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  • A seed that leads to distortions

    Article in Live Mint, March 6, 2014

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    Sebi’s seed capital mandate may not have intended results

    Shyamal Banerjee/Mint

    Last month, capital market regulator Securities and Exchange Board of India (Sebi) said that all fund houses must put in 1% of their own money, called seed capital, subject to a maximum of ₹ 50 lakh, in all their open-ended mutual fund (MF) schemes. Existing and new funds will have to comply. Sebi wants fund houses to have their “skin in the game”; it wants to align the fund house’s interests with those of the investors. But will it work?

    To be sure, Sebi’s idea of seed capital is different from the typical western culture of fund managers having to invest personal money in their funds. In the US, market regulator Securities and Exchange Commission (SEC) mandated in 2005 that fund managers must disclose their own stake in their own schemes. That was the SEC’s way of showing whether fund managers eat their own cooking. Sebi’s idea of showing “skin in the game” is to mandate that fund houses have their money invested in their own schemes at all times. While SEC’s rule is just on disclosure, and it’s still voluntary for fund managers to put their own money, Sebi’s rule is mandatory. In the US, funds need to invest about $100,000 of their own money (SEC’s definition of seed capital) in all their schemes, build a track record based on this, and then open the schemes to investors.

    Sebi has also asked fund houses to raise their net worth to ₹ 50 crore, up from the earlier requirement of ₹ 10 crore.

    Both these rules form a part of Sebi’s grand plan of propelling the Indian MF industry from about ₹ 9 trillion of assets under management (AUM) to ₹ 20 trillion over the next five years, as per the recent board meeting note.

    What works

    When fund managers invest their own money in their schemes, it shows that they have confidence in their strategies. In a study named “Do Fund Managers Eat Their Own Cooking?” that Morningstar Inc. (one of the world’s leading MF tracking and research firms) did in 2011, it found that only 12% of domestic equity funds had their fund managers invest more than a $1 million in their own schemes. About 71% of balanced funds did not have any fund ownership and a staggering 80% of municipal bond funds had zilch fund ownership. Eventually, Morningstar found that there is a correlation between fund ownership and performance; those schemes where fund managers had invested substantial money typically did better than those where fund managers didn’t invest their own money.

    It’s a good idea for fund managers to have their “skin in the game” and “eat their own cooking” as this column has previously argued ( As an investor in a diversified scheme at least, I’d be uncomfortable if my fund manager refused to invest her money in the scheme. It’s like eating in a restaurant where the chef doesn’t eat her own cooking or taking fitness advice from an overweight or an unhealthy person. Or, as a US-based wealth manager friend said to me once, taking dental advice from someone with missing teeth.

    What doesn’t

    What must be noted, however, is that Sebi has asked fund houses, not fund managers, to contribute seed capital. And therein lies danger.

    First, since the new rule covers only open-ended schemes, it could lead to MFs launching more closed-end funds especially on the equity side. Data from Value Research shows that a fund house has almost 17%, on average, of its debt fund assets in closed-end debt funds. Most of these funds are fixed maturity plans (FMPs). Doesn’t Sebi think FMPs are risky? They are meant to prevent capital loss, but some fund managers have been known to take credit risks.

    As it is the number of closed-end equity launches has gone up in recent months partly because they pay high commission to distributors compared with open-ended schemes. We saw the same shift in tide in April 2006, when Sebi banned amortization of launch expenses in open-ended funds. Between April and December 2006, 10 closed-end funds were launched that garnered about ₹ 7,760 crore, against six new open-ended funds that garnered ₹ 1,521 crore. In 2007, 32 closed-end funds were launched against 28 open-ended funds. Eventually, Sebi plugged the gap and covered open-ended funds as well.

    Second, to recover the capital that sponsors put in their own schemes, some experts claim that expenses (asset management fees) in debt funds—where there is room for increase—may go up, since equity funds have already almost reached their limits.

    Third, and the most dangerous, there could be a conflict of interest. When sponsors invest their own money, it could put pressure on the fund manager to perform; to take lesser risks than she usually would, for instance. Can the owners of the seed capital cast an influence on the fund manager on what to buy or what to avoid? You can’t ignore the possibility.

    Disclosures versus mandatories

    Perhaps, Sebi underestimated the power of disclosures this time when it made seed capital mandatory. Used as a tool to separate the wheat from the chaff, disclosure can have devastating effects. PPFAS Asset Management Co. Ltd came from out of the blue and immediately struck a chord with conscientious MF investors when it launched its maiden scheme last year because it said that its top management invest their own money in their funds.

    Fund managers abroad of a European fund house that does business in India thwarted its management’s idea to make it mandatory for its fund managers to invest in their own funds. A public disclosure like that is enough caution.

    The original article could be seen here.

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