1—INR 20,00,000 range is the most populated one, accounting for 27% of the top-50 funds.

Cumulatively, the bottom two ranges (no investment, plus INR 1—INR 20,00,000) account for a staggering 47% of the top-50 funds. This is disappointing to say the least.

It can be safely stated that several Indian portfolio managers have little or no confidence in their investment abilities.

Defending the Indefensible

At this point it must be stated that manager remuneration disclosures reveal that an annual compensation of roughly INR 1 crore (INR 10 million) is common even at mid-sized fund companies. So the defence that managers don’t have monies to invest in their funds doesn’t hold water.

Managers can’t take refuge under the pretext of low tenure either, since 80% of the top-50 funds have had their present lead manager at the helm for over two years.  

Finally, a portfolio manager helming a niche fund (such as a money market fund or a sector fund) is perhaps justified in having a small investment. However, the top-50 list is comprised of conventional equity funds, which means that there is no excuse for having zero or tiny investments.

The Counterview

Sceptics might claim that a manager making a substantial investment in his fund doesn’t guarantee performance. But, it is an undeniably important evaluation tool, which demonstrates the manager’s conviction in his investment approach and acumen, and more importantly, his commitment to the fund.

I fail to see why investors should invest in a fund that the manager isn’t entirely committed to. I am certain that like me, most will be wary of the chef who doesn’t eat his own cooking. 

On a final note, perhaps AMFI should initiate an ad campaign targeted at portfolio managers to convince them about the benefits of mutual funds.

Why Investors Shouldn’t Deify the Portfolio Manager

In the recent past, debt mutual funds have witnessed two significant events. Oddly, these seemingly unrelated events have evoked an identical response from investors.

In the first week of February 2017, RBI’s Monetary Policy Committee unanimously voted in favour of keeping policy rates unchanged. It was widely anticipated that the central bank would cut rates in keeping with the accommodative stance it has adopted over the last two-odd years.

Debt markets reacted negatively to the pause in rate cuts, with bond yields surging sharply.

Several portfolio managers running debt mutual funds had increased the maturity of their portfolios, to capitalise on the anticipated rate cut. Expectedly, their performance took a significant hit.

Last week, some debt funds from Taurus Mutual Fund were in the news on account of their poor showing; the funds posted losses ranging from 7% to 12% in a single day. The reason—they were invested in debt instruments from Ballarpur Industries. A credit rating agency downgraded the issuer’s long-term rating, on account of “delays in debt servicing by the company”, among others. The episode brought back memories of similar instances that have occurred in recent times.

In both the aforementioned instances—RBI keeping rates unchanged, and Taurus Mutual Fund’s credit bets—it is evident that portfolio managers were pursuing distinct investment strategies. In the former, managers were engaging in duration plays, while in the latter, taking credit risk was central to the strategy. However, both strategies came a cropper to the chagrin of investors.

Deifying the Portfolio Manager

Since then, I have had conversations with several investors. The most common refrain was that portfolio managers are to blame. But the grouse wasn’t along the lines of the justifiable “portfolio managers need to take responsibility for poor investment decisions”.

Rather it was akin to “how could the portfolio manager make a mistake?”

On digging deeper, I learnt that their rationale was: The portfolio manager is an investment expert. He gets paid a sizeable compensation for running the fund. Hence he shouldn’t be making a mistake, and as a result, exposing investors to a loss.

I was surprised to note that many investors view the portfolio manager like a superhero who cannot err. And therein lies a fundamentally flawed line of thought.

Selecting the Portfolio Manager

Admittedly, the portfolio manager plays a significant part in determining the fund’s fortune. Also, it must be stated that portfolio managers encompassing the entire spectrum—mediocre to supremely talented—exist in the mutual fund industry. Hence, the importance of selecting the right portfolio manager cannot be overstated.

One would expect the manager to be skilled, and have proven his mettle over the long haul. He must have successfully plied his craft across a market cycle. Furthermore, he needs to demonstrate confidence in his abilities by investing substantial monies in his funds alongside investors.

