Nurturing Financial Advisors - Part 3 - Don't oversimplify "Investors can and will pay for advice"

Posted by: Uma Shashikant on Sat, May 5th, 2012

Advisor as top-down asset manager

If the fee for managing assets, creating and reviewing a portfolio is with the fund or portfolio manager, the fee for asset allocation and keeping the funds in these portfolios should go to the financial advisor. The fee to a fund manager is the payment for a bottom up research of companies, selection of securities and review of the portfolio.  The performance indicator here is the beating of peers and the benchmark in terms of relative return. The fee to an advisor is a payment for top-down research of macro indicators and strategic and tactical allocation to various asset classes, selection and review of portfolios and products.  The performance indicator here is the absolute return required for the stated goal of the investor, within accepted levels of downside risk.  The financial advisor should earn a fee based on asset performance, just as a fund or portfolio manager does.  Else there is no incentive to specialize, invest in expertise, increase assets under advice, or compete efficiently with peers.

 

Why the Sebi step was ill-thought out

But it is in the payment of the fee that we have tied ourselves up in knots.  An advisor uses multiple products, not just funds.  The fee for each of these product types is not unfirms, both due to market forces and due to presence of multiple regulators.  An advisor would earn therefore varying levels of ongoing fee for assets.  For example, in advising on acquisition of a property, the advisor may settle for a different level of on-going fee, given the large ticket size of the asset; for an advice on cash-like assets he may charge no on-going fee at all, since it would get deployed into another asset.  Even then, it is operationally difficult to agree upon a variable fee with the client, though that may be the direction to take. After establishing the framework for evaluating an advisor’s performance, its measurement, disclosure and value to investors.  We have not even begun this exercise in India yet.

 

In the interim therefore, it may be easier for the product manufacturers to share a part of their variable fee with the financial advisor, however unpalatable it may sound to regulators fixated on manufacturers paying nothing to advisors.  If assets are brought in by the agent, a token commission on mobilized amounts can be paid to the agent.  If the assets are retained by the product manufacturer, because the advisor continues to recommend the product, the trail commission, which is a part of the annual fee charged from investors, should be payable to the advisor. The conflict that most fear perhaps can be plugged using an easier mechanism of simply mandating a fixed trail rate for each product category.  If all equity funds pay a 0.40% of net assets as trail commission per annum, disclosed upfront by both manufacturer and advisor, the advisor earns more only by recommending more of a performing fund.  By paying the trail to the agent distributor who brings in the money, we already have the bad incentive of investors paying for no tangible service.  This is an anomaly that needs correction.

 

Churning the investor from one fund to another by an advisor,  may result in loss of revenue if the choice of funds was wrong. The onus of recommending the right product is with the advisor who should earn the trail commission, and the agent earns a small token commission for his limited role.  As an extension of this principle, the exit load currently charged to the investor can also be collected from the advisor, who takes the responsibility for what he recommends to buy or to sell.

 

This model ensures that it is viable for someone to focus on becoming an expert financial advisor.  It also integrates the financial advisory profession with the known models for fund and portfolio management, where annual, variable performance-linked fee is the norm.

 

Advisors vs Agents

Agents who have made a disproportionate amount of revenue by merely pushing products and completing transactions, will have to move lower in the pecking order, to make it viable for advisors to find a space in the value chain.  Manufacturers will favour agents to push products, as long as they have a direct access to simple resources that have the ability to gather assets.  Regulating upfront commissions may also be tough to implement.  A simpler solution would be to make the agent subservient to the advisor.  It should not be possible for an agent to sell a product to an investor, unless the product is specifically recommended by an advisor.  The advisor would hold the power to recommend, and the agent would only implement the recommendation.  It is easier to create exceptions for index funds and such over-the-counter products that may not need advice before being bought.  It may also be possible to create a sub-category with no trail fee, which investor can buy without advice.  Manufacturers will have adequate assets to manage to be worried about this category that has to push itself to the investors, based on lower expenses, while investors will have the choice should they wish.

 

If we define the agent as one who simply focuses on completing financial transactions and associated paperwork, two outcomes are possible:

  1. Commissions to agents would drop, since barriers to entry in a low-skill profession are low. For example, since mutual funds would pay out the trail to advisors, and there is no entry or exit load charged to customers,  product manufacturers may be willing to pay less and less for mere asset mobilization.
  2. It may be viable for technology solutions to be set up, that mechanically enable allocation of client assets across product manufacturers.  Banks and institutional advisors may find it viable to set up such platforms, that can wrap multiple financial solutions for their clients and implement financial advice seamlessly.

 

The concept paper suggests "Chinese walls" when agency and advisory reside together in an institution.  These need to be clearly and more elaborately defined.  It is possible to move to a "free" distribution model where advisors earn enough variable revenue from assets they advice, that they would need no commission from manufacturers.  Regulatory action should consider such possibilities, before recommending a strict division and bifurcation of advisors and agents.

