Honey, They Shrunk the Money

Samantha de Bendern is an analyst of European political trends. She has worked with the European Commission and NATO
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Can you trust your financial advisor? Will Sebi’s new regulations make it any easier?

On 21 January 2013, India’s regulator of capital markets, the Securities and Exchange Board of India (Sebi), issued a set of regulations for investment advisors. It stipulates that all those whose primary professional role is to offer investment advice must obtain certificates of registration from Sebi. This requires both educational and financial-adequacy qualifications. Only then can they formally call themselves investment advisors. They must also disclose any conflicts of interest they may have (if, for example, they are beneficiaries in some way of a company that sells investment packages). News of these rules has already created a stir. The clause that could create an upheaval, however, is one that bans advisors from receiving commissions on the products they sell. From now on, they must base their remuneration solely on fees paid by the client.

A similar law that came into effect in the UK on 1 January this year took six years of intra-industry consultations to draft and is transforming the business of investment advice there. Sebi’s new regulations also have the potential to transform the financial advisory business in India. But before going into their details, let us turn the clock back a few years with a personal illustration that explains why change is welcome.

In March 2007, when I was working as a wealth manager in a large American bank in Europe, we were given an intensive two-day training course in CDOs: collateralised debt obligations. The now infamous financial instruments which have become synonymous with the global 2008 financial crisis were presented to us as the investment to propose to clients: they offered the holy grail of low risk, high returns and big fat commissions for bankers.

  The only drawback was that they were somewhat complicated (so much so that it later emerged that many banks trading them did not really understand how they had been put together). Hence the training course. It was conducted by the traders who were structuring these products, and at the end of it, we were given an upbeat sales pitch, emphasising that CDO sales would generate a 3-per cent commission for each banker.

“Why do we get such a high commission,” I asked, “as high commissions are usually reserved for high-risk financial products and these have an AAA rating?” Our trader-trainer sighed in exasperation. This was the last of many questions (what exactly they were made of, how one could be sure of their low risk, and so on) I had been nagging him with for two days. “The way these products are constructed allows us to factor in high commissions ,” he said, adding that this was a wonderful deal being offered to us private bankers, with fantastic profits we could pass on to our clients.  I shrugged, none the wiser, and ended up blaming my inability to comprehend what my colleagues were embracing as a wonderful opportunity on some flaw in my own thought process. And since I could not figure out what CDOs really were, I stubbornly refused to sell any to my clients. 

At my midyear review a few months later, I was berated for not having any CDOs in my clients’ portfolios.  Moreover, with equity markets at an all-time high, I had advised some of my more risk-averse clients to exit equities and discuss reinvestment opportunities after the summer. This was also a ‘problem’ for my review manager, because the bank was earning very little with my clients’ money sitting in money markets or fixed deposits. I defended my position saying that these clients had enjoyed huge returns over the past year, and that they, I, and even the bank’s own research department felt uncomfortable with the way equity markets were heating up. My reviewer just looked at me and asked: “Who actually are you working for? The bank or the clients?”

  That question was, of course, spot on: my job was first and foremost to make money for the bank, and the interests of clients, while important, were secondary. While the above may be a stark example, one followed by an extreme sequence of events that began in late 2007, it sums up the way the wealth management industry was—and by and large still is—run almost all over the world.  Indeed, whether you are a regular retail client or ‘high networth individual’, your bank, your financial advisor and your insurance agent typically earn most if not all their income on commissions from financial products they advise you to invest in. Generally, the riskier the product, the higher the commission. And if the money is not invested in ‘high-return’ products, no matter whether or not the timing is actually good for you, the bank loses out. This should make customers wary of acting on the word of ‘advisors’ who are incentivised to maximise the returns of those who pay them: that is, product-pushing corporate entities.

Since the crisis, banking regulations have been tightened the world over, forcing banks and all other actors in the financial advice industry to offer greater transparency on the products they sell and on the commissions these products generate.

To address what the Nobel laureate economist Joseph Stiglitz calls ‘perverse incentives’ in the financial sector, regulators and industry players in many parts of the world are now discussing banning commissions altogether and effecting a shift to a fee-based remuneration model. The UK is the first country to have introduced comprehensive and unambiguous legislation on the matter, Australia and Denmark are considering similar measures, and Sebi’s new regulations are a step in the same direction. Only a step because shielding consumers from unethical practices would still need to overcome two big problems: loopholes in the regulations and the behaviour of consumers themselves.

While Sebi’s order, as outlined earlier, requires all investment advisors to register themselves, individuals or firms for whom financial advice is ancillary to their activities need not register. This includes lawyers, chartered accountants, insurers, distributors of mutual funds, fund managers, pension advisors and even stock brokers. In other words, most of those to whom people turn for advice can keep at it without charging advisory fees, and even get commissions on the products these people invest in.

According to Uma Shashikant, managing director of CIEL, a Mumbai-based financial education and training company, while the direction of Sebi’s move is commendable, it will leave large numbers of ‘advisors’ unregistered and still operating on commissions; they will not be able to call themselves ‘investment advisors’, but since most consumers are hardly aware of the distinction between a registered advisor and any other professional who offers such advice, this would be of no consequence. Moreover, she believes that many consumers will not be willing to pay for a service whose value they cannot fully understand and which many assume to be free. 