Simply put, the portfolio manager must indisputably earn his stripes before investors can entrust him with their monies.

Pragmatic Expectations and Evaluation

On their part, investors must be pragmatic while evaluating the portfolio manager. Investors would be justified in expecting the manager to get more calls right than wrong. For instance, a manager running an active strategy is expected to beat the benchmark index over the long haul.

However, expecting him to never err, or deliver a positive return consistently is unrealistic. Even the best of managers, can and will make a poor investment decision at some point. That is par for the course in market-linked investing.

Idolising the manager can also hurt investors by preventing them from making an accurate evaluation when the manager hits a purple patch. Consider the case of a manager who takes on unduly high risk to clock superior returns.

The Flipside of Deification

There’s a marked difference between holding the manager to high standards, and having unrealistic expectations. The latter can lead to disenchantment, and investors turning their back on mutual funds.

Sadly, investors whom I interacted with seemed to be leaning in that direction. They have jumped to the conclusion that since the portfolio manager cannot guarantee success, they are better off investing on their own. For most, that isn't the right course of action.

What Investors Must Do

Investors would do well to understand how portfolio managers operate, and then devise an evaluation system that works for them. A manager who fails to retain the investor's confidence should be penalized.

But deifying the portfolio manager and expecting him to deliver in a like manner is neither rational, nor in the investor's interest.

Do Fund Companies Dislike Direct Plans?

Recently, I had a rather curious interaction with a fund company. Promoted by a public sector bank, the fund company ranks among the larger ones in the industry.

I invested in an equity fund opting for Direct Plan; as per norm, the payee on the cheque was: XXXX Fund – Direct Plan – Growth; the same was explicitly mentioned on the transaction slip as well. Oddly, the statement of account revealed that I had been allotted units under the Regular Plan.

Assuming that it was a clerical error, I wrote an email to the fund company explaining the facts of the case. To my surprise, they wrote back saying “With regards to your query, we would like to inform you that a broker code (ARN Code) was mentioned in the application submitted by you, hence we allotted the units in regular plan. We request you to kindly contact with the respective branch for further assistance.”

I haven’t engaged a distributor for several years now. Furthermore, even if that were the case, the fund’s Scheme Information Document (SID) states that in cases where a broker’s code is mentioned and the plan mentioned is ‘Direct’, the default plan is deemed to be ‘Direct’.

In effect, the fund company had violated its stated guidelines.

After a significant back and forth over email and several tele-conversations, the fund company grudgingly agreed to modify the plan from ‘Regular’ to ‘Direct’.

This episode got me thinking about why my investment had been earmarked under the Regular Plan instead of the Direct Plan. As was evident from the email, it wasn’t an oversight. Rather, the fund company staff was following laid down procedure. Simply put, they had been instructed to act in a manner that was in contradiction to what the SID stated.

But why would a fund company indulge in such skulduggery?

It is common knowledge that despite Direct Plans having been in existence for nearly four years now, a bulk of mutual fund assets continue to be garnered by distributors under Regular Plans.

Moreover, Direct Plans have a lower expense ratio as compared to Regular Plans since distribution expenses et al are excluded. Also, no commission is paid to distributors under the Direct Plan.

In other words, assets under Direct Plans can’t be utilised to compensate distributors. Sadly for some fund companies, that’s unacceptable because in their books, distributors are more important than investors.

Don’t get me wrong. I’m not making this out to be a 'distributor versus investor' debate. However, the fund company has done so, by creating a mechanism to surreptitiously transfer investments from Direct Plans to Regular Plans.

Distributors have an unquestionable role to play in the mutual fund industry. Fund companies are entitled to utilise their services and compensate them as deemed fit. However in their zest to provide for distributors, investors’ interests shouldn’t be compromised.

Investors on their part must evaluate a fund company’s pedigree while making investment decisions. Fund companies that fail to watch out for investors should be steered clear of.

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.

Will This Be Robo Advisory Firms’ Achilles' Heel?

