The need to make portfolio management more robust

The equity market has been in a downward trend for some time now. This is especially true for the mid and small cap sectors of the market. There are several reasons for the market downturn and various commentators, including myself, have talked of these. However, there is another aspect of the downturn that has not been adequately captured in public discussions yet. That is the impact of the downturn on certain portfolio management services (PMS) schemes and on the investors in such schemes.

The PMS schemes are fundamentally different from Mutual fund (MF) schemes in that the former are managed by portfolio managers on a private and contractual basis for their clients. These are usually smaller in size and often at a higher market risk level.

Since the PMS schemes are privately managed, their performance is not available in public domain. As a result of this, independent market analysts do not have adequate information to comment on these schemes in a general or specific manner. However, recently, there have been some news items about certain PMS schemes suffering heavily in terms of performance and a few of them not being able to provide exits to their investors.

This reminds us of some of the issues faced by the Indian MFs in the early days. A few schemes had faced similar problems in the aftermath of the market meltdowns in 2000 and 2008. More recently, a few MFs have faced difficulties on account of their exposures to loan against shares (LAS) and housing finance companies (HFCs).  The Securities & Exchange Board of India (SEBI) has since taken several steps, including revisions in the MF regulations to ensure that the investors are not trapped in case of poor risk management practices of any of the MFs.

The key lessons from the earlier episodes, to ensure a continuous transaction by MFs with the investors, have been to:
a)    Ensure that the valuation of the holdings in the portfolio is as close to realisable value as possible;
b)    Liquidity risks are well managed; and
c)    Disclosures are of a high standard.
With this background and experience from MFs, let us now see if the same are, and can be, applied to the PMS schemes as well.  The focus of analysis in this article is on the schemes investing in mid and small cap sectors, as the afore-mentioned issues are more pronounced in such schemes.

Valuation:
The bid-ask spreads are wide and the impact costs are high, while trading in small firm stocks. The valuation of such stocks should therefore be always done at the bid price, and not at the mid-price. The last traded price, used in the valuation of portfolio holdings, is often equal to the mid-price or even the offer price at the time of last trade. This differentiation becomes important especially in a volatile or a shallow market.

Liquidity risk:
A portfolio manager must have the capability to understand and fairly assess the liquidity risk in the portfolio. It is true that liquidity risk is the most difficult of all financial risks to assess. However, it is also true that this risk is the most dangerous of all and has been at the fore-front during the major financial crises. Liquidity risk models are quite notorious in failing and hence have relatively low predictive value. It is therefore highly imperative that a portfolio manager be willing to maintain adequate resources and tools to manage the under-estimated liquidity risk with a high confidence level.

Disclosures:
Caesar’s wife must be above suspicion. Any person charged with a fiduciary responsibility must disclose, with equanimity, all risks and failures to the stakeholders. A portfolio manager must make timely and periodic disclosures to the investors, more so in times of heightened uncertainty. Warren Buffet and a few other portfolio managers offer us lessons in this regard. Investors should be empowered to freely make their choices, based on adequate and timely disclosures.

None of the above points is a revelation. These have always been the tenets of sound portfolio management. And therein lies the rub. In spite of being well known, these are often very difficult to practise because they require a high level of competency and character in the portfolio manager.

It is difficult for an independent analyst like me to make any judgment on the degree to which the above tenets are being followed by the portfolio managers. There are likely to be good ones as well as poor ones, like in any industry.  It is therefore required of the policy makers to lay down a sound framework including clear measures on the above factors, uniformly applicable to all the PMS schemes.

The SEBI (Portfolio Managers) Regulations 1993 (last amended on May 10, 2019) is the primary regulation for portfolio managers. I have a few suggestions to strengthen the framework.
1)    The Regulations do not elaborate on, or even talk of, the parameters of valuation. This must be incorporated with a specific section devoted to the boundary parameters of valuation of various risky assets in the portfolios.
2)    The Regulations state in Clause 14 (vi) that “the agreement between the portfolio manager and the client shall, inter alia, contain attendant risks involved in the management of the portfolio”.  This clause is necessary, but not sufficient. The clause should be made more detailed with focus on assessing the capacity of the portfolio managers to manage various types of risks.
3)    The Format-1 for disclosure by a portfolio manager to the clients is quite inadequate for two reasons. Firstly, it is compliance-driven rather than risk-driven. It encourages the portfolio managers to just check the boxes rather than explaining and standing behind the various risks in the portfolio. Secondly, the disclosures are quite generic in nature. It is not clear, for example, as to how a portfolio manager is to be evaluated in terms of the quality of disclosures. As a result of this, SEBI is forced to undertake a lot of unnecessary effort and exercise a lot of discretion in approving, auditing, and assessing the portfolio managers.

SEBI needs to place, in much more elaborate and transparent manner, the primary responsibility of delivering high quality of risk management and disclosures on the portfolio managers. The industry is now large enough to follow the best practices.  We need not wait for a crisis to take the critical measures for reform.

Hemant is “Associate Professor and Area Head – Finance at SPJIMR (SP Jain Institute of Management & Research)

[This article has been reproduced with permission from SP Jain Institute of Management & Research, Mumbai. Views expressed by authors are personal.]