Posted by: Uma Shashikant on Mon, Sep 20th, 2010
Mutual Funds: Fee-based Selling Alone Won't Do
Many seem to think that fee-based advisory is the only way to do financial product distribution. I argue the need to allow a range of services, in the interest of growth and expansion of the business. Allowing only fee-based advisory may shrink the markets and may leave out the small investor.
Clamour for the Ideal
The fee-based advisory model has a ring of nobility to it. It is ideal in more ways than one. First, it empowers the investor to pay with discretion, for the services received from the advisor. Second, it delinks the income of the advisor from the commission paid for selling a product, so that advisors do not push a high commission-paying product that may be ill-suited to the investor. Third, it compels advisors to enhance the value-added in their transactions with the investor, as the only way to demand and get a higher performance-linked fee. World over, the fee-based advisory model is lauded for its goodness and for its ability to link the advisor fee to investor interests. But it has not emerged as the only model that has prevailed over all others. Why is this so?
What is the downside to the model? Fee-based advisory assumes that advisors should be full-service managers of the investor portfolio, reviewing, rebalancing and working to the financial planning goals of the investor. It precludes a ‘transaction-only’ module of distribution, where investors may like to only buy a few financial products not necessarily from a single advisor. Financial product distribution involves various levels of engagement with the client - from a basic single-transaction model to the more intensive family office that manages the entire wealth of the customer. Fee-based advisory oversimplifies this hierarchy of engagement and its pricing.
Fee-based advisory also assumes that all advisors will be able to make the investment in product and performance research, in technology-enabled platforms and in customer relationship management systems. The costs of advisory are by definition high this model. Fee-based advisory may end up not creating adequate incentives for market penetration and expansion. It may instead provide higher incentives to hold and manage larger clients rather than service small-ticket size transactions. It would also move the business away from entrepreneurial individual advisors, to institutional distribution networks that can make centralized investments in research and technology.
How about Stocks?
Consider investing in stocks for example. There are issuers who are required to provide disclosures as required by regulation on what they are offering to clients. Then there are brokers who simply enable transactions and earn a fee; and there are brokers who invest in and sell research and recommendations. There are institutional investors who invest in research and analysis and offer solutions to other investors for a fee. There are speculators who stake their capital and trade on markets. The market has expanded because of its ability to offer the space for various types of players. We are unable to argue that there is no product pushing (tips and trades, for instance) ‘harmful-for-investor’ practices (uninformed investors throng broker offices for day trades as the only way to profits) or mis-selling (IPO frenzies). We seem to have acknowledged that within a fair regulatory framework, various business models will prevail. The prevalence of a large number of players has also ensured competition and the need for players to build reputational capital as the key differentiator.
The assumptions in the mutual fund industry space are, in sharp contrast, very simplistic. Producers assumed for a long time that commission-linked selling of newer and newer products would grow their markets. It resulted in expansion of the markets, but at a great reputational risk to the industry and its advisors. The assumption that SEBI is making, to sure this malaise, is also simplistic. They assume that there should be space for only those advisors who can offer a full-service financial planning solution to the client for a fee. To assume that only one of the many distribution models is superior to all others, will lead to shrinkage of markets, as we have seen in the last year.
Enable a Range of Services
In the mutual fund space, it is important to recognize the need for diversity in services to investors, in the interest of market development, expansion, product penetration and nurturing of various models of investment advisory business. Offering mutual funds on stock exchange platforms does not fit the bill, only because the transactional efficiency of brokers is based on non-delivery based, margin-paying transaction-based model dependent on short term investors. They are unlikely to find the incentive to sell delivery-based long-term investment products like mutual funds. The need is to provide for a range of service providers - from those that enable simple transactions, to those that can offer a full-fledged advisory service for a fee.
What is needed is a calibrated approach that recognizes the range of services and creates incentives in a manner that aligns investor interest with the interest of the industry and its advisors.
Rajesh Pai on Mon, Sep 20th, 2010 6:21:08 pm
I agree with your viewpoint that a Fee based advisory model alone will not do. This model may suit certain HNIs and the distributors may also be in a position to recover their due fees from such investors, but this model may not work for the smaller investors, especially from the distributor point of view, in recovery of the fees for the services of the distributors. This could result in the distributors neglecting such investors which eventually leads to these investors being left out which is not the spirit or the intention of the regulations / regulatory framework. Hence there is a need for differential methods of fee charging based on different classes of investors. One option could be to have a fixed standard fee across the mutual fund industry for each type of investment (equity, debt, balanced, structured products). This will ensure that there is no added incentive to a distributor for promoting any particular fund house / investment. This will also ensure that the investor gets unbiased advice on his investments. This still leaves us with the question of how the distributor would get his fees. The possibility of the fund house paying the fees (on a trail basis) to the distributor on the basis of the tenure and the amount invested should be considered with due approvals from the regulator with full transperancy to the investor. This should be clearly disclosed to the investor as a separate fee (over and above the Fund fees and expenses limit). This will address the distributor's concerns too for the payment of his legitimate services. In any case, the investor has a right to change the distributor if he is not satisfied with the services.
Chandra on Mon, Sep 20th, 2010 6:16:15 pm
Good article. As an online financial services provider we fully agree with the philosophy of offering a range of services to the customer and let the customer choose the right service that he/she wants to. Some investor wants hand-holding, some want to do on their own and others a combo of the two. There is space for all levels of service offerings in a country like India.