Robo advice has become a buzzword in the financial services domain, and robo advisory firms are mushrooming at a furious pace in India. A combination of factors—growing financial literacy among investors (especially in urban areas), internet penetration, and enhanced awareness about mutual funds, among others—has contributed to this phenomenon. It can be safely stated that robo advice is an idea whose time has come.

As the name suggests, robo advice eliminates human intervention. Instead of an adviser, the investor is guided by algorithms run on a website. Typically, the investor feeds in information about his age, risk-taking ability, income and expenses, current assets and liabilities, financial goals, expected inflation et al. The robo adviser uses the data to produce a suggested asset-allocation and a list of mutual funds that can aid the investor achieve his financial goals while adhering to his risk appetite. Furthermore, robo advisory firms also enable investors to make online mutual fund investments thereby acting as distributors too.

To my mind, several of the robo advisory firms do a decent enough job when it comes to risk-profiling and arithmetic calculations. Likewise, it is evident that some have paid due attention to areas such as user interface. It is the last mile—recommending mutual funds—where most err.

It is commonplace to see funds being recommended based solely on performance. Typically, the three-year period is considered, and top-performing funds make it to the robo adviser's list. Recommendations are also offered in the form of a portfolio of mutual funds. Yet again, the three-year showing is the primary factor for picking funds from various categories. Given the strong showing posted by small/mid-caps in the recent past, it comes as no surprise that at present several recommended portfolios have a strong small/mid-cap bias.

A rule of thumb approach is perceptible in the recommendations. For instance, investors with a moderate risk appetite are offered large-cap funds. However, no thought is applied to the nature of the fund. For instance, a large-cap fund wherein the manager aggressively churns the portfolio, and draws on factors such as news flow, market sentiment and momentum while investing might not be suited for a moderate risk-taker. Yet such funds make the cut thanks to their performance and large-cap classification.

Not only is making recommendations based solely on performance a fundamentally flawed approach, it also reveals a poor understanding of the basics of investing. When the present top-performers are replaced by others (as it can and does happen in the case of market-linked investments) will investors be expected to churn their portfolios? Robo advisory firms can’t take refuge under the premise that their advice is bound to be ‘formulaic’. There is a difference between formulaic advice and flawed advice.

Don’t get me wrong. I’m not questioning the utility of robo advice. For first-time investors and those with uncomplicated investment needs, robo advice can be the way to go. But robo advisory firms must realise that there is more to investment advice than just running calculations. Indeed, flawed advice can significantly hurt investors' interests.

Robo advisory firms have a huge opportunity at hand. If tapped well, robo advice can prove to be a game-changer for both the mutual fund and distribution industries. However ignoring the ‘advice’ aspect of the business will prove to be a costly miss.

Direct Plans: Much Ado About Nothing

Admittedly, when I first heard someone complain about direct plans, I was surprised. But over time, the negative buzz has only grown. A few months ago, I met some individuals who are engaged in mutual fund distribution. Their grouse was that introduction of direct plans has resulted in a significant loss of business for smaller distributors like them. They were convinced that it was only a matter of time before all mutual fund investors migrated from regular plans (wherein the expense ratio includes distribution expenses, commission et al) to direct plans.

Then there were investors who were unhappy with their investments in direct plans. They maintained that direct plans were responsible for their woes. Things came to a head last month when SEBI issued a circular mandating that fund houses disclose information regarding commission paid to distributors, among others. Some concluded that this was a sly move to promote direct plans at the cost of regular plans.

In all the aforementioned cases, direct plans were painted as villains of the piece. But do those arguments hold weight?

       

Let’s consider the first grouse: direct plans have resulted in small distributors substantially losing their business. As per data released by AMFI, as of Feb 2016, “39% of the assets of the mutual fund industry came directly. A large portion of direct investments were in non-equity oriented schemes where institutional investors dominate”.

It is common knowledge that most institutional investors were (and continue to be) serviced by large distributors i.e. distribution arms of banks, broking firms and distributors with a nationwide presence. So it can be safely stated that institutional monies flowing from distributor mode to direct mode hasn’t had a significant impact on small distributors.

