May 23, 2010

life in financial markets: what is the worth of net worth?

A lot of debate has been stirred by the recommendations in a recent report of a Sebi-appointed group. The group basically wants the present minimum amounts of net worth requirement for various market intermediaries such as stock brokers, mutual funds and debenture trustees be raised significantly (2-7 times).

Now, what is net worth? Essentially, a firm's paid equity capital plus cash reserves makes up for its net worth. Intermediaries in the financial market normally act as agents of investors although there are some that execute transactions in their own firm's name.

I think the Sebi committee has made a grievous mistake in not de-linking the networth requirement of those who act as agents for others in their business and those who do business in their own proprietary name. The net worth requirment should be jacked up significantly only for the latter, that is, for those who register themselves as intermediaries (brokers etc) but the trades that go through their memberships include proprietary trades.

The intermediaries who only act as agents should not be made to suffer the burden of arranging for high capital. It disincentivises brilliant and efficient entrepreneur firms who may have the intelligence and the zeal but not too much of capital of their own, at least in the beginning.

With regard to the impact of a potential increased net worth requirment on mutual funds I present below a hard-hitting, excellent write-up by Ajit Dayal, the CEO of Quantum Mutual Fund in its regular newsletters.

Here is Ajit Dayal's write-up (first few paras have been deleted by me for space reasons):

......But while the mutual fund industry re-groups around a new set of ethics and business practices, a SEBI-appointed sub-group to look into the eligibility norms for setting up (and maintaining) a mutual fund business have come out with a swatter to knock off all us ants, cockroaches, and other irritants that threaten the regime of the elephants.

So, while SEBI is trying to clean up the industry and ensure that the rogue elephants are sent packing, the sub-group wants to extinguish the ants.

In 1993, one needed to have a Rs 3 crore net worth to set up a mutual fund business. Now it takes a net worth of Rs 10 crore. The sub-group wants to raise this minimum net worth to Rs. 50 crore.

Table 1: Hi, Doctor, how rich are you?
Name of the AMC, mutual fund house Quantum Reliance Birla Sun Life Fidelity HDFC Franklin Templeton
Year ending data available 30-Jun-09 31-Mar-09 31-Mar-09 31-Mar-09 31-Mar-09 30-Sep-09
Net worth (Rs cr) 12.08 842.33 92.08 49.55 284.64 321.03
AuM, March 2010 (Rs cr) 102.67 111,819.33 69,531.84 7,795.22 94,702.79 34,911.90
Net Worth / AuM (%) 11.77% 0.75% 0.13% 0.64% 0.30% 0.92%
Source; SEBI, web sites

The sub-group was headed by Ms Roopa Kudva, MD & CEO, Crisil. The other Members of the sub group were:
  • Mrs. Chitra Ramakrishan, DMD, NSE - a stock exchange
  • Shri S. H. Bhojani, Sr. Partner, Amarchand Mangaldas - a law firm
  • Shri Paresh Sukthankar, ED, HDFC Bank - a bank with a distribution business
  • Shri A. Balasubramanian, CIO, Birla Sun Life AMC Ltd - a large AMC
  • Shri Sanjay Shah, MD, Morgan Stanley India Securities Pvt. Ltd. - a broking house,
  • Shri Milind Barve, MD, HDFC AMC Ltd. - a large AMC
  • Shri Nilesh Shah, DMD, ICICI Prudential AMC Limited - a large AMC
In their questionable recommendation, the sub-group members note that capital is not really a significant factor in determining who gets - or does not get - a license to manage money in Singapore, UK, Europe, and USA.

They also recognise that the "operations of the AMCs are in the nature of a pass through". In plain English what this means is that, as a fund manager, Quantum Asset Management Company Private Limited does not any time own the shares that it buys.

The money in the Quantum Mutual Fund belong to you, the investors; and the shares, gold, or government bonds in the Fund all belong to you. The fund managers only decide where to put your money, how much to buy, how much to sell, when to buy, when to sell. At no point is the ownership of any of the underlying assets passed on to the fund manager.

Like a doctor or a lawyer or a CA, fund managers provide a professional service. When you visit your doctor, do you ask him: how rich he is? No. You want to know how good he is.
When you hire a CA to write your accounts, do you ask them what their net worth is? No, you want a knowledgeable CA with a good track record to do your work for you.

Table 2:How good are you at your work, Doctor?
Name of largest equity fund of that fund house BSE 200 Index Quantum Long Term Equity Fund Reliance Growth Fund Birla Sun Life Frontline Equity Fund-Plan A Fidelity Equity Fund HDFC Equity Fund Franklin India Bluechip Fund
Size of largest diversified equity fund (Rs cr, as of April 2010) N.A 52 7,346 2,103 2,871 6,025.42 2,954.86
Returns from March 31, 2006 till May 20, 2010 for growth option 10.08% 16.31% 16.64% 17.07% 14.19% 16.35% 13.17%
3-year Ranking based on Value Research as of May 20, 2010*   18/175 17/175 32/175 57/175 13/175 47/175
Source: Value Research

But now, to get a fund manager, the sub-group recommends that they have a net worth of Rs 50 crore. That is the entry ticket to enter the sweepstakes of an industry that has, in the past fifteen years, shovelled thousand of crore of money from your pocket into the distributors’ pockets.

