Transparency as to the various intermediation costs suffered by clients has been a key concern of Securities Exchange Board of India (Sebi).
In the latest drive to achieve this objective, Sebi came out with a circular on October 5 2010 (the Circular) significantly altering norms regarding the fees and charges (fees) that can be levied by the Portfolio Managers (PMs).
PMs are persons who, pursuant to a contract with a client advise or direct or undertake the management or administration of a portfolio of securities or funds of the clients for which they are required to be registered with Sebi.
Sebi mandates PMs to stipulate the quantum of fees to be levied for providing services to clients in its agreement with the client. The fees charged may be in the form of fixed fee or a return based fee or combination of both. In practice, PMs charge both fix and return based fees and in different proportions.
The Circular mandates PMs to provide a detailed structure for the performance of the portfolio as well as an itemised list of charges (including brokerage and custodian) levied on the client for such portfolio. The radical change is that the performance fee on a portfolio shall be computed on the basis of the High Water Mark principle (HWM). This means that the highest value a portfolio has reached, and on which the fees have been charged, is treated as the threshold for the future fees.
The value of the portfolio on the day of charging the fee is considered as the highest value. Subsequent performance fees can be charged only on crossing the previous watermark and only on incremental rise. For example if the client's portfolio is INR1 million ($22,000) and rises to INR1.2 million the performance fee has been charged on the amount of INR200,000. In the subsequent year, the portfolio value drops to INR1.1 million then no performance fee can be charged. The next performance fee can be charged only on crossing the water mark of INR1.2 million and if it is INR1.25 million, then on INR50,000 only.
The Circular also stipulates that the performance fee cannot be charged before expiry of a quarter. Although Sebi's intention behind the Circular is noble it tends to ignore relative performance. In other words, it ignores the performance of the portfolio vis-a-vis a benchmark index.
Therefore even if the portfolio managed by a PM outperforms the benchmark indice the PM cannot charge any performance fee if it has not reached the previous HWM. If in a given year the market falls by 30% and drop in the value of the portfolio by only 10% the PM can still not charge any performance fee (rather unfair for the PMs!).
The Circular lessens the odds of the PMs charging performance fees to the clients, which often acts as a steroid motivating PMs to perform better than the market. This may lead to PMs taking a passive approach for the portfolio of investor with less risk-taking appetite.
Conversely, it may also push PMs to take unnecessary and higher risk for investors with high-risk appetites in order to cross previous HWM (so that they may charge performance fees) which may actually backfire resulting in further depletion of the value of the portfolio! But then greed is good?
Bharat Budholia and Arunabh Choudhary
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