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.

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.

Why Investors Must Cheer SEBI’s Initiative On Mutual Fund Disclosures

Last week, market regulator SEBI released a circular that among others, enhances mutual fund disclosures. The new directives have the potential to be game changers.

Let’s start off with the disclosure that has garnered most attention—commission paid to distributors. SEBI has ruled that henceforth half-yearly account statements sent to investors will have information regarding commission paid to distributors. Commission has been defined to include both monetary and non-monetary payments made by the fund company to the distributor. Furthermore, the statement will also have information regarding expense ratios (for both regular and direct plans).   

Some quarters are up in arms against this ruling. While some feel that disclosing commission-related information will push investors towards direct plans, others argue that this is a conspiracy to ease out small distributors. I believe the reservations are a case of stretching the point.

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 must stop compensating distributors. Also, to assume that an investor who is satisfied with his distributor’s service, will turn his back on the same and opt for a direct plan, because the commission is disclosed is a fallacious argument. So long as the distributor adds value, the investor will continue to be associated with him.

In the confusion, most have overlooked what to my mind is the most important ruling—investments in funds by portfolio managers and other personnel. From May 2016, every fund’s Scheme Information Document (SID) will have information related to investments made by the fund’s portfolio manager(s), the AMC’s Board of Directors and other key managerial personnel.

The rationale behind this move is to encourage 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 fund companies to annually disclose how much portfolio managers invested in the funds they run. At its core, 'skin in the game' is about inspiring confidence in investors. Managers who invest alongside their investors show conviction in their investment approach and acumen. It’s a classic example of putting one’s money where the mouth is. This regulation offers investors insights into funds, and the opportunity to evaluate them in a manner hitherto unavailable.

Then there’s the directive on soft-dollar arrangements. So far, investors have been blissfully unaware of soft-dollar arrangements between fund companies and brokers, and how the same impacted their investments. SEBI has decided that henceforth, soft-dollar arrangements will be limited to benefits that are in the interest of investors, and the same shall be disclosed.

Admittedly, some rules seem odd—it has been mandated that compensation of the fund company’s top brass be disclosed. Likewise, fund companies will have to publish a list of employees whose annual remuneration is equal to above INR 6 million, and also the ratio of CEO's remuneration to median remuneration of employees. I fail to see how these provisions can help investors make better investment decisions. Investors’ interests would have been better served if the method of computing annual remuneration had been disclosed. That way, investors could have comprehended what fund company top bosses are mainly compensated for—growing assets or fund performance.

That said, all in all, the mandated disclosures have the potential to usher in an era of transparency in the mutual fund industry. However, one must understand that a disclosure (read transparency) isn’t an end in itself. Learning more about funds should translate into informed investment decisions, and in turn, goals being achieved. The onus to make the most of the information on hand, lies on investors, advisers and distributors alike.

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.

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.

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.