Performance validation

Sebi's proposal will aid all investors

The Securities and Exchange Board of India (Sebi) has released a consultation paper proposing to create an independent “Performance Validation Agency”, or PVA, for tracking and validating any claims of performance related to investment advice given by Sebi-registered intermediaries and other entities such as investment advisors (IAs), research analysts (RAs), portfolio managers, asset management companies, and stockbrokers. Such an agency would be useful to investors, who currently have no means of verifying performances of financial advisors. From the perspective of IAs or RAs also, such a PVA would be useful since it would enable them to credibly showcase performance and thus attract investors. Currently any claims such entities may make could be inflated, or could rely on cherry-picked data, and, in any case, are impossible to independently verify. Several private players in fact have attempted to put performance validation systems in place. But these are voluntary and remain hard to independently verify.

A PVA will have to handle large amounts of sensitive financial data and maintain confidentiality. Moreover, it will have to be conversant with processing diverse types of recommendations and orders, and also must possess an understanding of algorithmic trading systems since these are often offered to traders. This requirement — the need to understand and process financial data pertaining to securities trading — makes a PVA a natural fit with market infrastructure institutions (MIIs), such as the exchanges and depositories, since these entities handle enormous amounts of exactly this kind of data. Hence, the regulator is suggesting that ideally any such PVA could be a wholly owned subsidiary of a single MII, or an entity owned by multiple MIIs. The PVA will have to validate claims and performances related to investment advice including stock recommendations, mutual fund schemes, portfolio management services, algorithmic trading, and so on. The paper doesn’t delve into the question of whether signup with the PVA would be mandatory or voluntary for intermediaries but market forces would induce signups anyway.

A PVA will validate claims on specific parameters like returns, risk, volatility, and any other key performance areas as may be decided in consultation. It will also have to work with other “knowledge partners” such as credit-rating agencies when necessary and it should be allowed to charge a “reasonable fee” for its service. Such an agency will have to create systems and processes for maintaining data and grievance redress, and share data with Sebi and other regulators as required. Importantly, Sebi suggests that such validation should always be carried out for all clients of the registered intermediary, which needs performance validation. It should not be done selectively for specific clients. The performance of algorithms should also be checked by testing the algorithms during a “reasonable test period”. The performance of all such algorithms shared with the PVA for validation shall be displayed on its website. If any public recommendations are made, those should also be displayed with performance. In other cases, where recommendations are not public, restricted access may be offered to the clients concerned only. The core principle for validation will have to be that there will be no selective cherry-picking of favourable events, strategies, or clients. Also, any claim should be independently verifiable from sources other than the entity making the claim. Such an agency will be useful to all stakeholders.