Now let’s focus on retail investments i.e. the universe largely catered to by small distributors. AMFI data reveals that of the total industry assets (INR 13.5 trillion), roughly 44% were held by individual investors; of these just 13% were invested in direct plans.

It is noteworthy that direct plans with a lower expense ratio have been on offer since Jan 2013. In other words, even after more than 36 months, a bulk (87%) of retail assets continue to be invested via distributors. The much-feared and speculated exodus of retail assets from distributor to direct mode hasn’t taken place.

The second grouse—investors expressing dissatisfaction with direct investments—has its roots in a half-baked understanding of how direct plans should be utilised. After they were introduced, benefits of direct plans (lower cost versus regular plans, and thereby higher performance potential) were universally extolled. Expectedly, some investors decided to invest independently, and chose direct plans over regular plans. However while doing so, several overlooked an important caveat: direct plans are meant for informed investors who can make investment decisions independently.

Not all investors who severed ties with their distributors were capable of investing prudently. To further complicate matters, their chosen alternative for the distributor—experts in media—left a lot to be desired. Experts offering generic opinions on investing in the media doesn’t necessarily qualify as investment advice.

A distributor offering advice based on the investor’s risk profile, investment objectives and horizon cannot be substituted by a media talking head. The need for robust investment advice was accentuated in the last 18 months or so, when markets were at their volatile best. Sadly, some investors have erroneously chosen to blame direct plans for their woes.

The merits of direct plans are indisputable. Indeed, their introduction has gone a long way in democratizing mutual fund investing. 

For investors who need investment advice and services, engaging a distributor and investing in regular plans is a viable option. Conversely informed investors can utilise direct plans and benefit from lower costs. The onus of making the apt choice lies with investors.

Stupid Portfolio Manager vs. Ignorant Portfolio Manager

Aggression seems to be the flavour of the season. Several politicians routinely breathe fire; at present, students at a New Delhi campus are in a belligerent mood. No discussion on Indian cricket is complete without the mention of aggression; likewise, a bespectacled newscaster known for his confrontational demeanour tops the TRP charts. And just when one thought it couldn’t get any more interesting, aggression has reached the mutual fund industry.

Recently, the promoter of an asset management company published a piece insinuating that competing portfolio managers are stupid. His contention is that since the NDA government assumed charge at the centre, bogus/hyped earnings estimates have been doing the rounds. Hence, equity portfolio managers who believed in and acted on the same are stupid. Furthermore, portfolio managers who didn’t fall for the hype, but failed to communicate their misgivings (on lucrativeness of equities) to investors are dishonest.

Apart from a touch of arrogance, the piece also reveals a poor grasp of how investing works. Investing is a personalised activity i.e. each investor pursues an investment philosophy and strategy that works for him. This principle holds good for portfolio managers as well.

For instance, while some managers pay more attention to top-down factors, others rely on bottom-up analysis. Some invest with a growth-bias, while others have a value-bias. There are managers plying research-oriented strategies and others who deploy a sentiment and momentum-driven approach. Even the investment horizon can vary significantly. Admittedly some strategies are more efficient than others, but that doesn’t take away from the fact that investing isn’t a one-size-fits-all activity, as the article erroneously suggests.

Equity investing isn’t a pure science. When a manager evaluates a business, factors such as his investment philosophy, interpretation and biases (among others) come into play. To suggest that every manager should have (or did) read the macroeconomic environment in a uniform manner is oversimplification. More importantly, is it apt to evaluate managers based on one event? Prudence demands that an equity manager be evaluated over the long-haul spanning a market cycle.

An element of bragging rights is perceptible too. Over the last year or so, equity markets have experienced a fair bit of volatility. The flagship equity fund (from the author’s AMC) takes cash calls based on valuations, and has expectedly fared well in a peer-relative sense. The portfolio manager and strategy deserve credit for the showing. However, that doesn’t diminish the credibility of competing managers who don’t take cash calls; expectedly, such funds have fared poorly in the recent past.

