The Lament Of A Mutual Fund Specialist

Guest Post

For 22 years I have been helping investors design and nurture their portfolios using mutual fund schemes.  I have also suggested fixed deposits- in banks, with the Post Office and with companies.  However, most of my advice has centred on  mutual funds.  Mutual funds are a bona fide investment option- arguably the most versatile investment option there is, anywhere in the world.  I am registered with the Association of Mutual Funds in India (AMFI). Thus, I have always positioned myself as an investment advisor.

But SEBI now has a problem with that because I am not registered with SEBI as an investment advisor.   It wants me- and others like me- to stop calling ourselves as such.  It could have just told us not to use the word ‘registered’.  It could have told us to clarify that we only offer advice on mutual funds.  No, no, no- it wants us to altogether stop calling ourselves as investment advisors. 

That’s like telling a wood craftsman that just because he specializes in home furniture, he can only call himself a carpenter.  I think that’s unfair and disrespectful.  My lawyer thinks that’s illegal. 

It isn’t easy to offer advice on mutual funds.  I am a specialist in this area.  I practically live, breathe, sleep mutual funds.  At the risk of sounding arrogant, I declare that SEBI would be hard pressed to find ten individuals more capable than me to advise an investor on mutual funds.

When I asked for guidance on all of this from people in AMCs, their replies were useless.  Rather than a solution, I got replies like: “What can we do? This is SEBI’s decision.” “It won’t change the way investors think about you.”   Of course now AMFI has come up with a solution.  The problem is that it is an idiotic solution.

Among other things, AMFI wants me (and all advisors registered with it) to clearly state that we are ‘distributors’.  The people who came up with this idea don’t realize that ‘distributor’ is a term that is best understood by people within the mutual fund industry.  What is an investor to make of my being a ‘distributor’? 

Letting me call myself a ‘mutual fund advisor’ would have been nice.  Letting me call myself a ‘mutual fund consultant’ would have been acceptable.  Barring me from doing so and instead asking me to denote myself as a ‘distributor’ is ridiculous.

So, no thank you, AMFI- I will not label myself in that manner.  Instead I will now officially designate myself as a ‘mutual fund specialist’.  If someone at AMFI or SEBI has a problem with that- I pray that the wrath of God descend upon those who prevent me from honestly pursuing my chosen profession and correctly positioning myself.

See, I am a peace-loving person and I don’t like quarrelling.  But the heart of the problem is that the people at SEBI don’t know how to really stop mis-selling.  Because it is convenient, they have painted all mutual fund advisors- good and bad- with the same brush.  They treat us with the same scorn that they have for stock tip marketeers.  They suspect that we are guilty till proven innocent.  And the ineptitude of AMFI in this regard hasn’t helped either.

The truth is that a much more amicable and meaningful solution could have been achieved just by understanding the advantages of the commission-based structure on which mutual fund advisors are compensated.

Thanks to that structure, when someone comes to me for advice on mutual funds, that advice is free.  Yes, free.  I don’t make money from the advice.  I make money if and only if you invest via me.  Most importantly, you get all the advice without any obligation to invest via me.

If someone has doubts about the schemes that I recommend, they can always ask me the reasons for my recommendation and also how much commission I get from those schemes.  Everything is transparent.  And like I said, until you are satisfied, you are under no obligation to invest via me. 

If SEBI really wants to help investors seek quality advice, then it should urge investors to bear all of this in mind in dealing with any commission-based advisor. That will help investors much more than attaching labels to advisors can, or will. 

There’s one more thing.  It is because of the fact that commission is calculated as a percentage of AUM, that I can easily offer even a small investor the same quality of advice that I give big investors. The big investors are subsidizing the small investors and I tell my big investors that.  Mind you, as I said earlier, because there is no obligation, a big investor is free to decide how much to invest via me.

I think it is high time SEBI and AMFI recognized all of this and accorded more respect to mutual fund advisors. 

The Scourge Of Volatility

Last week, one of my frequent collaborators brought to my attention the case of an investor who had been sold a closed-end equity scheme by his relationship manager at a private sector bank.  On the face of it, the episode had all the key elements that I associate with the rash of mis-selling pursued by young, ignorant, callous, smooth-talking bankers, fuelled by excessive incentives from sales-hungry fund houses.  Among other things, the investor was given the impression that this scheme was the real deal, and that the client could exit anytime he liked (“all you have to do is sell it on a stock exchange”).  For their efforts, the bank charged the client 1.50% of the amount invested (this was over and above what they gained on account of getting the client into the regular plan). 

