[Aditya Bhayal is a 4th Year, B.A.LLB (Hons.) student at NALSAR University of Law, Hyderabad]
On 20 November 2019, the Securities and Exchange Board of India (“SEBI”) introduced certain amendments to the SEBI (Portfolio Management) Regulations, 1993 (the “Regulations”). In doing so, SEBI considered the recommendations of a working group formed for suggesting changes, and comments received from public on the same. In light of the growing attractiveness of portfolio management industry, SEBI felt a need for a comprehensive review of the extant Regulations and consequently embarked upon a reform process. The approved changes are expected to have a wide and tangible impact on the hitherto largely unregulated portfolio management industry. On a broader scale, these changes seems to be aimed at improving transparency, reining in the services within an enhanced regulatory net, and creating additional safeguards in the interest of investors. In this post, the author discusses the likely impact of some of the changes and highlights some possible areas where the SEBI missed an opportunity for reform.
To begin with, portfolio management refers to services provided by entities wherein they undertake to manage the portfolio of securities for investors and advise them on possible investment opportunities based on the profile of the client. Portfolio management services (“PMS”) are of two types, viz., discretionary and non-discretionary. A discretionary portfolio manager is entrusted with the power to take investment decisions without consulting the client at various stages, whereas a non-discretionary portfolio manager can only advise the client on a possible investment avenue, but cannot execute it without prior approval from the client.
With this background, the post now proceeds to analyse the changes SEBI has recently introduced, and their possible impact on the investors and the portfolio management industry as a whole.
Minimum Investment by a Client
Under the existing regulatory framework (being regulation 15 of the SEBI (Portfolio Manager) Regulations, 1993), a client has to make an investment of minimum rupees 25 lakhs to avail of the PMS facility. Agreeing with the recommendation made by the working group, SEBI has increased the minimum investment limit from rupees 25 lakhs to 50 lakhs.
The most likely impact of this measure would be to keep the retail investors away from the PMS arena. This is a laudable change, as retail investors are most vulnerable among the varied set of investors and are sometimes not well versed with the risks associated with certain investments. Raising this investment cap will deter the small saving retail investors from investing in portfolio management which, by its traditional nature, is known for aiming at larger returns and, in the process, undertakes risky endeavours. There have been examples in recent times where PMS investors have failed to derive profits from their investments. PMS facility is generally availed of by the high net worth individuals (“HNI”) and institutional investors who are considered financially savvier than their retail counterparts, and have enough cushion to fall back on in case the portfolio manager’s investment schemes fails and results in huge losses for clients. PMS is meant for investors with high risk-taking capacity who can evaluate the risks involved in an investment in an optimal manner.
This escalation of investment limit will likely direct the retail investors towards mutual funds, which provide higher safeguards for the low-scale investors as these services are more extensively regulated in comparison to the PMS industry. One of the pitfalls of investing in a PMS is that the portfolio in the PMS could be unduly concentrated in a few stocks. Bereft of the benefits of diversification, this can be a very risky approach as the benefits derived would be largely dependent on the successful investment in a few particular stocks. Mutual funds, on the other hand, come up with a comparatively diversified portfolio, which gives investors sufficient alternatives to fall back on in case an investment in one or more specific stocks do not function as expected. In the author’s opinion, retail investors should have a well-diversified portfolio instead of putting all their eggs in one basket in terms of stocks, which is generally the case with PMS.
SEBI’s new move will ensure that only those well-informed investors with high risk taking appetite to withstand the vagaries of the stock market will invest in this highly volatile and concentrated industry.
Enhancing the Eligibility Criteria
A principal officer is the person responsible to take key managerial and administrative decisions with regards to PMS. Prior to the amendment, the eligibility criteria for a principal officer read (in regulation 6(2)(c)):
The principal officer of the applicant has either–
(i) a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university; or
(ii) An experience of at least ten years in related activities in the securities market including in a portfolio manager, stock broker or as a fund manager;
(iii) A CFA charter from the CFA Institute.
Keeping in mind the surge witnessed in the PMS industry in recent times, it was essential to ensure that the persons managing portfolios on such a large scale are sufficiently qualified and pass through multiple SEBI-imposed qualificatory criteria before they are entrusted with investors’ funds. SEBI responded to this challenge with an increased eligibility criterion, which would now read as follows:
A principal officer to have a minimum qualification of:
(i) a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university and relevant NISM certification, and
(ii) an experience of at least five years in related activities in the securities market including as a portfolio manager, stock broker, Investment Advisor or a fund manager.
