Skin in the Game
In this week's FinMail we understand SEBI's new Skin in the Game rules for the Mutual Fund Industry. We also understand its impact on a Mutual Fund Investor.
The Story:
On April 28, 2021, SEBI came up with an interesting circular titled Alignment of Interest of Key Employees of AMCs with the unitholders of Mutual Fund schemes (you know we'll simplify it for you, wink!
Basically, SEBI by changing the rules and framework of AMCs wants to safeguard the investor's money by aligning the interests of those managing investors' money on behalf of them i.e. The AMCs and Fund Managers (classic SEBI as always).
So what is the plan?
Skin in the Game! SEBI wants to align the interests of AMCs with that of the investors by introducing Skin in the Game framework for AMCs. Under this, the AMCs are required to pay a minimum of 20% of the compensation (including salary, perks, bonus, non-cash bonus, & excluding contributions towards EPF/PPF/Gratuity, and deducting income tax) of the Key Employees (Designated Employees) of the AMCs in the form of the units of Mutual Fund Schemes that they manage or oversee.
So you might be wondering why are we suddenly discussing a circular published in April?
Well, this framework came into effect on 1st October 2021. Earlier it was going to be implemented from the 1st of July but after receiving some criticism, SEBI delayed the implementation to 1st October 2021.
And in the hope of cooling down some criticism, SEBI published another circular in September that clarified some points and also mentioned that the compensation rule would also be implemented for Junior employees but in a phased manner from October 2021 - October 2023. For Junior Employees, the compensation would be paid out as a minimum of 10% in the form of scheme unitstill September 2022 which would increase to 15% till September 2023 and would come at par i.e. 20% in the form of MF unitsfrom October 2023.
And basically, this is how SEBI plans to solve the problem of 'Misalignment of Interests'.
And this is what we are going to understand in this FinMail. We will first understand what exactly it is (in simple terms, obviously). And then, we will understand the Advantages and Disadvantages of the new rule while also understand how it will impact us, the Retail Investors. So let's start right away.
Skin in the Game Framework: The Crux
SEBI plans to align the interests of investors and the AMC employees by making them invest mandatorily in the scheme that they are involved in. It's like they are getting the salary but in the form of investments.
So if a Fund Manager that manages a scheme and has a CTC of ₹1 Crore annually would be paid ₹80 lakhs as usual but the remaining ₹20 lakhs would be paid in the form of units of the scheme that he/she manages. Basically, MF units worth ₹20 lakh would be credited in his/her MF Folio.
But does this rule apply to everyone working in the AMC?
SEBI has currently implemented this framework for the Employees that are in any way involved in the Management of the scheme. SEBI has classified them as Designated Employees. So the AMC employees like CEO, Fund Manager, and the Fund Management Team, Chief Investment Officer (CIO), Chief Risk Officer (CRO), Compliance Officer, Sales Head, Investor Relation Officer (IRO), Research Team, Heads of the departments, etc. (You can read the list of all the impacted employees in the circular as we have tried not to make it more ambiguous while reading this).
So to summarise, every employee that contributes to decisions related to the management of the scheme will be getting their 20% compensation in the form of units of the schemes that they are involved in. And if an employee is included in more than one scheme, then such compensation would be paid proportionately (as in some units of Scheme A and some of Scheme B).
Is that it? No!
SEBI has also said that such units would be locked in for 3 years from their date of credit and employees would not be able to redeem it before 3 years. If there's an emergency then SEBI has allowed employees to borrow such units on humanitarian grounds.
SEBI has excluded employees that are included in the management of ETFs, Index Funds, and Overnight Schemes as the employees have little control in the management of schemes.
There are some other technicalities with the new framework but we have skipped that part so that it does not get confusing for you to understand. You can read the circular for the same and if you have some doubts you can reach out to us anytime.
So yes, this is the crux of the new framework and this will do as the brief that you'll need to understand the same.
How is this framework going to align the interest of Investors and AMC?
It's no big secret that every investor wants decent, if not great returns and profits from their investments. They also expect that their money would be managed and invested in the best and the safest way possible. It's totally 2 different wishes but we all know it's true. However, the employees of AMC who are managing the investments (or are involved in any activity affecting the management of investments) on the behalf of such investors aren't really motivated to earn that extra buck. It is a little harsh to say but honestly, they seem to be content with the paycheck that they receive for managing the fund. And that is what SEBI is trying to change by asking how about you getting a portion of your paycheck in the form of units of the fund that you manage?
This way, the management is also a unitholder of the fund and thus would now expect that their money generates decent enough returns with utmost care. So it is expected that if they have their "skin" in the game, they will play the game better and in a fair manner.
Why this Framework now?
SEBI has a clear intention behind this - making top-level management of AMCs more inclined & responsible towards managing the money which is not theirs!
