Mutual Funds and Skin in the Game

Markets regulator SEBI has directed that key employees of asset management companies (AMCs) would be paid 20% of their salary in units of the mutual fund schemes under their supervision. The lock-in period would be 3years. The circular is called ‘skin in the game’

Source: ET

Further details: Key personnel of AMCs must get at least 20% of their CTC from investments in their own funds, excluding tax and mandatory PF contributions. Of the 20%, fund managers can invest up to 50% in their own schemes, and 50% in a scheme with a similar or higher risk profile. For the senior management, such as CEO or CIO, the investment has to be made across schemes managed by the AMC, and in proportion to the assets under management. The money will be locked-in for three years, and can be clawed back (seized) in case of a fraud.

Benefits 🏅: Well, of course if SEBI has released the circular, its got to have some benefits right? Thankfully, it does! Sebi has made changes to the mutual funds governance rules several times. In fact, ever since the ILFS crisis, SEBI has been working to bring more transparency and better corporate ethics to the finance industry as it affects the retail investors, like you and me! Following the issues faced by Franklin debt schemes in 2020, it only made sense that the employee also lose some part of their earnings if their funds went bust. To summarise, it hits right on the values of reciprocity, accountability, and incentives.

Drawbacks ❌ : Hmm!! I feel the circular has a good intention and poor execution. Wait, I have heard that before! 

- The circular assumes incorrectly assumes that the employee is also the target market for any product. Well, we all know how absurd that sounds! Imagine being asked to send all your money by cheque because you work at a brick-n-mortar bank branch. The mutual fund manager’s risk appetite and willingness might be very different from that of the consumers of the fund. Why would a multi-crore fund manager want to invest in a debt fund?

 - To add, the circular will also have tectonic impacts in the way it shapes this industry going forward. The ciruclar directly disincentivises launching of funds at either end of the risk-return spectrum in fear of low returns or high risk. A young professional with a profound understanding of interest rates wouldn’t want to start a debt fund where 10–20% of his salary gets locked in low income fund. 

“But Deven, if the fund is providing really low returns or is adding extremely high risk, why should it even be there?”

Well, let’s leave that for the competitive market forces to decide. While the bulk of the users will always be in the belly of the curve, the MF customer statistics show fat-tails. In a country like India, fat-tails coupled with a large population are enough to start a business to cater to it. We all know people who would be happy to get 7% returns ‘safely’ and not ride market risks. We also know people wanting to go stonks with their risk! Let’s not kill these markets maybe? or incentivise employees to take higher risk to generate higher returns on these funds.

- Lastly, it is cruel to ask an employee to take 20% of their salary with a 3y lock-in. Lower incomes generally would be at the bottom of the hierarchy, for young staff members who, to begin with, have little say in the performance of the fund.

Lesser disposable income → Higher Wages → Higher Costs for AMCs → Higher Charges for Mutual Funds

Implications 🤼‍♂️: It is risky and problematic to have so many insiders working in their own fund. If a key employee sold off his/her holdings right before a large sell-off or market crash how is that going to be perceived? And surely, it could lead to fund managers window dressing their performance, since their money along with their credibility is also at risk now! The challenges are many, and execution doesn’t seem very promising

My views 🤔🧠: The circular has its upsides, and tries replicating the ‘ESOP’ model of startups. Having said that, MFs are not startups and employees aren’t the early team. They have little control in the working of large fund houeses and often have other investment options they would want to explore. Additionally, the fund handles the money of the masses. A single wrong intention could have larger impact than any tiny startup. 

All-in-all the circular seems unfair to the employees and the fund unit holders in the long term, and will definitely make long-term behavioural changes in the MF Industry!

DM 🚀