SEBI's skin-in-the-game circular to mutual fund AMCs has good intentions, but is not well thought out

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This week saw yet another mutual fund circular being published by market regulator Securities and Exchange Board of India (SEBI), which has stakeholders scratching their heads. The subject of this latest circular is alignment of interest of key employees of asset management companies (AMCs) with unit holders of mutual fund schemes.

To uphold this objective, SEBI has decided that a part of the compensation for key employees must be paid in the form of units of the schemes either managed directly by them or under their purview.

As a mutual fund investor, I’m happy. This circular is good news because it is aimed at building in accountability for performance. It’s being referred to as ‘skin in the game’ for affected mutual fund employees.

At first, it’s good if my mutual fund scheme’s fund manager has a chunky investment in the scheme; it ensures an alignment of interest, just as the regulator desires.

Once you start peeling off the layers and asking questions around what will change in terms of management of schemes to bring more accountability, the regulations start to seem haphazard and too adventurous in intent.

For one, how will it ensure accountability if the Investment Relations Officer or compliance head mandatorily has 20 percent of their income invested across the tens of schemes in the mutual fund house?

It would be misguided to question SEBI’s intent here, which clearly is towards protecting the small investor by getting the manufacturer to move beyond tokenism. In theory this works, but in practise those directly responsible for fund performance may not have an incremental incentive to change how they are already managing the schemes.

Fund manager compensation, especially the variable component, has long been linked to fund performance. For market-linked financial securities such as mutual funds, volatility ensures some amount of variability in their annual compensation packages.

While it was not known at the time, we now have media reports highlighting that in case of the six wound up debt schemes of Franklin Templeton (India), key employees and their kin were invested personally. Yet it was the small investor who suffered the most when those schemes were unceremoniously wound up in April 2020.

Mere participation in the mutual fund scheme by employees and directors of the AMC is not a shield against underperformance or indeed wrong doing.

Many veteran fund managers and a few younger ones do invest in the schemes they manage. Are investors in such schemes where fund managers already have a skin in the game better off than others? If anything there may just be a perverse incentive to take more risk with the skin in the game.

The SEBI circular has also challenged the basic and foremost principal of personal finance; each individual investor is different and has a unique risk profile. An equity fund manager’s job is to manage a portfolio within prescribed risk guidelines, but their own risk profile may not be adventurous enough to embrace 20 percent of monthly salary being forcefully invested in equity.

Each employee will have their own personal finance priority. While one junior research analyst in the equity investment team may want to invest more in creating wealth through equity, another may not want any equity risk on account of a large loan repayment issue. However, this new guideline forces the same investment allocation for both.

Not just that, it also takes away access to their savings by locking in the investment for three years. What about the liquid fund manager who has to remain locked into that scheme for three years? It’s not just a question of the individual’s allocation but also the structure of a liquid fund is not optimised for a three-year holding period.

Why is SEBI deciding asset allocation for individuals? What if the employee is attached to overseas funds or sector funds such as technology or FMCG; are they to just forget about investment goals and put 10 percent of their annual salary in these schemes (the circular mandates at least 50 percent in the relevant schemes).

The rest of the mandated 10 percent should go to schemes of similar or higher risk, but what if one individual employee wants to hold lower risk funds and not increase their personal investment risk? What about employees without a direct scheme link, should they simply invest in all five or 10 or 30 schemes of the fund house?

It’s easy to say that AMC’s should not have launched as many schemes but SEBI has given them the permission to do so, and now penalising them means washing off responsibility.

That brings us to the claw back rule, which should be applauded, but, who is going to prove wrong doing on behalf of the employee? If wrong doing is proven a year later how will the claw back get affected? SEBI itself has experienced that penalising wrongdoing can take years on end.

Plus, has SEBI checked whether all affected employees can afford to save 20 percent if they are living in cities like Mumbai and Delhi, which is where central employees of an AMC are based? Nearly 13 years ago when this author worked as a research analyst with a mutual fund house, the salary wasn’t anything great and the 20 percent saving was a maximum limit achieved only in some months; which also came thanks to being part of a double income, no kids set up.

There is scanty rationale in using brute force via regulation given that this is a fiduciary business of trust. There are fund houses which have built trust through a skin in the game approach as a choice and they are seeing positive outcomes, while others are losing investors. This is how a free market functions.

Within a day of the circular being released, there are simpler solutions being suggested across social media, keeping the objective in mind. One has to wonder if the guidelines were discussed and debated internally and in collaboration with the industry body Association of Mutual Funds of India (AMFI), or whether it was a just a bureaucratic tick mark for one more action completed for the year?

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