I am not aware of the risk profiling that was done by the bank, but soon afterwards, the client started getting jittery.  He was tracking the NAV movements of the scheme, and what he saw, perturbed him.  At one level, he was flustered by the fact that despite the current surge in stock prices, one month on, the scheme had not shown any positive returns.  More than that, though, it was the seemingly unending daily spikes in the NAV that left him aghast.  If that sounds hard to believe, consider this: on 6 of the 7 business days in this month so far, this domestic, diversified equity scheme rose or fell more than any other equity scheme (including sector specific schemes and international funds). For the investor, things came to a head last week when the scheme’s NAV fell by an astounding 4.3% on a single day: a day when the scheme’s benchmark index, the BSE 200, fell by just 0.8%, while the BSE Sensex fell by a mere 0.6%.

So how on earth did this scheme manage to be so volatile?  What was it holding that caused such a fall?

The November-end portfolio was officially uploaded just this weekend, so till then we could only speculate about what the portfolio might be.  My guess was that this scheme was holding concentrated positions in dubious mid-cap/ small-cap stocks.  I was wrong.  It turned out to be a well diversified portfolio, with no concentrated positions.  Moreover, the top stock holdings were all respectable names.  Even more baffling was the fact that only about two-thirds of the portfolio was in stocks.  As much as 35% of the portfolio was in money market instruments.  With such a portfolio, that kind of a fall was impossible to fathom.

But then my collaborator pointed out a tiny element of the portfolio that I had overlooked.  The scheme had some exposure to Nifty December 2020 Put Options.  It was this part of the portfolio that was a key contributor to the fluctuation.  For those who understand how prices of derivative contracts fluctuate, this should not be a surprise.  But for those who don’t, consider this: on the day of that huge fall in the scheme’s NAV, the prices of the two sets of contracts held by this scheme tumbled by 67% and 71% respectively.  It seemed ironical, given that this exposure was ostensibly meant to hedge the portfolio against a fall in equity prices.

If you think that this is an isolated case, I’d like to suggest otherwise.  This may be an extreme case, but when I did a quick check on the data available at Value Research, I found closed-end equity schemes to be, on an average, 17% more volatile than open end schemes.  Additionally, within the limitations of what I could analyze, I could link this to the exposure that many of these schemes took to long term derivatives contracts.  If you consider the added impact of this on an investor’s ability to get a fair price in the event that he/ she decides to exit before maturity, you may get a sense of how much of a scourge volatility can be to investors in closed-end schemes.  Take the aforementioned investor, for instance.  The day after the NAV fell by 4.3%, he tried to exit the scheme, but couldn’t find a buyer.  Even if there had been a buyer, would he have got a fair price?  As it is, trading a closed-end fund on an exchange is loaded in favour of the buyer: it can be expected to happen at a discount to the NAV.  If the scheme happens to be as volatile as this scheme was, I’d say that it would significantly increase the level of discount that a buyer would expect. 

When I shared my thoughts with some industry insiders, the argument that I was offered was that most investors in closed-end schemes do not seek to exit before maturity, and hence volatility would not matter to them.  I find it hard to agree with that.  In the imperfect but real world that we live in, I believe that many, if not most investors feel humanly compelled to periodically track the performance of the schemes that they have invested into, regardless of whether these are closed-ended or open-ended.  And if they see excessive volatility, they are likely to feel uncertain about the future, and to consider exiting.

But more than my own view, let me give the final word to Peter Stanyer, an authority on the subject of wealth management and more.  In his marvellous book, Guide To Investment Strategy, in the context of investing with a target date, he makes the point that it is reasonable for an investor’s confidence “to be shaken by disappointing developments along the way, even if those developments are not surprising to a quantitative analyst.”  He further goes on to say that “the perceived risk of a bad outcome will be increased by disappointments before the target date is reached, undermining confidence in the investment strategy.”  Now that‘s food for thought.

Special thanks to Robin Jehangir for his valuable inputs to this post.

Of Commissions and Biases

At the end of each financial year, AMFI discloses on its website, the commissions paid across fund houses to key mutual fund distributors.  Looked at, in the right way, this information can give investors, as well as industry insiders, a lot to think about.  It can also be a source of trivia and gossip.  This year, for instance, thanks to a write-up in at least one newspaper, and reports on other financial portals, there was some buzz on social media about the rising number of “crorepati mutual fund distributors”.  I am not an expert on these matters but I can’t help feeling that the so-called journalists and reporters would have had a much more news-cum-gossip-worthy story on their hands if they had chosen instead to report on the presence of Reliance Gas Transportation Infrastructure Limited in the august list of top mutual fund distributors.  I suspect that it would have been most interesting for their readers to know why a company that is engaged in the business of construction and operation of pipelines for the transportation of natural gas, also acts as a mutual fund distributor, and was ranked among the top 50 in terms of Gross Inflows in 2016-17, and among the top 100 in terms of average AUM and commissions received.  I have my own theories about this but I’ll park those for another day, and instead get straight to the purpose of this post i.e. to spotlight a few of my more substantive observations in AMFI’s latest Distributor Commissions report.