Let's understand this with a simple example here:
Let's assume that you're a beginner in the markets and your friend who has been an investor for a few years had introduced you to this "heaven" as you call it. One fine day you have a thought that why not let your "experienced" friend manage your money. So you ask your friend to manage and invest your money on your behalf. The friend agrees but asks for compensation in return. (bas na, yahi hai teri dosti...) Note here that the friend of yours is asking you to pay him a fixed compensation on your investments. There is no performance clause; whereby your friend gets his compensation on the basis of his performance in generating returns.
So, you start having some doubts as you feel that there is no motivation for your friend to generate better returns on your investments. Regardless of however your investments perform, your friend is going to earn his fixed compensation but you will have to bear the risk of the "variable returns". Also, there's no guarantee that your friend will prioritize your investments against his in critical situations as he has nothing to lose. So what if, your friend's money was at stake along with yours? He'll be definitely more cautious and more encouraged to generate better returns on your investments. And that is what exactly SEBI is trying to do here.
With events like Franklin Templeton shutting down its six debt MF schemes blocking about ₹26,000 crores of investor funds while some of the "insiders" got to take home the money before it actually happened, leaving the ship right before it was about to sink. SEBI clearly doesn't want such incidents to happen in the future as it not only affects the existing investors but also the overall market sentiments. And we all also know how the public at large perceives Fund Managers and this is the same reason which is that they don't care in reality most of the time (again, a little too harsh but true).
So we understood what the new rule is and we also understood why it is introduced. But why should you as a Mutual Fund Investor even bother? For that, let us shed some light on the good things and the bad things about the framework.
Let's make you happy first (TWSS) If you read this FinMail throughout, you already have encountered the benefits of the move. So let's just summarise:
With this move making the investments in the scheme mandatory for the employees that are included in the management process, the employees will be more responsible & cautious now as their money would be at stake too.
The events like Franklin Templeton can be avoided as the insiders would not be able to take out the money which would be locked in. The fund managers would now think twice before taking more risk than they are intended to. In and out, SEBI has tried to do a groundbreaking job in protecting the interests of the investors. So yes, the interests of investors are checked. But, are the AMCs and AMC employees really happy about it? Uhmmm, it doesn't look like it and there are some genuine reasons which we are going to discuss now.
Skin in the Game rule is not a newly adapted framework for the Indian Mutual Fund Industry. SEBI already had a similar framework for AMCs in place wherein the AMC Sponsor had to invest 1% of the amount raised via NFO or ₹50 lakh (whichever is less) in the NFO schemes that they launch, to ensure that they stay focused on contributing to the fund's objectives and norms. Making them invest their own money in their new scheme ensures that the AMCs are equally attentive to each of the schemes and not any one scheme in particular. And AMCs are also not allowed to redeem such funds before the scheme gets wound up or matures (in case of close-ended schemes). But now it not only exists at the AMC level but also at the employee level.
Now just hear us out what we are trying to say here. Consider the employees of the AMC as individual investors like yourself. How would you react if someone makes it compulsory for you to invest 20% of your earnings in a scheme that might not be suitable for your Investment Objective?
20% of your earnings! Sometimes less than 20% of your income is what is left for all the savings and investments to be made. And here is SEBI forcing the employees to 'purchase' the fund units.
No matter how this new framework sounds compellingly good for the investors but it is coming at the cost of other 'investors' who were probably not going to invest in the scheme if the rule had not been in place. Consider a fund manager who is in her 50s managing a Small Cap Fund. So, looking at just the age we can say that it is not safe to invest 20% of the income in a small-cap category and that too in a single mutual fund scheme. It doesn't matter if she is managing a fund that is not in line with her own risk profile but she will now have to invest in a scheme that is not advisable for her finances.
Leave this aside, what if she would have been a manager of a liquid fund? So now as per the new rule, she will have to mandatorily stay invested in a liquid fund and that too for 3 years. And thus, one disadvantage is that it is going to negatively impact the Personal Finances and Financial Goals of such employees.
The second disadvantage can also be classified as an advantage as well which is that the funds will now experience added inflows as the employees' investment would also flow into the Mutual Fund schemes. High Inflows can be a good thing and can be a bad thing as well.
The third disadvantage is the risk of personal bias of the employee managing the fund. If the Fund Manager's money is also invested in the MF Scheme that they are managing, there's a possibility that they would be unable to keep their emotions at bay while taking critical decisions for the fund.
And the last but the concerning disadvantage of all is that it could affect the growth of the Indian Mutual Fund Industry. The new Skin in the Game rule would surely strike fear in the minds of the aspirants who want to be a part of the Indian Mutual Fund Industry. If there's this mandatory rule that forces them to invest in a place where they personally wouldn't want to, they are surely going to look for opportunities somewhere else. And this can hamper the growth of the Indian MF Industry.
Final Verdict:- SEBI in an attempt to protect the interest of Investors has surely taken a step in the right way but it is coming at the cost of the small community of Investors that are by chance managing the majority of investor's money. It is like Thanos trying to do the right thing but in the wrong way. We can only do one thing which is to watch how this unfolds. What do you think about SEBI's new framework? Tweet to us your opinion @yourfinman.
That is it for this week's FinMail Keep learning, keep spreading some love and we will see you in the next one.