 Posted by Shrinil Shah on Sun, May 26th, 2013 10:13:57 am

If advisor has to pay for everything then why advisor should remain as functionary? The major role is played by the Advisor to look into the portfolio of the investor. At the end the investor is going to make the advisor responsible and not the agent. The advisor is responsible to Fund House, SEBI, Investor. Dont youthink he is eligible for that larger share? Please give your comment ma'am.
 Posted by Abhinav Gulecha on Sat, May 19th, 2012 10:46:44 am

Hello Mam Thanks a lot for the three part series. It was very informative and gave me several new perspectives. Also thanks to Mr. Srikanth from Funds India for a very well thought out comment and alternate perspective. Rgds Abhinav
 Posted by Srikanth on Sun, May 6th, 2012 8:52:22 pm

Uma,Thanks for the series of articles. It presents a reasonable argument for a fair financial product distribution architecture. However, there is atleast one structural flaw, and a few practical issues with this model.


The structural flaw is about self-service clients. You touch upon this briefly in the third part, but the solution that you propose in passing is inadeqate. Your articles assumes a very clean three tier structure in the form of manufacturer, agent and advisor. In reality, the picture is more cloudy. Sometimes, the manufacturer influences the decision of the buying directly (ads, NFOs, index funds, structured products like lifestyle funds etc); sometimes, a client does their own planning, asset allocation and product selection. In between these there are other methods such as social influences, advise from newspaper columnists (I'll plead guilty to this one), and many more. Your suggestion is to treat all this as one and create a separate product class for such situations with less managment fees (by eliminating trail). What will end up happening is that once there is a cheaper variant available, everyone (including the advised client) will always want that variant resulting in a negotiation with the advisor or the advisor will have to hide this detail from the client. Then, the client will feel grieved later that the advisor sold him an expensive variant when a cheaper one was available.


Also, there are situations where there are packaged and programmatic recommendations provided to clients by smart systems. At FundsIndia (where I work), we have pre-packaged portfolios for several purposes and risk categories available for our investors. We also have a pretty nifty algorithm that takes an investor's profile, requirement, time-frame, and amount of investment to create a personalized SIP portfolio. Anyone can use these methods of getting "advice" from us, and invest. There are other online platforms that do atleast the packaged portfolios for their clients. It is impossible to keep track of who invested after seeing this, and who invested on their own. Our system, at least in such cases, is not a mere order routing system with a pretty interface.


One solution would be to create different classes of investors and sell different classes for funds to each of them. However, it will be very easy to defeat such a system - all you need is one investor in the higher class, and an entire social circle will be able to access our recommendation services. It would be much more elegant to be egalitarian about it and give them all the convenience and a same set of funds.


The reason these alternate methods of advice are important is that we need a scalable advisory model. We need to be able to leverage technology to help advice a large number of clients do proper financial planning, allocate assets wisely, and choose good products in their portfolio. The model that you propose is a human model that is not sufficient currently, and hard to scale anytime soon.


Also, obviously, any advisor would choose to go to the creamiest of clients so that they can make the most money with minimal or focussed effort leaving large segments of middle-class population fending for themselves or as would more often be the case, be sold "differently regulated" products.


The other practical issue relating to your solution is on the business side of the equation. The distribution business is not sustainable without trail fees. As you very well know, the equity broking business is struggling right now due to low trade volumes and the brokers are facing unhappy decisions to up their charges and lose clients. The mutual fund market has FAR fewer transactions compared to equities, and even a scalable technology platform will not be able to sustain as a business without AUM-based recurring fees. The equity broking business can get away with urging their clients to churn their portfolio (sell calls and stop losses and profit bookings and what not) and make up brokerage. In the mutual fund business where we are talking long term holds, that would be a terrible thing to do, obviously.


Also, from an investor's point of view, he is already is feeling that the fund management expenses that he pays are sufficiently high for the services he is getting for forking over his cash. To add another layer of transaction fees to the equation would be completely unacceptable to him.And I am already talking about a scalable technology solution - in your model, you can forget about street-side human distribution network. As it is frequently pointed out, mere distribution agent fees will not even cover the commute expenses.


So, at the end of the day, what will happen is that MF distribution in isolation will cease to be a business and advisors will end up taking care of fulfillment as well - which will get us back, nicely, to the present status quo. Separately, of course, I assume that the model that is presented would be cross-industry - covering insurance related products as well. If not, any implementation of such a model would make the insurance industry very happy.


In summary, let me make these points:


1. Mutual funds are structurally sound products that are well-regulated. Since the ban on entry loads, the arbitrage between high commission funds and low commission funds have reduced dramatically, and churn is minimal. Yes, theoretically, there is an argument to be made for an advisor having a conflict of interest between the manufacturer (who pays him) and client (who is serviced). However, in reality, this concern is overblown. To create a perfect, provably correct system would be a theoretically fulfilling exercise but will have ruinous effect on the market with the impact felt most by the very investors it is trying to shield.


2. Any remnant of churn and consequent investor disservice can be effectively addressed by rationalizing up-front commissions with trail commissions thus aligning the intersts of the advisor/distributor, client and the manufacterer.


3. In the larger context of an industry-friendly IRDA, and an RBI that turns a blind-eye to malpractices and mis-sellings at grass-root bank level, any MF only regulation will be disastrous to the industry.


Thanks, Srikanth FundsIndia.com

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