Sucheta Dalal :Will Portfolio Managers Be Accountable?
Sucheta Dalal

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Will Portfolio Managers Be Accountable?  

August 25, 2010

SEBI is trying to make changes in the much-abused portfolio management schemes. It’s about time

Regular readers of Moneylife know that we have done our best to expose dubious portfolio management  services (PMS) over the past year or more. At the end of July 2010, the Securities & Exchange Board of India (SEBI) took a big step towards making portfolio managers accountable. It has issued a crisp, five-page consultative paper which, if quickly implemented, will go a long way towards making PMS fairer and safer for investors.

We have been following PMS schemes rather closely to establish that these are essentially harmful products in the way they are used especially by broking companies. However, it is fraught with difficulty. In the absence of a publicly accessible, statutory reporting system, information is available only from investors who want to share their tales of woe. This makes the information a tad lopsided from an industry-wide perspective. But that is apparently not an issue that worries the regulator or service-providers, since the new consultation paper does not plan to introduce a reporting system either. 

We focused on PMS schemes, because it was the biggest lure for high net worth individuals (HNI) in the five-year bull run that ended in 2008. Most people have a rather simplistic notion of PMS. They would hand their money over to an expert who would invest it smartly and take a cut, out of the profit earned, with a performance incentive above a certain ‘hurdle’ rate.

Other costs and the brokerage are never taken into account, since the investor expects to incur them even if she managed the portfolio herself. Busy professionals are willing to pay a fat fee to have an expert manage their portfolio and allow them to participate in wealth creation through stocks. Unfortunately, what happened to their money in the past few years was vastly different. In theory, when the portfolio delivers returns that are higher than a certain pre-decided ‘hurdle’ rate (say 10%-12%), the portfolio manager is entitled to a fat performance fee. This ought to be an incentive for portfolio managers to deliver their best for the customer. In practice, however, a significant number of portfolio schemes have underperformed their benchmarks or even made huge capital losses. This could be due to gross incompetence on the part of portfolio managers or fraudulent dealing. Some of them may have bigger incentives to stuff customer portfolios with dubious scrips, which are being ramped up by their management or market operators or supporting shady initial public offerings (IPOs). The market grapevine is rife with tales of such deals.

Consequently, tens of thousands of people were ripped off by greedy finance companies; most of them have now sworn to stay away from the capital market. Dubious dealing by PMS companies is certainly one big reason for India’s shrinking investor base.

Consider a couple of examples. Last week, we met the former chairman of a giant foreign company. A finance-whiz, who is on the boards and audit committees of a dozen-odd globally recognised companies, he read out a letter he had written to the Kotak group chief. It said that he had no option but to end his relationship with its PMS since Kotak thought it fit to claim fees and charges from him without delivering any returns. “In the five years I am with them, I have earned nothing,” he says.
Kotak executives are now working hard to appease him and have offered to waive their fees. But five years with no returns? Surely, it is not a situation that any of us would accept. One invests in the capital market to be able to beat inflation (post-tax); otherwise, it is safer and wiser to put your savings in bank fixed deposits.

In another case, a senior lady doctor was persuaded to invest Rs40 lakh (Rs24 lakh in cash and the rest in stocks and fixed deposits) with JM Financial’s PMS in December 2007, at the peak of the market. In April 2009, after struggling to get an explanation, she walked out with just Rs20 lakh.

Typically, JM officials blamed her for withdrawing the money after the crash; but by their own admission, she would only have recovered 90% of her corpus by holding on. As in the other case, JM made sure that it recovered its (mis)management fee. What is worse, she discovered massive churning of her portfolio (251%), with some fairly dubious stocks which were purchased high and sold at rock bottom. The brokerage was earned by sister companies of the group. The JM group chairman has now promised to look at her case, after our intervention.

How much of such mischief will be fixed by SEBI’s proposed regulatory changes? The consultative paper, indeed, addresses several key issues. It mandates disclosure of fees and charges and specifies the manner in which they should be charged and disclosed. It also wants a transparent dispute resolution mechanism to be specified.

The most important change planned by the regulator is that portfolio managers will charge performance fees/profit-sharing based on the “high water mark principle over the life of the investment.” What exactly does this mean?

SEBI explains, “The high water mark principle means that if the portfolio value goes down and then recovers, the manager does not earn fees till all losses have been made up. High water mark shall be the highest value that the portfolio/account has reached. And, the value of the portfolio for computing the high water mark will be the date on which performance fees are charged.” Further, the performance fee can only be charged on the “increase in portfolio value, in excess of the previously achieved high water mark.” These fees will be charged only on actual funds under management and, if there has been a partial withdrawal of funds, then the fees as well as the high water mark will be adjusted accordingly.

Interestingly, SEBI has also proposed investors’ liability to the extent of his/her investment. The very nature of these recommendations provides further pointers to how portfolio investors have been ripped off over the years. These changes, when implemented, will be a significant step forward. But they still do not allow investors to compare and judge performance across finance houses in order to choose the portfolio manager/scheme intelligently. That will happen only when SEBI creates a statutory reporting platform and puts the performance of PMS in the public domain. This is not an unreasonable demand in the Indian context. —
Sucheta Dalal

-- Sucheta Dalal