   

On the dishonesty bit, yet again the author displays his ignorance by mixing up the roles of an adviser and a portfolio manager. The latter is responsible for running the fund to the best of his abilities and in the investor’s interest at all times. However, offering the investor asset allocation-related advice, or managing the investor’s portfolio is not the manager’s role. That’s what advisers are engaged for.

In the competitive asset management industry, the need to celebrate and spread the word about one’s success is understandable. However, branding the competition as stupid and dishonest on untenable grounds reeks of ignorance.

Why Indian Fund Companies Shouldn’t Fear Greater Transparency

Media reports suggest that several Indian fund companies are at loggerheads with market regulator SEBI. The latter wants to increase transparency by disclosing commissions paid to distributors in investors’ statements of accounts. On the other hand, fund companies believe that doing so will be detrimental to their interests. According to reports, industry body AMFI has communicated its reservations to the regulator.

Reasons for opposing the move are varied: some fund companies think disclosing commission-related information will dissuade investors. Others feel that bombarding investors with too much information will be detrimental. 

To my mind, the concerns raised by fund companies are both misplaced and weak. To begin with, the proposal doesn’t alter the working of the fund industry in any manner. Fund companies pay commissions to distributors for selling their products (and rightly so!); all they need to do is disclose the same to investors (who bear the cost). No one’s suggesting that fund companies should stop compensating distributors.

As for fears of investors becoming upset by learning about commission payments, or becoming confused on account of too much information—those are weak arguments. Fund companies would do well not to underestimate the investor’s intellect. To assume that an investor who is satisfied with his investment will turn his back on it, because the agent’s commission is disclosed is a fallacious argument.

When an investor invests in a mutual fund, effectively he engages a fund company to manage his monies. The fund company charges a TER (comprising everything from operational expenses, the fund company’s fees, to the distributor’s commission) for the service. An unambiguous disclosure will aid investors better understand the fund’s working, and thereby make informed investment decisions.

For instance, a fund company which keeps costs (including fees and commissions) low and thereby enhances the fund's returns can benefit by communicating the same to investors. It can be safely stated that such disclosures will go a long way in winning investors’ patronage.  Conversely, the investor has a right to know if his fund is losing its competitive edge on account of exorbitant commission pay-outs.

Case for more disclosures

I’m surprised that in its quest for greater transparency, SEBI didn’t start at the top of the pyramid i.e. with fund companies. There is a strong case for making public, information related to the fund company’s compensation policy for its investment staff (portfolio managers and analysts), and also information regarding a portfolio manager’s personal investments in funds he runs.

Taken together, the two can reveal a lot about the fund company’s culture, its attitude towards investors, and a manager’s commitment to his fund—all of which can be vital in helping investors make better decisions. 

Admittedly, from the perspective of fund companies, revealing information that hitherto was private can be discomforting. But it is in their interest to embrace this change. Greater transparency isn’t an end in itself. The intent is to improve investors’ investment experience, and in turn make mutual funds more appealing. And when the investor wins, so will fund companies.

Investment Lessons from Yuvraj Singh’s T20 Innings

On Sunday, I watched the third T20I between India and Australia. Chasing a stiff target of 198 runs, India seemed on course until the third wicket fell. The next batsman Yuvraj Singh, was making a comeback to the national team. In the initial part of his innings, Yuvraj struggled, scoring just five runs in nine balls. As the required run-rate rose, the buzz on social media and the views of television commentators weren’t particularly charitable.

Then something interesting happened with India needing 17 runs to win in the last over. 11 runs were scored from the first three deliveries which Yuvraj faced – including a four and a six – putting the run chase back on track. With India winning the match, Yuvraj was hailed as a 'hero' all over.   

To my mind, the reaction was a classic case of circular logic; in other words, the result was used to selectively determine the cause. I have no doubt that had India lost, the focus would have been on the first half of Yuvraj’s inning wherein he struggled; furthermore, he would have been painted as the villain of the piece. However a win meant that the focus shifted to his impressive performance in the last over.  

