As the fund industry in India has evolved over the years, the regulator believes that one area still resides in the dark ages – a contentious one at that: The disclosure of fund manager remuneration.
On March 18, the Securities and Exchange Board of India issued a circular stating that asset management companies, or AMCs, have to disclose annual salaries on their respective websites under a separate head called ‘Remuneration’. This applies to the CEO, CIO, COO and employees whose annual remuneration is equal to or above Rs 60 lakh.
Since executive compensation comes from the management fees charged to the scheme, in the tug of war between employee privacy and relevancy of investor disclosure, the latter triumphed.
Much to the antagonism of AMCs.
What does the regulator hope to achieve? is the most common lament.
Why not restrict it to just the CIO and relevant fund manager – why all employees earning above the threshold? is another.
How will it help the investor make a better investment decision? Now this is what Morningstar would like to address.
All the industry players we spoke to were unanimous that the remuneration profile of the fund manager must be linked with fund performance. Some included other factors too – overall profitability of the business, contribution to the overall investment team result, and business development contribution. But fund performance stood tall because the general consensus is that if compensation is largely driven by fund performance, it aligns the fund manager’s interests with the interests of the investors. On the face of it, that sounds perfect. But one has to dig deeper.
- Is the fund manager rewarded for performance?
- If yes, is it for exceeding a relevant benchmark and which one is it?
- If it is compared to a benchmark and peer group norm, what weights are accorded to each?
- Are trailing or rolling returns taken into account?
- Is the fund manager’s remuneration tied to short-term returns or a sufficiently long time horizon? What time periods are considered and what weights are accorded to those periods?
- If fund manager’s compensation is tied to performance over short time periods, would it not be tempting to take on excessive risks in order to maximize his bonus? It could also trigger risk-taking tactics to play catch-up at year-end.
- Is the fund manager’s compensation tied to asset growth, even partly?
- This is not a good sign because fund assets, as a metric, are a better gauge of marketing craft than investing acumen.
Way back in 2004, Morningstar unveiled the Stewardship grade for mutual funds in Chicago. The analysts went to great extents to determine the structure or specific formula behind a manager’s compensation – which was a difficult task given that manager compensation in the U.S. at that time was kept under wraps and not disclosed to the public.
The information obtained by Morningstar analysts helped them answer three very important questions regarding Stewardship, which are mentioned below with illustrative examples valid at that time.
1) Does the compensation structure complement the management’s strategy?
- Selected American: The compensation scheme paid out bonus awards in fund shares, with those grants vesting only if the fund outperformed the S&P 500 Index and the fund's peers over the ensuing five years. This complemented the fund manager’s low-turnover, value-investing ethos.
- Oak family of funds: Managers were paid a nominal base salary and received bonuses on a quarterly basis based on two factors--the revenue Oak brings in over the period and founder’s assessment of each manager's performance. This quarterly payout approach seemed at odds with the low-turnover, long-term-oriented strategy that is Oak's signature.
- Longleaf Partners: One component of the bonus compensation methodology measured the performance of individual stock picks in terms of how much the intrinsic value of the firm's business increased over the course of the year based on the free cash flow it generates. This encouraged managers to pick companies that created value for shareholders - consistent with Longleaf's absolute-value-geared strategy.
2) Does the compensation structure emphasize long-term, rather than short-term, investment objectives?
- Putnam: The compensation system ensured that managers kept their eyes on the ball over the long haul. At some funds, performance incentives generally accounted for 70% of compensation. The majority of the incentive goals were based on fund returns relative to peer groups over 3- and 5-year periods. Specific goals were to rank in the top third of those peer groups and avoid falling into the worst quartile, which encouraged managers to shoot for steady outperformance.
- TIAA-CREF: Incentive structure at some of the funds entailed that the bonus calculation skewed heavily to the trailing 1-year period.
3) Does the compensation structure mitigate or heighten potential conflicts of interest?
- Ariel Fund: The bonus system was tied to firm profitability, which is often a thorny setup given that it's difficult for managers to effectively serve the management company and the fund shareholder. However, the fund's board set up clear portfolio-management goals designed to ensure that the fund is managed consistently and that the manager is not taking on risks that are intended to drive the firm's profitability. The board evaluated whether each fund's forward P/E ratio remained at a significant discount to appropriate benchmarks and whether turnover was kept at a reasonable level.
As mentioned earlier, the above illustrations may no longer be accurate as of today. However, it indicates that disclosure of the structure of a fund manager’s pay, not a blind reporting of numbers, does help investors make prudent decisions. It proves the point that while transparency can be a burden, it is also a tremendous asset (when sensible and well thought out).
Worth noting is at that time (regarding the above examples), the Securities and Exchange Commission, or SEC, did not require mutual funds in the U.S. to disclose how their portfolio managers are compensated. The ruling on disclosing the structure of compensation was made mandatory only in 2005.
More recently, the battle began to get waged in the U.K. where it ruffled quite a few feathers. Last year, the Investment Association wrote to all members asking them to publish details online of how their fund managers are paid. (This is a representative body in the U.K. for unit trust and investment fund managers.) Later, it was revealed in the press that the industry body’s chief executive Daniel Godfrey was ousted from his position after a revolt from some member firms such as M&G and Schroders, two of Britain’s biggest fund manager companies.
But the issue continues to be debated. Recently, Investment Week reported that Richard Woolnough, who manages the Optimal Income, Corporate Bond and Strategic Corporate Bond funds for Prudential, received bonuses of £17.5 million and £15-odd million in 2013 and 2014. While The Independent speculated a fall in his 2015 bonus citing bad performance.
In Australia the remuneration of fund managers is closely guarded, despite some noise a few years ago.
For better or for worse, India is one step ahead in that area.
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