Putting reins on portfolio managers
A few years ago, a friend asked if she could get her friend to talk to me. On the promise of anonymity, he spoke to me. He had made the mistake of following his adviser from one portfolio management scheme (PMS) to another. He said that the firm had managed to reduce ₹7 crore to a few lakhs in just over a couple of years. He is not a newbie in investment and can follow data and disclosures quite well. His problem was that the disclosure standards of the two firms were starkly different. In his first firm, the entire disclosure was geared towards indicating risk and advising him on how much a decision would potentially cost him, all the while showing the upside as well. The second firm managed disclosure in a manner that totally obfuscated the risk, showing him in the green all the time, while the underlying portfolio was haemorrhaging. He lost ₹7 crore and there was nothing the regulator or any court could do.
As the rules around the mutual fund industry have tightened, the rush to open the loosely regulated PMS became a flood over the last two years. One estimate says that almost half of the current PMS firms today that manage about ₹18 trillion of investor money, or almost three-quarters of the mutual fund industry, were set up in the last two years and have hard-sold small- and mid-cap portfolios. These are currently in deep distress and before the foul stuff hits the fan, the market regulator is trying to tighten rules of the game by doing what it has done best for the past few years—setting up a working group or committee, populated with industry representatives, analysts, academics and others—to offer solutions to the problem.
The draft of the working group is out and you can read it here: bit.ly/2MX5RpR. The draft has put down a much higher standards requirement, while keeping the basic foundation of the PMS regulation intact. The higher standards are largely across skills, net-worth, investor thresholds, costs, returns and disclosures. PMS firms will now need ₹5 crore of net worth, up from the current ₹2 crore. This is aimed at curbing some of the fly-by-night operations that are currently in business. The higher skill requirement for the staff and the setting up of a compliance officer are in line with best practices in the interest of investor protection. The minimum amount an investor has to bring has also doubled from ₹25 lakh to ₹50 lakh. This threshold enhancement is in keeping with the rising wealth of the upper middle class investor and was overdue. The Securities and Exchange Board of India (Sebi) should put in place an automatic review of this limit and that of the net worth criterion every five years.
The most contentious issues in the draft are around how returns should be calculated, disclosed and what benchmarks can be used. The draft has advised moving away from the current anarchy, where returns are disclosed in any manner, cherry picking the best portfolios and years, across simple, compound and other measures of returns. And moving towards the time weighted rate of return measure to be disclosed over a standardized period. Other prudential norms make only listed securities eligible for investment, distributors fee to be only trail (it does seem that upfronting is banned) and a cap on exit fees.
The one area left grey is the benchmark fixing. Given that a PMS is meant to be an offering that is more customized than a mutual fund, fixing benchmarks is a problem. But look at the world from the investor point of view and see what matters to him. He wants to know if, post cost, his portfolio is doing better than a guaranteed return product and the broad market. The reason that a PMS can charge a higher fees and have a profit sharing agreement is on the carrot of a higher than market return. It may be a good idea to give a standard return figures of five-year SBI fixed deposit, 10-year G-sec, the Sensex, a mid-cap index and a small-cap index. Anybody who has ₹50 lakh to invest should be able to do the math to see how his portfolio is doing in relation to other products in the market. Trying to find a benchmark for each PMS is to totally miss the point of a benchmark in such a bespoke product.
The draft is a step in the right direction. Just because a person is well off does not mean that he does not deserve a well-defined and regulated market. The socialist hangover over our policy and regulators is beginning to go away. And that is a good thing.
Monika Halan is Consulting Editor at Mint and writes on household finance, policy and regulation.