Now let’s draw a parallel with the world of investments. Investors often rely solely on the performance to draw an inference about an investment avenue’s worthiness. For instance, if a mutual fund clocks a strong showing, investors infer that the portfolio manager must be skilled, the investment process must be robust, and so on. However such ‘analysis’ is fundamentally flawed. 

To begin with, in a rational approach, one or more causes lead to a given result, and not vice versa. Also, the performance-based approach fails to separate luck from skill. Consider, a mediocre fund helmed by an incompetent portfolio manager who got lucky with his stock picks. On account of the positive performance, the manager will be considered to be skilled. Likewise, a skilled manager whose investment style is currently out of favour will be given the thumbs-down on account of a poor showing. Investors’ woes will be further worsened if they choose to focus on near-term performance in an asset class like equity. 

A prudent approach would be to identify and evaluate factors that will influence performance. The results of this evaluation must then be compared with the fund’s long-term performance. If the two are in sync, then the analysis can be considered to be accurate.

Market-linked investing is inherently risky. Investors who base their decisions on performance, further accentuate the risk borne. While adopting this approach in cricket-related matters is harmless, doing so while investing could be a recipe for undesirable results.

Of Mutual Funds, Asset Sizes and Oblivious Experts

With calendar year 2015 coming to an end, business dailies are busy publishing round-ups of the year gone by. Expectedly, performances clocked by various investment avenues have been put under the scanner. An article detailing the performance of the largest (by asset size) equity mutual funds caught my eye. In a year when equity markets have had a rough run, most of the abovementioned funds fared better than their respective benchmark indices.    

However the truly interesting bit was an expert’s take on the performance. He attributed the positive showing to a combination of active fund management and strong flows into funds. The former makes sense. In a year when large-cap stocks struggled (the S&P BSE 100 posted a loss of 3%) and small/mid-caps fared somewhat better (S&P BSE MidCap: up 6%, and S&P BSE SmallCap: up 5%), a benchmark-hugging strategy wasn’t going to work. Skilled stock-picking and portfolio management were the need of the hour.

Robust inflows aid performance?

Now for the latter part: strong inflows in equity funds aiding performance. Not only is this reasoning questionable, it also exhibits a poor understanding of how mutual funds work.

Let’s take an example: Both Rs 100 and Rs 1,000 invested in a stock that appreciates 20% over a year deliver the same annual rate of return—20%. Simply put, a higher investment sum doesn’t alter the rate of return.

Critics might argue that the return varies i.e. while Rs 100 yields Rs 20, Rs 1,000 returns Rs 200. Fair enough. But let’s not forget that inflows (a higher investment amount) also result in a proportionately higher number of mutual fund units being issued. In other words, the higher return (Rs 200 versus Rs 20) is equalised by a larger number of units, resulting in the same rate of return.

Buying on dips: Theory vs. Practical

The expert further elucidates how robust flows helped portfolio managers invest smartly during corrections. Portfolio managers would like inflows to coincide with downturns; invest on downturns and then see those stocks outperform thereon. Admittedly in theory, that premise sounds fine. However in practice things work a bit differently. 

To begin with, typically such a phenomenon plays out over the long-term, and not over a year. Furthermore, in 2015, not many of the better performing stocks displayed a ‘V-shaped’ recovery. Any manager expecting the ‘downturn-inflows-invest-upturn’ cycle to play out consistently and immediately is banking on luck.    

On the other hand, a skilled manager focuses on portfolio construction—stock and sector allocation, managing liquidity and risk, among other aspects—which in turn enables him to rejig the portfolio and increase allocation to attractively valued stocks. Hence, yet again it doesn’t take inflows to deliver a positive showing.    

Asset size and performance

To buttress his point, the expert adds that fund asset size being a constraint for performance is a myth. Let’s examine this hypothesis. In India, the framework for expenses charged to a fund is structured to reduce cost when asset size grows. Hence, the larger a fund gets, cheaper it becomes; this is certainly positive for investors. Also for debt funds, it might help to have a larger size to enable making investments in government securities, given the standard market lot size of Rs 50 mn.    

