Lessons for the fund management ecosystem

(A version of this article appeared on April 12, 2019 on Bloomberg Quint, link below

https://www.bloombergquint.com/opinion/a-bankers-lessons-for-the-fund-management-ecosystem)

Lessons for the fund management ecosystem

Investors in a few debt fixed maturity plans have recently realized that their mutual fund investments are indeed subject to market risk. 

As usual, we will likely go through some all-round hand-wringing, and then move on. 

That would be a pity, because there are constructive lessons for every stakeholder to take away – for investors, commentators, the government, regulators, and most importantly, for asset managers.

Starting with the man in the mirror

As investors, we have to recognize that the statutory warning that accompanies mutual fund investments is for real.

Likewise, as commentators in this twitter age, we have to take a deep breath and put things in perspective. There are issues that need to be urgently addressed. But there’s little to be gained either by spreading panic, or baying for anyone’s blood – as yet. 

Government, taxes and FMPs

The finance ministry needs to recognize that its taxation policy practically pushes savers into debt mutual funds. 

All earnings from fixed deposits and direct bond investments are taxed at the marginal income tax rate.

On the other hand, returns from debt mutual fund investments held for over three years benefit from inflation indexation, and the net gains thereafter are taxed at a lower capital gains tax rate. 

With such a large tax arbitrage, it makes sense even for bond market experts to invest in debt funds, pay the fund fees and save on tax, rather than invest in the same bonds directly. 

Equity investments do not suffer from this anomaly of differential tax treatment between direct holdings and investments through funds.  

Unless the government wishes to underwrite the risk of debt fund investments, this anomaly – bordering on moral hazard - has to be removed.

Direct debt investments need to be taxed at the same low rate as mutual fund debt investments. This will encourage investor participation in debt, build familiarity with bonds, and bode well for the entire debt ecosystem – including for fund managers.  

Red Flags and the Regulators

There are several long-standing red flags that regulators need to respond do. Let’s focus on low secondary market volumes and ambiguous valuations in this section.  

Even as fund Assets Under Management (AUM) have grown rapidly in the past few years, there isn’t sufficient secondary market depth to cater to any large-scale redemptions. 

As pass through vehicles for their investors, mutual funds rely entirely on the secondary market. Unlike banks, they have no formal recourse to any lender of last resort. 

We have allowed the fund ecosystem to grow to a point where it is collectively too big to falter, let alone fail. 

The answer is clearly not to bring down fund AUMs. After all, regulators want more funding through capital markets rather than via bank lending. 

Instead, regulators have to dust off and implement the many committee recommendations to improve secondary market liquidity. In the interim, as distasteful as it may sound, a backstop contingency to provide liquidity against fund assets needs to be in place. 

An offshoot of low secondary market volume is the ambiguity it lends to any valuation process. There simply isn’t comfort that valuations are credible, uniform and reflective of the true realizable value of any portfolio on any given day. 

Questions for Asset Managers to consider...

Here’s some unsolicited advice to mutual fund asset managers, from an ex-banker who has endured many banker jokes. Don’t make the mistake that bankers made.

You now manage the savings of many, many small investors. Being the custodian of their funds and trust is a privilege that calls for immense honesty and humility. 

On honesty, here are a few sample test questions for fund management – that regulators would do well to mull over as well.

Are you confident that your distributors – especially third-party distributors – have ensured suitability and appropriateness when selling to your investors? That your smallest investors have been sufficiently appraised of all the risks, and the uncertainty of the returns in balanced funds, fixed maturity plans and other schemes?

Are you confident that your smallest investors are fully aware at all times of how your scheme is performing, in relation to benchmarks? In FY18, the return across all equity and balanced funds was 4.9%, while NIFTY returned 10.2%. In FY19, the return across all equity and balanced funds was 4.0%, while NIFTY returned 14.9%. You have often compared NIFTY returns (typically from the low base of the year 2003), against other asset classes, to encourage investments into equities. Are your investors aware of how your own schemes have performed in this regard, and what expenses they are paying you for those returns?

Are you confident that inter-scheme transfer of securities is not being misused just to get around illiquidity of securities, or manage redemptions or scheme NAVs? 

Are you confident that all your scheme NAVs reflects the realizable portfolio value in the market as on date, and is not merely a hope around where the portfolio value “ought” to be? 

Are you confident that to the best of your knowledge, there is no market misconduct such as manipulation of stock prices, index manipulation, insider trading, front-running of orders, or circular trading? 

Are you confident that you have deployed adequate resources to thoroughly analyze the risks of your investments, and are not excessively relying on third party and credit rating agency certifications? 

Are you confident there are no other such grey areas which would show you and your ecosystem in very poor light, if they were uncovered by a regulator or a whistleblower? 

...and their answers

If your answers talk of disclaimers in offer documents and your compliance with regulations, as bankers found out, small investors and regulators will not let you hide behind the letter of the law.

If your answer is that you cannot be held accountable for the conduct of your independent distributors – then maybe you shouldn’t be using them in the first place. You cannot enjoy the fruits of their sale and claim immunity from the manner in which the sale was achieved. 

If your answer is that you are clean, but a few others are not, that should not offer you comfort. It is your responsibility that you speak up and ensure the ecosystem is kept honest. As bankers found out, you will be painted with the same brush as the least scrupulous person in your community. 

Some say that too much honesty will kill the system and is bad for the country. If investors are explicitly reminded how much of gross fees they are paying, how will the investor base expand? If revaluations and NAVs have to reflect realizable value in illiquid markets, how will investors ever be comfortable? If investors are given continuous data about scheme returns, how will they take the long-term perspective needed to save? 

If these are the thoughts (really??), don’t worry, the country is too big to need you to bear the cross of dishonesty. And investors are not children who have to be protected from the bad world with comfortable fairy tales. Stick to your mandate with honesty, and the country will get by very well, thank you. On the contrary, the country could truly suffer if a make-believe edifice was to come down crashing suddenly. 

The test of the honesty of the system is when mistakes come to light. Of course, you are allowed the occasional honest mistake. However, when these come to light, you need to come clean and introspect with humility – not try and bluster your way through with indignant grandstanding or plain obfuscation and white lies. 

The manner in which the recent FMP redemption issue was handled by funds is a classical case in how not to respond to investor issues. 

There are those that argue – somewhat understandably – that every ecosystem will evolve over a period of time and that expecting perfection in a growing market is unrealistic. I have sympathy for the view – but that cannot be an excuse for status quo. The frontline has to demonstrate that is proactively identifying and addressing issues with alacrity, rather than letting sleeping dogs lie. Learning from bankers, you’d much rather be in charge of change, than have change thrust upon you by an irate mob baying for your blood. 

Finally, if any fund management is unable to make changes that make the system honest, maybe it is time for them to move on. Bringing in fresh management that does not have the baggage of being compromised with past practices is a great way to cleanse the system. 

Overall, barring exceptions, funds have done a great job in growing the system. But fund managers would be well advised to stay humble and honest, particularly as they enjoy the privilege of managing the trust and savings of small investors amidst significant tax benefits. They must recognize that the ecosystem is far from perfect, and that they need to take proactive and continuous steps to make markets safer and transparent for the smallest of investors. To be fair, many fund managers are quite conscientious and worried around some of the issues. Maybe that is not enough – maybe now is a great time for them to be paranoid, when things are still going their way.