7th December 2011

Will the 550 large distributors who fall into the ambit of SEBI's Aug 22nd circular have to go through individual due diligence with each AMC they are empaneled with or will there be a common process for the entire MF industry? Will the due diligence process eventually percolate to all ARN holders or will it remain restricted to the large distributors?

The text of SEBI's latest missive suggests that each AMC is individually responsible for conducting its due diligence. The industry's and AMFI's views are that yes, while each AMC will take responsibility, they can nevertheless appoint a third party - like an audit firm - to execute this job for them - in a collective manner. We understand AMFI has taken up this matter with SEBI. There seems to be a good chance that this collective approach will prevail - where the task of due diligence will be administered through a set of large audit firms, but each AMC takes responsibility for the process and its outcome. The current industry preferred stance is that a panel of audit firms be appointed and each audit firm be given a pre-defined set of distributors to cover within the list of 550. AMCs in this scenario will be free either to avail of the services of these common empaneled auditors or conduct their own independent process.

Meanwhile, the confusion that has been prevailing over the last week has given rise to all sorts of speculation. We have these scenarios being painted that going forward, large distributors will only work with 5-6 AMCs - and that this will suffocate the smaller AMCs, who are already under pressure. One hopes that in the days ahead, clarity will emerge on the due diligence process and that AMFI will be able to get a regulatory nod from SEBI for its common due diligence approach.

While clarity on process will hopefully emerge soon, there are some wider issues that perhaps need to be looked into.

Why should bank distributors be upset?

Most of the large bank distributors, private wealth management firms and a few large national distributors have been subjecting AMCs to a very rigorous due diligence process for years. Very exhaustive forms need to be filled in by AMCs who wish to get into these distributors short lists. Extensive meetings are conducted with the fund managers and the business management team to understand and record fund management processes, risk management processes, business practices etc. Fund performance is scrutinized very minutely, attribution analysis is often asked for and discussed - in short, a very exhaustive due diligence process is conducted by large distributors on each AMC that they finally agree to work with.

AMCs do not have the luxury of asking for a common due diligence process by a common auditor - each of the large banks and private wealth firms conducts its own independent due diligence process and AMCs have to equip themselves to satisfy each of these processes separately. These large banks do not work with all 40 plus AMCs - they choose to work with a smaller set of AMCs and carry out their due diligence exercise for each one of the chosen AMCs. Once an exhaustive first time exercise is conducted with each AMC, the annual review is a much smaller affair, as it deals with only incremental aspects, if any that need to be covered off.

If this process is working well for years now, surely these large distributors should not find anything too amiss if the same set of AMCs were to now conduct their own due diligence, as required by the new regulations. If it worked one way, it should also work the other way - after all, due diligence should be a two way process.

Are AMCs the right entities to conduct due diligence?

A lot could have been done much earlier, in a more orderly manner, if only SEBI and AMFI had been in agreement, years ago. SEBI has been saying since for at least the last 5 years that distributors need to be regulated and that SEBI lacks the bandwidth to regulate them. Since the time that Mr. Damodaran was the SEBI chief, SEBI had been nudging AMFI to take up the role of an SRO and effectively discharge this responsibility. AMFI was at that time unwilling, perhaps because it was worried about its own bandwidth constraints. Now therefore, the buck rests with individual AMCs - they are being asked to conduct distributor due diligence and effectively assume greater responsibilities towards distributor compliance. Distributors are now getting effectively regulated - by individual AMCs rather than a collective SRO. This obviously cannot last for too long - what happens when this due diligence extends beyond the 550 large distributors into a wider set?

In parallel, we see SEBI trying to create advisor regulations and establish an SRO. If and when this happens, presumably the onus of monitoring compliance will shift to the SRO - but only for those who become advisors. Will AMCs continue to conduct due diligence for ARN holders who remain agents? Are AMCs a long term solution for monitoring compliance of distributors - given their inherent conflict of interest - they want distributors to sell more of their products, and yet they also have to pull up the same distributors on compliance issues. If important distributors get upset with an AMC's stand on due diligence, what will AMC managements do? Will they risk not doing business with these important distributors or will they become more flexible in dealing with due diligence issues?

We are seeing too many piecemeal efforts rather than a comprehensive plan of action. This only results in confusion.

Are you doing your own due diligence on fund houses?

Why do large distributors the world over go through this due diligence process? Because, as advisors to their clients, they need to first be comfortable that the AMCs whose products they short list meet their criteria in terms of fund and risk management processes and only then will they consider performance of individual funds. It's part of their fiduciary responsibility towards their clients.

Many distributors in India are keenly working on upskilling themselves and offering better advice to their clients. One of the important aspects here is short-listing your recommended funds based on a well defined process. While returns and volatility numbers will give you a lot of quantitative parameters to help you in your short-listing process, you will need to pay a lot of attention to the qualitative aspects as well - which is what a due diligence process is all about.

In case you are not already doing this, you may want to ask the fund houses you deal with regularly some of the following questions, and get your comfort (or otherwise) about the processes they employ in managing your clients' money :

1. What is the process by which stocks and debt instruments are selected for inclusion in fund portfolios? Is there evidence of a structured process or does it appear ad-hoc and fund manager centric?

2. What is the process by which portfolio risk is controlled and monitored? Is there an independent risk management mechanism or does the fund house rely on the fund manager to comply with risk management policies?

3. How does the fund house ensure that funds are managed strictly in accordance with fund mandates? Is there an independent mechanism or is it left to the fund manager to comply on his own?

4. Are there any internal policies in place to align fund managers interests with those of their investors? This could be by way of investment guidelines that stipulate that fund managers should invest in their own schemes. It could also be by way of ensuring that fund manager bonuses are aligned more with fund performance and less with assets gathered or profits of the company.

Not very complicated questions - but the answers you get may give you a good idea of the robustness of the company's policies and processes. There are of course many more questions that you can ask - and many large distributors already do that - but, if you haven't started formally asking any of these questions, at least you can start with these 4 questions above. Your comfort with the AMC on these aspects plays a crucial role in your confidence in the funds you recommend.

Just as an AMC needs to do due diligence on its distributors to satisfy itself that the distributor has adequate processes in place that enables him to sell appropriate products to his clients based on suitability, the distributor has an equal responsibility to carry out his own due diligence on the AMC whose products he sells, to satisfy himself that the company has adequate processes in place to invest his clients' money appropriately. After all, due diligence has to be a two way street.

What do you think ?

Do you think due diligence is a two way street? Do you think you need to satisfy yourself on the basic due diligence parameters listed out above? What are some of the other qualitative parameters you use in deciding fund houses where you have greater confidence in? Share your thoughts with fellow advisors across the country - its YOUR forum !