But there is a flip side too: A large fund size can pose challenges in the form of market-impact costs, the opportunity cost of having to spread trades over longer periods and liquidity management; this is especially true in small/mid-cap funds. In India, several small/mid-cap funds have mutated into large-cap dominated funds thanks to unrestricted asset flows. It’s worth mentioning that in many cases the performance in the new avatar was a shadow of its former self.

Finally there’s the often unappreciated fact that the dynamics of running a large fund are vastly different versus those of running a smaller sized fund. Not every portfolio manager has the skills to successfully run a large fund. 

Why investors must beware

There’s a plethora of investors who are yet getting used to the idea of investing in mutual funds. Sadly, misconceptions such as invest based only on performance, focus on the one-year showing are prevalent. When oblivious experts go about preaching that a large asset size aids performance et al (in other words, ‘invest in a large sized fund’) they are doing investors a disservice. On their part, investors would do well be wary of such experts and their advice.

Data sourced from: www.bseindia.com

Don't Treat Debt Funds Taking Credit Risk Like Pariahs

The JPMorgan Mutual Fund episode continues to reverberate in the investment community. The focus has seemingly shifted from the two affected funds to the investment strategy of taking credit risk (also referred to as high-yield investing). Media reports suggest that market regulator SEBI has sought details on investments in lower-rated securities from fund houses; also, it has been reported that SEBI has asked fund houses to not rely solely on credit ratings while investing in debt securities. Consensus suggests that fund houses have erred by taking credit risk, and as a result, investors’ interests have been compromised with. But this line of thinking is both myopic and fundamentally flawed.

To begin with, let’s understand what the strategy of taking credit risk (or high-yield investing) entails. The portfolio manager invests in securities with a lower credit rating. Such instruments offer a higher coupon rate (versus securities with a higher credit rating); furthermore, there is a possibility of the bond price appreciating if the credit rating is upgraded. Does this investment strategy entail risk – yes, it does. There is risk of the issuer defaulting on the payment of interest and/or the principal amount. Often such bonds can be illiquid which further accentuates their risk profile.

Given the risks, did fund houses and portfolio managers err by adopting a credit-based strategy? No, and here’s why: The strategy of taking credit risk is as legitimate as any other. Several managers have plied it successfully and delivered pleasing long-term results for investors. That the strategy entails risk doesn’t make it faulty. Some experts have claimed that investors are better off investing in debt funds that follow the duration strategy. That’s a weak argument because failing to accurately read the direction in which interest rates will move can also lead to losses.

The only reason funds with credit risk are in focus at the moment is the JPMorgan Mutual Fund episode. Oddly, over the years when these funds delivered attractive returns (and inherent risks didn’t surface) no concerns were raised. Therein lies the crux of the matter. Mutual fund investing is not without risk. Sure, some strategies are riskier than others, but risk is omnipresent. 

Treating debt funds with a credit strategy like pariahs is a knee-jerk reaction. A prudent approach will be for investors to acquire an unambiguous understanding of the risk involved, and then decide if they are comfortable taking on the same.

For instance, before investing in a debt fund wherein the credit risk strategy is employed, investors must ask themselves the following questions:

• Does their risk appetite allow them to invest in the fund?

To gauge one's risk-taking ability, it might help to visualize a scenario wherein testing conditions (read more downgrades and underperformance) prevail for a prolonged period. If investors believe that they are likely to push the panic button, then these funds aren’t for them. 

• What is the apt allocation for the fund in the portfolio? 

An investment advisor/financial planner can help decide if the fund should be utilised as a core holding or a supporting player in the portfolio. Clarity on this front will also help pragmatically evaluate performance, and decide on the fund's continuation in the portfolio.

• Is the portfolio manager adept at taking credit bets?

Not every manager has the skills to successfully ply the strategy. It is pertinent that the manager’s skills are in sync with the strategy. Seek managers who have conviction in the strategy over those who deploy it because it is the flavour of the season.

• Is the fund house trustworthy? 

Notwithstanding the kind of fund investors are seeking, the importance of being invested with the right fund house cannot be overstated. This aspect is only accentuated in times of adversity. Investors should select fund houses which have a track record of being investor friendly.

