Market regulator SEBI has come out with a new guideline that could soon send the mutual fund industry knocking at AMFI’s door for support.

In order to align the interest of the ‘Key employees’ of the AMC with the unitholders of the mutual fund scheme, SEBI has decided that a part of compensation (a minimum of 20% of the salary/ perks/ bonus/ non-cash compensation (gross annual CTC) net of income tax and any statutory contributions – i.e. PF and NPS of the Key Employees of the AMCs will be paid in the form of units of Mutual Fund schemes in which they have a role/ oversight.

It has further stated the following:

• The units will be proportionate to the AUM of the schemes in which the Key Employee has a role/oversight. Exchange Traded Funds (ETFs), Index Funds, Overnight Funds and existing close-ended schemes will be excluded for this purpose. 
• It will be paid proportionately over a period of 12 months on the date of payment of salary/ perks/ bonus/ non-cash compensation. In case of compensation paid in the form of employee stock options, the date of exercising such option shall be considered as the date of such payment.
• The amount will be locked in for a minimum period of 3 years or tenure of the scheme whichever is less. The employees will not be able to redeem the units during lock-in period except in case of exigencies such as medical emergencies or on humanitarian grounds where they will be able to borrow against the units.
• Further, the redemption of units will not be allowed in case of resignation or retirement before attaining the age of superannuation as defined in the AMC service rules. However, in case of retirement  on  attaining  the  superannuation  age,  such  units  can  be released from the lock-in and the Key Employee will be free to redeem the units, except for the units in close-ended schemes where the units shall remain locked in till the tenure of the scheme is over.
• Additionally, with a view to allow the Key Employees to diversify their unit holdings, in case of dedicated fund managers managing only a single scheme / single category of schemes, 50% of the aforementioned compensation shall be by way of units of the scheme/category managed by the fund manager and the remaining 50% can, if they so desire, be by way of units of those schemes whose risk value as per the risk-o-meter is equivalent or higher than the scheme managed by the fund manager.

The new rule on compensation of Key employees will come into effect from July 01, 2021. Rules for close-ended schemes will be notified separately.

The following will fall under the ambit of Key employees as per the new circular:

i.   Chief Executive Officer (CEO), Chief Investment Officer (CIO), Chief Risk Officer (CRO), Chief Information Security Officer (CISO), Chief Operation Officer (COO), Fund Manager(s), Compliance Officer, Sales Head, Investor Relation Officer(s) (IRO), heads of other departments, Dealer(s) of the AMC

ii.   Direct reportees to the CEO (excluding Personal Assistant/Secretary)

iii.   Fund Management Team and Research team

iv.   Other employees as identified & included by AMCs and Trustees

What is the rationale behind SEBI’s circular?

Over the past few months, investors have grown wary of investing in mutual funds, especially equity-oriented schemes, due to high underperformance rate across various categories. Since fund managers are directly responsible for the performance of the scheme, they could not justify the hefty salaries drawn. The new circular is probably aimed at gaining back the trust of investors.

SEBI’s move works on the logic of fund managers having their ‘skin in the game’. In other words, SEBI expects that getting the key employees to invest in the schemes they manage can lead to better accountability on the part of the fund management team paving way for a better quality of securities and improved performance. Moreover, investors in general, will have a better sense of confidence if the fund manager’s interest aligns with their own.

The move was also probably driven by the recent Franklin Templeton Fiasco which raised questions on the integrity of some of the top executives at the fund house who had access to unpublished information about the upcoming liquidity challenge. It was reported that some key personnel of the fund house, their family members, trustees and entities linked to the fund house had redeemed their holdings together worth Rs 56 crore, before announcing the shutdown of the schemes.

The new move can potentially prevent such instances of insider trading as well as discourage fund managers from assuming higher risk than necessary.

It has also introduced the ‘Clawback’ provision so that the fund managers cannot wash off their responsibilities in case the situation turns haywire. Under this, if the key employees are found violating the code of conduct, or in the event of fraud, gross negligence by them, the units of the employee will be redeemed and credited back to the scheme.

So why are fund houses unhappy with SEBI’s move?

While fund houses have welcomed the idea of ‘skin in the game’, they have expressed their desire for more flexibility in implementation of the rule and fine-tuning of certain aspects of the circular.

One of the major concerns of the fund houses is that employees will be forced to invest in an asset allocation plan that may not align with their risk appetite. For instance, a fund manager of fixed income securities will have to invest a substantial portion in debt schemes even if his/her investment objective is more suited to an aggressive profile.

AMCs fear that the rule may hinder their ability to attract fresh talent since the rules will apply to a range of employees who may or may not be directly responsible for making the investment decisions and the performance of the scheme. Mandatorily investing a fifth of the compensation in the schemes of the AMC may not a feasible option for many employees because it will constrain their cashflows. The mandatory investment and lock-in of three years could be especially difficult for employees if they have loans to service.

Therefore, fund house may request SEBI for more flexibility in terms of investing in schemes within the fund house. They may also request the regulator to reduce the scope of ‘Key employees’.

Will investors benefit from the new guidelines?

SEBI’s intent is good, but it will in no way guarantee improved performance of the scheme neither will it assure that the fund house/manager will follow prudent investment processes despite having invested heftily in the scheme/s. Do note that many fund managers already invest in the schemes that they manage or other schemes of the fund house.

What should investors do?

It is important that you select mutual funds carefully based on a host of parameters (both quantitative and qualitative) not limited to the returns generated by the scheme/s. The fund should be able to adequately reward investors with suitable returns without taking excessive risk.

Furthermore, you should be looking at the portfolio characteristics of the scheme to assess its ability to generate reliable returns by analysing the following:

• Whether the scheme is well-diversified across stocks and sectors
• The quality of securities held
• Portfolio churning rate

And since the fund’s performance is directly dependent on the ability of its fund manager, check the qualification and experience of the fund manager and the track record of the other schemes managed by him/her. Invest in schemes of fund houses that have a reliable performance record and follow robust investment processes with adequate risk management systems in place.

This article first appeared on PersonalFN here