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Posted by: Uma Shashikant on Fri, May 4th, 2012

Nurturing Financial Advisors - Part 2 - Why Variable Asset-based Fee is Needed

All advisors including portfolio managers, fund managers and financial advisors build reputational capital based on performance. To make this viable they need to earn a variable fee for assets under management or assets under advice.  The economic incentives an expert advisor will require will be high.  By recommending a fee from investors, which is currently understood as a fixed annual fee, Sebi has delinked the earnings from the volume of assets under management or advice.  Para 9 of the discussion paper also explicitly bars the advisor from holding the assets or securities of the investor.  This can be interpreted to mean that financial advisors would not directly control assets of investors. 


Asset-linked Fee

It can be argued that without an asset-linked variable fee, any form of expert advisory business will turn unviable. Fund management and portfolio management, for example, is executed through a well regulated structure of custodians, but the fee to the manager is variable and is a percentage of assets under management.  There is no reason why financial advisory should not have a similar incentive structure that enables earning for assets under advice.  Not being able to earn a variable fee will not only make it unviable and expensive to be an expert financial advisor, but also make it financially more attractive to be an agent or distributor who continues to earn a variable fee (trail commission).


Limitations of “let the investor pay” model

The critical principle on which there seems to a firm stance among regulators across the world, and rightly so, is that an advisor whose recommendation should be in the interest of the household, should not earn a variable fee from the product manufacturer.   This means that the advisor will have to earn the variable fee from the household, whose assets he advises.  There are three problems in assuming that this can be easily done:

  1. The restrictive role of an advisor is to only indicate how assets would be allocated. As long as the execution of advice is through various agents, neither the advisor, nor the investor will be able to holistically manage the assets under advice.  The basis for charging or paying a variable fee will not exist. Investors will prefer a fixed fee to a variable fee.
  2. The product manufacturer pays a variable fee to the agent for selling the product, but asking the agent to share this fee with the advisor will bring back the conflict of interest issue, through the backdoor. 
  3. The product manufacturer may be willing to pay the advisor for recommending his product, but such fee is easily paid to those that execute the transaction, than those that advice the product, since identifying who advised a product may be tough when the point of execution is the agent.

Why performance-linked fee is required

Product manufacturers such as mutual funds, insurance companies, pension funds, private equity funds and venture capital funds are able to charge an annual fee from the investors for managing their funds.  They are able to aggregate investor assets and manage them centrally, making it operationally easier to charge a fee.  As long as this fee is also performance-linked (as is the case in a mutual fund where the fee is a percentage of net assets that are marked to market) there is a direct incentive for the managers of these assets to focus on performance and be competitive. Assets are known to move away from poorly-performing funds to better-performing funds.


Unless a similar rigorous framework that links fee to the performance of assets under advice is implemented, financial advisory would become a market for lemons.  The proposed fixed fee would be reduced by those that continue to perform transactions, leaving little on the table for good advisors. A fixed fee  absolves advisors from being penalized for wrong advice. It also creates operational difficulties in rebalancing the portfolio. Without assets under advice being subject to regular review, advisors will be reduce to one-time fee collectors from investors. There would also be no scope to compare and choose advisors based on the performance indicators that demonstrate the quality of their advice.


Concluding part of this series will be published on May 05, 2012.

Vijay Mehta on Sun, May 6th, 2012 10:33:45 am

SEBI seems to be naive in thinking that by adopting adviser-agent model,all the ills of the mutual fund industry can vanish instantly? Can SEBI guarantee that there will be no conflict of interest in an adviser's advice? Just as a doctor insists on medical tests being done at a particular laboratory,so too an adviser may informally insist on routing the investments through a particular agent! Moreover, adviser model can still work provided investors realize the quality of advice, qualification and experience of the adviser. But with investor awareness being low (even SEBI has accepted so in its draft guidelines); does SEBI really believe that advisers can charge fees commensurate with his/her experience/ qualification? After all an adviser also needs to make a decent living....

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