Is SEBI fair in requiring fund managers to buy into schemes they manage?

If you have a pet and work at a plant producing pet food, should you feed your pet with it to convince your buyers about its quality, safety and nutrition?

A circular issued by capital markets regulator SEBI last week seems to be based on that assumption. It  says that from July 1, a fifth of the annual compensation of fund managers of asset management companies (AMCs) – those that invest the money of mutual fund investors in equities and bonds – should be paid with units of the schemes they manage. If they manage multiple schemes, they will be paid with proportionate units. These will have a lock-in of three years.

Some observers have hailed the decision. Prithvi  Haldea, the founder of Prime Database, says: “Fund managers would now be even more diligent about the schemes they manage.” Since 1989 Haldea has been advising companies that go to the public with initial and follow-on offerings of equity. Fund managers can be given employee stock options (ESOPs) in the AMCs that employ them, to enforce performance. But SEBI’s move is more nuanced, according to him, in that it gives fund managers a stake in the scheme they manage.

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Rohit Vajpayee, a director of Starseed Investments, a Delhi-based investment advisory, says SEBI’s directive will have a “signalling” effect and reassure investors.

While the directive may be well-intended, is it fair to fund managers? A fund manager’s risk profile may been different from that of mutual fund investors.  Some investors might think that healthcare companies have good earnings prospects because of the pandemic and might want to invest in a fund that is focussed exclusively on healthcare companies. Others might think that because of cost-cutting measures, employers will pay less and consumers with reduced incomes will privilege purchases of consumer staples over consumer durables. They might want to invest in a fund focused on fast-moving consumer goods. Others might want exposure to export-oriented companies selling in markets that have been spurred by stimulus payments and aggressive vaccination drives. Yet others might want portfolios that veer towards safety and triple-A rated debt instruments. Some might prefer large-cap funds, which invest in companies that rank among the top 100 in market capitalisation. Others might want small-cap stocks, believing they will bounce higher when the economy returns to normalcy.

A fund manager catering to the preferences of investors should not be required to buy into those preferences.

When one invests personally in stocks, emotions like fear and greed can cloud one’s judgement. The reason one buys mutual funds – apart from lack of expertise in selecting stocks, or lack of time to do so – is so that investment decisions can be taken unemotionally and clinically. A fund manager with stake in their schemes might become more cautious.

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SEBI’s mandate is to ensure that investors are protected from fraud and mis-selling and get the information they need for informed decisions. It cannot enforce performance. A mutual fund scheme may not perform for several reasons, including a fund manager’s lack of competence or diligence. It depends on the state of the domestic and world economy, the flow of funds from retail and foreign investors into the equity market, the political situation and on. Last August, Value Research, an advisory, said most large-cap funds were struggling to beat the index (Sensex or Nifty). Its founder Dhirendra Kumar was advising investors to park their money instead in passive funds that mirror the Sensex or Nifty 50 and do not do active stock selection. Since passive funds charged very low fees their returns would be better than that of actively managed large-cap funds, which charge high fees but do not deliver commensurate returns.

The conventional wisdom is that competition enforces performance. Investors will flock to those schemes that deliver superior results and fund houses will reward managers who ensure that. At last count there were 1,735 mutual fund scheme and 54 fund-of-fund schemes, that is mutual funds that invest in other mutual funds. If such acute competition cannot enforce performance, it’s unlikely that SEBI will be.

SEBI’s directive might have unintended consequences. Compensation packages might get fatter as fund houses try to retain talent and compensate for the money locked-up in units with a higher cash component. SEBI’s directive covers a swathe of employees, including those in research teams. Some of them might not have a say in how stocks are chosen for investment; their cash flows might also suffer if a fifth of their pay is impounded in mutual funds.

SEBI’s lock-in move might have been prompted by experience. According to news reports, some executives of Franklin Templeton sold their investments before six of its debt schemes were closed down last year because of poor liquidity.

To ensure that mutual fund managers do not use their privileged access to information for self-dealing, SEBI could require them to disclose their personal trading and investment activities. Its latest directive adds a layer of complexity. It is unlikely to shore up fund performance.