Billionaire investor Warren Buffett has popularised one of the most fundamental phenomena in the mutual funds investing space – skin in the game. This financial idiom translates to the situation where prominent and high-ranking insiders of fund companies spend their money buying shares in the companies they run, usually based on publicly undisclosed tips.
Skin in the game is important to investors because it shows that if a company’s executives invest in more shares, it might be much more profitable than the on-the-face appearance.
The Securities and Exchange Commission of India – SEBI – recently released a framework to align the interests of asset management companies (AMCs) and investing partners (mutual fund owners, shareholders, etc.). Under the new guidelines, asset managers must invest 0.03% to 0.13% in each plan pool, depending on the individual plan’s level of risk.
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'Skin in the game' refers to executives, owners, or heads having a significant stake in the shares of the company they manage.
Under existing rules, finance companies had to add Rs. 50 lakh of their own money for each mutual fund scheme. Now, SEBI has removed the upper ceiling. Instead, it has factored in the fund size and risk in the investment to ensure more skin in the game.
SEBI has also announced that companies must pay a part of the compensation (20%) for critical employees (C-suite and stakeholding executives) in units of the scheme they manage directly or look over indirectly. The idea is that this will connect the central staff of the AMC with the interests of their scheme’s unitholders.
Positive impact on mutual fund investors
Mutual funds asset managers raise funds from many investors to invest in a pool of stocks, bonds and short-term loans. Investors buy shares of mutual funds, and each stock is essentially their part ownership in the fund and the income it generates.
The new SEBI rule is set to avoid activities where ‘fund insiders’ redeem a significant part just before the announcement of a mutual fund schemes’ closure (or failure). Thus, the regulator has included a lock-in period of three years, which means that investments cannot be sold or redeemed for three years.
This rule also applies to the fund manager’s liability and the concept of incentive pay. It will ensure that investment by fund houses in the schemes will align with the strategy’s riskiness, assets under management (AUM), and investor’s interests irrespective of their size.
As a mutual fund scheme size will grow, AMCs will have to invest more funds. This is an encouraging step and will help align the interests of AMCs with that of unitholders more closely.
What do the new rules say?
According to SEBI, AMCs must conduct a planned risk analysis based on the preceding month’s risk assessment. They have to use the risk-o-meter for it. The investment needs to be held until the end of the project period. Risk measurement by risk-o-meter provides a picture of the risk in a mutual fund corpus.
The risk-o-meter chart is prepared following the Association of Mutual Funds in India (AMFI) guidelines. This is similar to a speedometer, showing the five investment risk (danger) levels in different colours.
AMCs and fund groups have to ensure that the temporariness of the mark to market loss is certified by the statutory auditor. Mark to market loss is the value of an asset concerning its current market price. For example, stocks that an individual holds in their Demat account are marked to market every day. This move will chiefly increase the cost and benefit many mutual fund investors.
AMCs are not required to invest in exchange-traded funds (ETFs), Index Funds, Overnight Funds, Funds of Funds schemes, and closed-ended funds, where the subscription period has closed as on date of coming into force of Mutual Funds Amendment Regulations.
In effect, the ‘skin in the game’ rule is necessary to consider the larger investing ecosystem, which includes investors as significant stakeholders. It will also increase ownership and discipline among fund managers while improving personal accountability.