In addition to raising the ceiling in terms of eligibility for the principal officer, SEBI further enhanced the eligibility criteria for all those having a decision making power under the PMS while also mandating the employment of another person besides the principal officer and a compliance officer.
All these changes evidently seek to bring the PMS industry within the regulatory umbrella in light of the increased attraction that investors seem to have found for this risk-bearing investment activity. Previously, there was a low threshold in terms of eligibility of the personnel engaged in these services, which resulted in limited checks over the portfolio manager’s activity. Another objective behind introducing these changes might be to bring about parity between PMS and mutual funds in terms of regulatory scope.
Investment in Listed Securities
SEBI has mandated that discretionary portfolio managers invest only in listed securities, money market instruments, units of mutual funds and other securities to be specified by the regulator. Furthermore, it has set a threshold of 25% for non-discretionary portfolio managers and investment advisors to invest in unlisted securities. The un-amended regulations did not carry any restrictions in terms of securities to be invested into by the manager.
This move can also be said to be motivated by a desire to protect the retail investors who, despite the increased ceiling, might entrust PMS with their investments. Unlike the HNIs and institutional investors, who are considered more sophisticated in terms of their awareness of the market and securities being traded, the retail investors might not be cognizant of the risks that an investment in unlisted securities carries.
The issue of liquidity, which PMS generally faces, can be addressed by this mandatory change. Investors are likely to encounter difficulty in valuation of their securities when they deal with unlisted stocks, as these stocks are bereft of the pricing mechanisms available to the listed stocks through the stock exchanges. Further, it is much easier for an investor to find a suitable buyer for the listed stocks, courtesy the exchanges, in comparison to an unlisted stock, in which an investor might fail to realize any profit when selling in a private arrangement. Moreover, the unlisted securities are a riskier endeavour as they do not attract a robust regulatory framework like that of SEBI, which is the case for listed securities. This is another move by SEBI to reduce the gulf between PMS and mutual funds. In September this year, SEBI issued similar guidelines for mutual funds as well.
Appointment of Custodian
SEBI has made it mandatory for all portfolio managers, apart from those providing only advisory services, to appoint a custodian. Previously, PMS with assets-under-management worth less than rupees 500 crores were not mandated to appoint a custodian (regulation 16B).
In simplistic terms, the custodian would be an entity which maintains the client’s assets for safekeeping. The main advantage of having a custodian in such services is to divest some power from the manager. These custodians can act as an additional check and balance over the portfolio manager. Having large financial entities as custodian can increase the credibility of the PMS among the investors. The investors repose their faith on the PMS with an assurance of having an accountable custodian to look after their securities. Moreover, this move can provide a safeguard to the investors from unforeseen future contingencies like bankruptcy of the portfolio manager.
This step can essentially add to the popularity of the PMS among the investors. As SEBI had previously mandated mutual funds to appoint custodian for their services, this change, as the aforementioned ones, can be said to be motivated by an objective to bring the two services on the same footing as much as possible.
Lost Opportunities
Although these amendments have brought some breakthrough changes, there are some areas that SEBI could have considered further and possibly made some alterations. The working group had suggested in their recommendation that SEBI introduce a standardized reporting format for the PMS. This recommendation was not accepted by SEBI. Considering the popularity that these services are gaining, it was essential to introduce a uniform disclosure requirement towards the investors as well as SEBI. Eliminating the information asymmetry has always been one of SEBI’s objectives and, by mandating a proper disclosure, SEBI could have made sure that investors take a conscious call before investing. Further, the working group had made some promising recommendations with regard to the working and eligibility criteria of distributors of portfolio managers. Unfortunately, that too was not appreciated by SEBI and, therefore, it did not find place in the list of amendments released by SEBI.
Concluding Remarks
The changes brought by SEBI were aimed at covering these loosely regulated services within its ambit. SEBI did a commendable job to protect the retail investor by increasing the minimum investment cap while also ensuring that the attractiveness of the services can be increased by bringing in the other changes. Aligning PMS with the mutual services will further boost the market for PMS. Although there have been some landmark changes, the amendments still fall short of addressing some essential issues. To realize its objectives behind such changes and to enable PMS services to flourish to its truest potential, it would be pertinent for SEBI to reconsider a few of the recommendations made by the working group and to incorporate them in the existing regulations.
– Aditya Bhayal