Seen in conjunction with what individual fund houses report, AMFI’s report can be particularly useful as a starting point to understand how unbiased the advice of a distributor might be.  While prudence would suggest that a distributor should not over-expose clients to a single fund house, having a bias towards one particular fund house, in itself is not dubious.  It depends on the motives for the bias, the extent of the bias and which is the fund house towards which the distributor is biased. 

Take State Bank of India, for instance.  In 2016-17, it ranked second among fund distributors in terms of net inflows, and seventh in terms of commission received.  It is, by far, the most prominent PSU bank distributor of mutual funds.  Yet the fact is that 99% of its commission came from SBI MF.  This would seem to indicate that the mutual fund distribution activities of State Bank of India exist only to promote SBI MF.  Put differently, it would appear to be foolish to walk into a branch of State Bank of India and expect to get unbiased advice across multiple fund houses.  But then, while State Bank of India may be entitled to adopt a strategy to only promote SBI MF, it raises a rather troubling question (in my mind, at least): if the mutual fund distribution division of State Bank of India is, in effect, an extended arm of SBI MF, then how fair is it to their clients, to offer regular plans, instead of direct plans?

The State Bank of India model is one that most, if not all, PSU bank distributors, that have their own fund houses, have sought to follow.  But what of the top private-sector bank distributors such as ICICI Bank, HDFC Bank and Axis Bank? 

In my conversations with people at these banks, I get the impression that they like to proudly position themselves as multi-fund house distributors.  In the process, I have heard terms such as “unbiased advice” and “one stop shop for all mutual funds” being thrown around.  And as proof of the diversity in fund houses and schemes offered, some shared with me copies of the monthly fund recommendations that they send to their clients.  Yet when I look at the Distributor Commissions reports, a different picture seems to emerge.  Consider the following, all relating to the year 2016-17:

• HDFC Bank, which had the highest average AUM among all distributors, received 44% of its commission from HDFC MF
• Axis Bank, which had the second highest average AUM among all distributors, received 61% of its commission from Axis MF
• ICICI Bank, which had the fourth highest average AUM among all distributors, received 69% of its commission from ICICI Prudential MF

Based on these numbers, the claims to offer “unbiased advice” would appear to be hogwash.  It would seem that these banks are not vastly different from SBI or other PSU Banks in promoting the interest of the fund houses that they have sponsored, or are associated with.  And hence, here, too I find myself questioning the fairness of these banks towards their clients in offering them regular plans instead of direct plans.

While the above named banks are among the leaders of the mutual fund distribution community they are, by no means, the only ones exhibiting such significant biases.  Also, the element of bias is not restricted only to firms that have promoted fund houses.  One of the more startling examples that caught my attention relates to a distribution firm that is not associated with any fund house.  It calls itself a “wealth management boutique”, and ranks among the top 100 distributors in terms of average AUM during 2016-17 and among the top 70 distributors in terms of commissions earned.  But more than any of that, I was struck by the fact that in 2016-17, it received 70% of its commissions from a single fund house: JM Financial MF (JM MF).  Not only that, it appeared that this firm was way more biased towards JM MF than even its own associate distribution firm, JM Financial Services.

When I shared my observations with one of my frequent collaborators, he asked me this question: “How widespread are these biases?” 

He happens to be  registered with SEBI as an investment advisor (RIA), and the way he asked the question, it seemed as if he wanted to see if my findings could help make a stronger case for RIAs.  At first, I tried to dissuade him from pursuing that line of thought but when he insisted, I decided to humor him.  In his way of seeing things, the receipt of at least 40% of one’s commissions from a single fund house was the key indicator of a questionable bias (there were a couple of other criteria as well, too lengthy to describe here). So, following those criteria, (and based on the data of the 687 distributors covered in the 2016-17 report) I put before him my findings in a nutshell:

• 32% of the key distributors appear to have a questionable bias
• These distributors were credited with a combined average AUM of 227,395 crore in 2016-17

He seemed to like my findings because I saw a smile light up on his face.  But then I said something else and his smile vanished completely.

“By the way,” I said, “that wealth management boutique that I mentioned earlier… the one which earned 70% of its commission from JM MF… well, that firm also happens to be a RIA.”