Will Offshore Funds Prove to be the Domestic Mutual Fund Investor’s Achilles’ heel?

Earlier this month, market regulator SEBI released a document titled “Consultative paper on managing/advising of Offshore Pooled Assets by Local Mutual Fund Managers”. The paper makes a case for removing certain restrictions existing under section 24(b) of the SEBI (Mutual Funds) Regulations Act.

At present, if an Indian asset management company (AMC) wants to manage or advise offshore pooled assets or funds, and for the purpose appoint a fund manager who is currently managing its domestic funds, the AMC can do so subject to: both domestic and offshore funds having the same investment objective and asset allocation. Furthermore, both portfolios must have a commonality in holdings of at least 70%; finally, the offshore fund must pass muster on the 20/25 rule applicable to domestic mutual funds. SEBI has proposed that for offshore assets classifying as Foreign Portfolio Investors (FPI) investments these restrictions be scrapped.

It’s not difficult to understand what’s driving SEBI. For a better part of the last five years, the domestic mutual fund industry has struggled to clock a healthy growth in terms of assets under management. With expectations of a strong economic revival and buoyant markets, India has resurfaced on global investors’ radar. The opportunity to freely manage/advice global funds can prove to be a significant opportunity for Indian AMCs.

To be fair, the present set of regulations though well-intended (more on that later) were restrictive for Indian AMCs. Let’s take an example to better understand this. Consider a global fund house which wants to launch an India-dedicated fund and hand its reins to a domestic AMC, which in turn has a skilled fund manager with a proven long-term track record. Expectedly, the global AMC would want it’s monies to be managed by the same fund manager. His track record and presence will be the new fund’s USP. However, the present set of restrictions (especially ones related to 70% commonality in holdings and the 20/25 rule) made it operationally difficult to have the Indian fund manager at the global fund’s helm.

Conflict of interest

If the aforementioned restrictions are done away with, life will become significantly easier for both Indian AMCs and fund managers. However, the flipside is that it could lead to a potential conflict of interest situation with domestic investors on one side and investors in global funds on the other. Global funds, by virtue of their asset size can prove to be lucrative for Indian AMCs, and the possibility of fund managers paying more attention to these funds at the cost of domestic funds cannot be ruled out.

Even SEBI recognizes this prospect and has provisions wherein AMCs are required to make a disclosure in the scheme information document (SID) that there exists no material conflict of interest across its activities and other like measures. Perhaps some of the restrictions which are now proposed to be scrapped had their origins in protecting domestic investors’ interests.

A quick glance at how AMCs reacted to these restrictions in the first place reveals a lot. There were cases of AMCs withdrawing their leading fund managers from domestic funds and instead utilising them to run/advice offshore funds. To placate distributors and investors in India, a standard (but off-the-record) refrain was that though the said managers no longer run domestic funds, they do ‘influence’ the local strategy. In 2011, when SEBI came up with the present set of regulations permitting managers to be named on both domestic and offshore funds, while some of the 'absent' managers returned, others yet chose not to do so. All in all, it isn’t difficult to see which piece of the pie Indian AMCs prefer.

Skin in the game

Admittedly, there is no foolproof method to ensure that domestic investors’ interests are not compromised. But what SEBI can do is institute a framework which prods AMCs and fund managers to act in a fair manner. To begin with, provisions requiring AMCs to invest its personal monies in new fund offers must be expanded to include all its domestic funds. Furthermore, SEBI should make it mandatory for fund managers to invest in every domestic fund helmed by them. Ensuring that AMCs and managers have their skin in the game, is perhaps the best way of ensuring that domestic funds aren’t neglected. Also, these investment must be periodically disclosed.

Another disclosure which will help is that of performance and portfolios of offshore funds being managed/advised by fund managers. This will help domestic investors track and compare the manager’s activities on offshore funds versus domestic funds. 

At their core, these measures can go a long way in revealing the true character of AMCs and fund managers. Using the former as inputs, the onus of making informed choices will rest with investors.