Non discretionary portfolio management

Last month, the Reserve Bank of India (RBI) released draft guidelines on wealth management by banks. I have no quarrels with the steps that the RBI has taken to reduce mis-selling. My comments are related to something that they did not change:

4.3.2 PMS-Non-Discretionary

4.3.2.1 The non-discretionary portfolio manager manages the funds in accordance with the directions of the client. Thus under Non-Discretionary PMS, the portfolio manager will provide advisory services enabling the client to take decisions with regards to the portfolio. The choice as well as the timings of the investment decisions rest solely with the investor. However the execution of the trade is done by the portfolio manager. Since in non-discretionary PMS, the portfolio manager manages client portfolio/funds in accordance with the specific directions of the client, the PMS Manager cannot act independently.

4.3.2.2 Banks may offer non-discretionary portfolio management services.

...

4.3.2.3 Portfolio Management Services (PMS)- Discretionary: The discretionary portfolio manager individually and independently manages the funds of each client in accordance with the needs of the client. Under discretionary PMS, independent charge is given by the client to the portfolio manager to manage the portfolio/funds. ... Banks are prohibited from offering discretionary portfolio management services. (emphasis added)

I am surprised that regulators have learnt nothing from the 2010 episode in which an employee of a large foreign bank was able to misappropriate billions of rupees from high net worth individuals including one of India’s leading business families. (see for example, here, here and here).

My takeaway from that episode was that discretionary PMS is actually safer and more customer friendly than non discretionary PMS. After talking to numerous people, I am convinced that the so called non-discretionary PMS is pure fiction. In reality, there are only two ways to run a large investment portfolio:

1. The advisory model where the bank provides investment advice and the client takes investment decisions and also handles execution, custody and accounting separately.
2. The de facto discretionary PMS where the bank takes charge of everything. The fiction of a non-discretionary PMS is maintained by the customer signing off on each transaction often by signing blank cheques and other documents.

When you think carefully about it, the bundling of advice, execution, custody and accounting without accountability is a serious operational risk. One could in fact argue that the RBI should ban non-discretionary PMS and allow only discretionary PMS. Discretionary PMS is relatively safe because the bank has unambiguous responsibility for the entire operational risk.

The only argument for non-discretionary PMS might be if the PMS provider is poorly capitalized or otherwise not very reliable. But in this case, the investor should be imposing strict segregation of functions and should never be entrusting advice, execution, custody and accounting to the same entity.

Posted at 1:59 pm IST on Sun, 7 Jul 2013         permanent link

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