Capital solves all crimes.
Why would such intelligent people - and believe me they are - come out with such a morally bankrupt recommendation of hiking the net worth criteria after recognising that it is a "pass through" business?

Is this an attempt to keep a closed club closed?
To increase the barriers of entry so that a select group of mutual fund houses can reap the rewards of growth in the mutual fund industry?

We have often argued that net worth is not a legitimate criterion for setting up an AMC. As custodians of your hard earned savings, the mutual fund industry has to comply with various norms to ensure there is no fraud.

But, as we all know, intent is in the heart and in the DNA of organisations.

You can be big - and still be the biggest crook in the world.
You can be small - and still be a big crook.
Size and net worth is not a determinant of crookedness or working in the best interest of investors.

I know for a fact that Quantum Mutual Fund is small, yet we work in your interest. All the AMCs represented on the sub-group have been built on the opaque distribution model. That is their choice and their business plan, our DNA would never allow us to compromise your interest and leave you hanging by the relationship of a distribution commission.

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And neither is size or net worth a determinant of how good a fund house is at risk assessment and risk control.
UTI was big and they went bust.
CanBank Mutual Fund was big and they, too, had to be bailed out.

The largest mutual funds were the one’s who did not assess the risks of the Fixed Maturity Plans (FMPs). When faced with the severity of the Lehman crisis, they had to be bailed out by the actions of the RBI and/or their parent companies.

Their fear and obsession with that is apparent and referred to in the report. The dates they had their 3 meetings coincide with the dates of the depth of the crisis, suggesting that fear - and not rational thought - may have dominated their minds.

Table 3: Fixed Maturity Plans became unfixed.
Name of the AMC, mutual fund house BSE 200 Index Quantum Reliance Birla Sun Life Fidelity HDFC Franklin Templeton
Amount of money in FMP type products in September 2008 (Rs. cr) N.A zero 21,790 7,935 402 12,308.84 4,468.64
Source: Value Research

In fact, showing their state of shock at their own lack of risk assessment, the committee writes: "The liquidity squeeze in the last quarter of 2008 resulting in redemptions from a number of debt schemes, the difficulties that they faced, and the subsequent change of ownership of some AMCs have brought these issues into immediate focus."

Hogwash! The mutual funds and their marketing teams mis-sold FMP debt products linked to real estate developers as safe products (probably backed by good ratings from the rating agencies). Their larger AuMs probably got them high salaries and bonuses in 2007. Then their fiction of the safety of real estate loans caught up with them and they - and their investors - were in trouble. No, they went pleading for help to the RBI. And they got it. Yes, they got to keep their fat bonuses and rewards, too. Just like Wall Street did.

Now they sit in judgement as members of the sub group and feel that all AMCs need more net worth to protect themselves from their own greed? For a "pass through" business?

We are in the business of managing your savings to give you sensible, risk-adjusted returns over the long run. The elephants and the distributors have made it into an asset gathering business.

Should wrongdoings disqualify a mutual fund?
The solution to ensure that sensible people manage your money is not to have a high net worth (not that Rs 50 crore can save such risk-taking of an FMP business) for staying in the business.

The focus of the subgroup was on "eligibility norms" for being in the AMC business. This got translated into (i) minimum net worth; (ii) infrastructure and manpower required to run the business; (iii) other function that can strengthen and smoothen the functioning of these intermediaries.

One of the crucial aspects is missed out: the moral and regulatory right to remain in the mutual fund business after you are caught doing not-so-nice things.

Should companies that have paid thousands of crore of their investors’ money (without disclosing this) to various distributors have the right to remain in the business? Should mutual fund houses that have violated their own stated investment objectives be allowed to stay in the business? Should mutual funds that have mis-sold products have a license to continue functioning?

The recommendation of a higher net worth is a direct challenge on the regulator’s attempts to bring in more investor-focus in the mutual fund industry. Over the past year, SEBI has tried to build a more transparent mutual fund platform which widens the access to mutual funds at a lower cost. This sub-group is focused on limiting the choices available to investors and reversing SEBI’s focus on investor-friendliness.

Higher capital needs can only hide bad business models for a longer period of time. Just a little longer. Eventually a bad business model shows its weakness.

Rather than raising the capital needed to start a mutual fund business, the sub-group should have recommended dropping the net worth criteria to Rs 1 crore so that hundreds of new, smaller asset managers can set up. And they should be allowed to compete for the assets shovelled by distributors to the elephants. We need a lot of ants to get the mutual fund industry moving forward, the elephants have had their days of blocking the sun.

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