Over the past few years, a debate has been raging in the financial circles on how to solve the problem of distribution and sound financial advice in mutual funds. The main issues involve the conflict of interest between intermediaries and investors.
It is well established that financial products are complex and opaque (in most part) and most investors need assistance in the form of advice. Intermediaries in the Indian context can be broadly classified into advisers and distributors. The latter being those who earn commissions from the fund houses, while the former charge the investors for advice.
Over the late 1990s and the first decade of the new millennium, distributors also played the role of advisers. This myth was busted when several cases of mis-selling came to light. The distributor-adviser regulations of 2013 sought to solve this problem by defining their roles. The adviser was made responsible for advice and was to be paid only by the investor while the distributor sold products on behalf of the mutual funds.
There were also regulations introduced by the Securities and Exchange Board of India (Sebi), which sought to improve disclosures by having intermediaries state upfront the amount of money they were making. It’s questionable as to how many intermediaries actually did so, and whether clients asked for the same.
Sebi has now mandated the disclosure of actual rupee value of commissions in the investors’ half-yearly account statements. Earlier, there was no compulsion on the intermediaries to mention the actual amounts and they could state a percentage figure, for example: stating 1% instead of Rs1,000 on a Rs1 lakh investment.
In this backdrop, the question that begs an answer is whether the above regulation—of disclosing the actual amount made by the distributor and the alternate returns that the investor may have made had he invested directly in the mutual fund—will lead to greater investor welfare.
To answer this question, we first need to define an abstract term called ‘investor welfare’. Financial experts and popular media would have us believe in the concept of ‘suitability of a product’ for a customer. And thus, based on the investor’s ability to take risks (psychological as well as wealth status) and his life cycle (age, employment status, family obligations), there is a particular set of products that are deemed ‘suitable’. This is a paternalistic approach to investment management, as it suggests that the investor may not be capable of taking his own decisions. Though there are several other dimensions to investor welfare, we will for brevity’s sake, define it as the least expensive product that is suitable for the customer based on his suggested asset allocation.
This particular definition covers three dimensions: cost of the product, suitability for the customer and the asset allocation. Note that the above definition omits any mention of the risk-return trade-off. We are assuming that suitability and the asset allocation subsumes the risk-return trade-off.
The other factor to be considered, and which seldom makes its appearance in popular media, is whether a customer having been proffered advice actually implements the advice. This rarely enters the discussion, as it is quite opaque to outsiders.
An adviser, as per the 2013 regulations, is expected to keep records of his recommendations to his investor but the investor may or may not disclose where he has actually invested, even to the adviser.
A series of experiments done in Germany in 2011 (published in 2013 in a reputed academic journal) throw light on some of these issues. The researchers establish experimentally, quite unequivocally, that when funds use commissions in order to steer advice (or sales), there is a real conflict of interest and the incentives for investors and intermediaries are misaligned. This leads to biased advice for the client and thus a reduction in investor welfare.
The researchers also wished to test whether voluntary payment to advisers by investors improved the quality of advice. This is also called the ‘pay what you want’ pricing mechanism; research in this is still fledgling.
The German researchers created experiments to test the effectiveness of voluntary payments. The paper is available here: http://goo.gl/shq72p. In a nutshell, the researchers find that advisers also tend to provide truthful advice when the payment is voluntary and large. The alternatives for the adviser were to recommend a fund where the commission was high. Further, the investors follow advice when the voluntary payment is large. The alternatives were a small and large stated charge to investors.
The researchers also tested a condition where an investor could pay a bonus based on the performance of the funds recommended. Both investor and adviser greatly benefited when the bonus was also paid. This meant that the adviser felt further incentivised to provide truthful advice when investors paid a bonus, which was a tangible reward for services rendered.
For a regulator this implies that making all earnings transparent, though intuitively appealing, may not ultimately result in investor welfare. There are enough studies which state that more information actually results in decision paralysis (e.g. http://goo.gl/cnS1LF). And perhaps a more robust model for investor welfare will need to be considered where the aspect of following recommendations of their advisers by the investors should also be considered. Thus, if one might go out on a limb, then the regulatory push needs to be made towards building a strong advisory ecosystem with voluntary payments rather than simply overloading investors with information.
An adviser may, however, wish to experiment with a model where he seeks voluntary payment from the investor. The study mentioned earlier also cites the example of a German financial institution that follows a model where the investor can pay voluntarily any amount for every consultation, based on the service provided. However, the institution reserves the right to terminate the relationship with the investor. So an investor could abuse the voluntary payment offer for a few sessions but knows that the free lunches are limited.
Sreeram Sivaramakrishnan, associate professor and area chairperson-marketing, School of Business Management, NMIMS