Discretionary risk does not disappear from systematic investments. It relocates.
Ask most investors to explain the difference between an index fund and an actively managed fund and you will get a version of the same answer. One follows a rule. The other follows a person. Risk, in this telling, is the price you pay for the person.
It is a clean distinction. It is also wrong, and it becomes more wrong the further you travel from plain-vanilla products into the categories where Indian investors are now being offered wider mandates. The investor who believes he has escaped human judgement by buying a rule has not escaped it. He has bought a decision that someone made in advance, on his behalf, and wrote down.
That is not a criticism of rules. It is an argument that we have been measuring the wrong thing.
The rule-writer never left the room
Consider what has to happen before a broad-market index can exist.
Someone decides how many names it will hold, and why that number. Someone decides that eligibility requires a minimum trading history, a minimum liquidity threshold, availability in the derivatives segment. Someone decides that weights follow free-float market capitalisation rather than equal weighting, or revenue, or earnings, each of which would produce a different portfolio and a different experience. Someone decides that the constituent list is reviewed twice a year and not monthly, and that changes take effect on a published date that the whole market can see coming. Someone decides what happens when a company demerges, when a large listing is fast-tracked into the index, when a single name grows so heavy that a cap has to be imposed and stock has to be sold for a reason that exists nowhere in the index construction logic itself.
None of that is mechanical. Every line of it is a judgement, made by a committee, subject to revision, and consequential. The index that an investor treats as a neutral description of the market is in fact one particular opinion about what the market is, maintained by a body that meets on a schedule.
Factor strategies make the same point more visibly. Two funds can both claim to buy quality. One defines quality as return on equity and low leverage. Another adds earnings stability and accruals. A third screens out financials because the ratios do not translate. These are not different implementations of a settled idea. They are three different ideas wearing the same word, and the investor chooses between them without usually knowing that a choice is being made.
Even execution is discretionary. When a rebalance forces a sale, does it happen at the close, over three sessions, at a volume-weighted average? Front-running around index changes is a documented cost, and how a manager handles it is a decision that shows up in the investor’s returns and in no fund’s marketing.
So the honest statement about a rules-based portfolio is not that it contains no discretion. It is that its discretion was exercised at design time rather than continuously, written down rather than held in a manager’s head, and disclosed to the investor before he committed capital.
Which suggests the axis we should have been using all along.
Bounded, and disclosed
Discretion is a constant. What varies is how far it can travel and whether you were told the distance.
A bounded mandate constrains what the manager is permitted to do regardless of what he believes. He may hold only listed equity, only within a stated market-cap band, with a ceiling on any single name and a floor on the number of holdings. His conviction is irrelevant at the boundary. He may be certain, and the boundary still holds.
A disclosed mandate tells you where that boundary sits before you invest, in a document you can read, in language specific enough to be tested against the portfolio afterwards.
These two properties are independent of each other, and every combination exists in the market. A tightly bounded, fully disclosed strategy is the most legible thing you can own. A widely bounded, fully disclosed strategy asks more of you but hides nothing. A tightly bounded but poorly disclosed strategy is a portfolio you will misunderstand in ways that only surface under stress. And a widely bounded, poorly disclosed strategy is the arrangement that has produced most of the unpleasant surprises in the history of pooled investing.
Two things follow, and both cut against instinct.
Bounded does not mean conservative. A mandate to hold the market in proportion to its capitalisation is one of the most tightly bounded instructions in existence, and it obliges the investor to become progressively more concentrated in whatever the market has already become concentrated in, at exactly the moment that concentration is most expensive. The bound is narrow. The risk is not small. It is simply a risk the investor agreed to in advance and stopped noticing.
And wide does not mean reckless. A mandate that permits a manager to take unhedged short exposure through derivatives, capped at a published fraction of net assets, is a wider bound than a long-only equity mandate. It is also a published one. The investor who reads it knows precisely the worst case the structure permits. Width that you can see is a different object from width that you cannot.
The failure mode, then, is neither discretion nor width. It is drift: the gap between the boundary as disclosed and the boundary as practised. A fund described one way and positioned another. A strategy that quietly migrates down the capitalisation curve, or up the leverage ladder, or into instruments the investor did not know were permitted. Drift is not visible in a monthly factsheet. It is visible in the mandate, if you read the ceiling rather than the average.
The worked example
Specialised Investment Funds are useful here precisely because they are new enough that nobody has settled into a comfortable misunderstanding of them.
SEBI created SIF as a distinct regulated category positioned between mutual funds and Alternative Investment Funds. It carries a minimum investment threshold that deliberately narrows who is offered it. It is launched by asset managers who meet specified eligibility conditions, under a brand kept separate from their mutual fund business. And it permits strategies that a conventional mutual fund cannot run, including the use of derivatives beyond pure hedging, and exposure that is short rather than long, subject to ceilings that are stated in the offering document.
The reflexive reading is that SIF is riskier because the manager has more freedom. That reading fails the test we have just built.
What SIF does is not add discretion. Discretion was already there, in the index committee, in the factor definition, in the execution desk, in the fund manager’s tilt away from benchmark within the tracking error he is permitted. What SIF does is widen the bound and require that the widening be written down. The strategy has to state its objective. The permitted instruments have to be enumerated. The ceiling on unhedged derivative exposure has to be published. The investor who wants to know the worst case the structure allows can find it, before subscribing, in a document.
That is a category that has moved along the width axis while staying firmly on the disclosed side of the disclosure axis. It is a different proposition from a long-only equity fund. It is not a less legible one.
Whether an investor wants that width is a separate question, and it is a real one. Wider bounds mean the manager’s judgement has more room to express itself, which means more of the outcome is attributable to him and less to the asset class. That is a genuine transfer of risk, from market to manager, and it should be made deliberately by someone who has decided he wants it. What it should not be is refused on the reflexive ground that flexibility is dangerous and rigidity is safe. The rigid mandate concentrated you in six stocks and told you it was diversification.
What to ask
Three questions do most of the work, and none of them are about past returns.
Where in this process is a human deciding, and when? Not whether, but where. If the answer is that all the deciding happened at design time, ask who reviews the design, how often, and what would cause them to change it.
What is the widest thing this mandate permits, as opposed to the typical thing it does? The factsheet describes behaviour. The offering document describes permission. Only one of them tells you what you own when conditions change.
What would cause this manager to deviate, and would I learn about it before or after? A boundary that can be moved without notice is not a boundary. It is a preference.
The question “is this fund discretionary?” has one answer, and it is yes. Every rule was written by someone. The question worth asking is where that someone sits, how far the rules let him travel, and whether anyone told you before you signed.
This is worth understanding, particularly if you are being offered a category you have not held before. If it is relevant to your situation, it is worth a conversation.
Gandhar Pramod Nigudkar Gandhar Financials, Goregaon West, Mumbai +91-7477858577 | contact@gandharfinancials.com | gandharfinancials.com
This content is for educational purposes only. It is category-level information intended to aid investor understanding and does not constitute investment advice, a recommendation to buy or sell any security or scheme, or an assurance of returns. Investments in securities markets are subject to market risks. Read all scheme-related documents carefully before investing.
AMFI Registered Mutual Fund Distributor (ARN-296406) | SIF Distributor | APMI Registered PMS Distributor (APRN07477) | IRDAI registered Insurance Distributor (128320)