  On this, consider the UK experience. Among the hurdles to a fee-based system, consumers had to be persuaded to start paying for a service they had hitherto assumed to be free. A study by the UK’s Financial Service Authority (FSA) in December 2012 revealed that 50 per cent of them believed they had been getting free financial advice; they had not realised the hidden cost of a sliver of their own funds being channelled back to advisors as commissions.

Consumers had to be educated on the value of paid-for advice, and even then the FSA estimates that many retail customers will opt for the non-fee-based sort. 

Anshu Kapoor, head of global wealth management at Edelweiss Financial Services, says that in India not only do clients not want to pay fees, they have somehow been co-opted by the commission system, with advisors often sharing their cuts with them. He also suggests the possibility that customers reluctant to pay fees would be tempted to pay heed to salesmen of insurance and real estate-based financial products (who incidentally get hefty commissions). This could create parallel markets, with similar products under the supervision of different regulators (the insurance sector has its own, for instance), resulting in much consumer confusion and vulnerability.

Shashikant also argues that the qualification criteria are so wide—from MBAs and chartered accountancy to various finance degrees—that it does not really count as an assurance of advisory specialisation. “We are trying to press Sebi to create a mandatory certification programme for all who want to call themselves investment advisors,” she says.   Such standardisation would help customers discern those who are equipped to offer advice from those who manage to scrape past the qualifiers.

That is not just an Indian problem. In the UK, the FSA now insists on higher educational qualifications for all financial advisors (equivalent to the first-year of a degree course in Finance) to ensure that industry standards improve and in the hope that this encourages customers to pay fees. As a result, the FSA estimates that about a quarter of existing financial advisors (mainly older ones) will be forced out of the field. The FSA also estimates that UK financial institutions have spent an average of two years training staff and improving their qualifications for the 31 December deadline. 

As all this has been happening in a country with one of the world’s most sophisticated financial sectors, it would seem that India still has a long way to go. There is, however, some good news. India’s relative immaturity as a market for financial advice could be a blessing in disguise: reforming customer behaviour could be easier and a younger and presumably more flexible workforce might be easier to re-train. Moreover, the very fact that Sebi has made such a bold move indicates a willingness to tackle an issue that few national regulators elsewhere are willing to confront so directly. 

  THIS IS NOT just a regulatory issue, however, and not just an Indian one either. Himanshu Kohli, founder of Client Associates, a private wealth management firm that has been offering fee-based advice for the past 11 years, highlights subconscious attitudes towards money as another obstacle to a fee-based model. “There are clients with significant portfolios who are reluctant to write a cheque even though they know that similar amounts are being deducted from their investments through commissions,” he says, “They would rather not see it go out so directly, even though they are aware of it.”

My own experience shows that clients, offered a choice, often prefer the idea of high-if-less-visible commissions over a smaller upfront fee straight out of their pocket. A 2011 study by JP Morgan Asset Management in the UK showed that while 60 per cent of consumers approved of the idea of switching to advisory fees, as it would result in unbiased and therefore more reliable advice, only 8 per cent would actually be willing to fork out the money. Another FSA study, conducted in 2010, concluded that on matters of money ‘consumers are not rational, utilitarian machines who weigh up equally the positives and negatives of each decision’. Rather, ‘they are emotional human beings who very often make decisions based on gut feelings’. That’s not all. Advisors themselves need the confidence that they can add value, observes Kohli. Once they fully grasp how they can enrich customers under the new norms without any conflict of interest, they may actually become more persuasive with their clients.

But even if one were to overcome all the behavioural ticks in the way of reforms, what exactly would be on offer apart from the honesty of the advice?  

Unsurprisingly, high networth individuals—who usually have more complex financial needs than regular retail customers—are far easier to convince that an advisor’s incentives should be perfectly aligned with those of clients.

Aditya Gadge, CEO of the Association of International Wealth Management India (AIWMI), claims to train investment advisors in how best to address these complex needs. This entails taking not just a client’s risk profile into account, but a range of tax issues, estate planning and even international needs. According to Kapoor, one of Edelweiss’ differentiators is that in a country where so much private wealth is intimately tied to family businesses, it offers solutions that take into account complex overlaps between business and family money.

As the advisory market develops and investment proposals turn increasingly relevant and customised, the value that clients see in impartial and high-quality advice is likely to go up. In the meantime, as the difference in motives between advice offered on client fees and corporate commissions becomes apparent to people looking for investment options, some agents may be tempted to offer rebates on their commissions to either retain or attract customers. This might lure many retail investors.

Professor Stiglitz is worth recalling again. “Bankers,” he once remarked, “are born no more greedier than the rest of us.” Greed is greed, and all those who make a living managing other people’s money are in a position to make the most of flaws in the system as much as customer naivete. We should be more vigilant but are not. This is irrational. And as irrationalities go, money is not in the same league as, say, fashion. Money is at the core of what mankind has come to consider ‘value’. Money, as they say, is what makes the world go round. Money builds empires, destroys families, and the pursuit of it explains why most of us get up in the morning and go to work.

Perhaps it is time we decided once and for all how to define our relationship with money and insist on real value and impartiality from those to whom we hand it over for management. This would mean paying for advice, which in turn could even mean—in some situations—paying to be told to do nothing and sit tight on one’s cash. As those whose wealth has survived the Great Recession can testify, sometimes advice to do nothing can be words worth paying for.