How an investment adviser gets compensated will be an increasingly important factor for an investor to select an adviser. As advisers graduate from being a “hunter to a farmer” or a “chemist to a doctor”, it might be even more crucial than a brand or pedigree.
As the industry develops and begins offering a variety of compensation models, on a larger scale the mode of remuneration will be a deciding factor for clients. Though we can talk about some direction here but there is no one size that fits all. Each adviser needs to find his own best solution.
Issue of adviser compensation can be looked at in two ways—based on source of income and on the basis of income.
Source of income
The adviser can be either compensated by the product provider, the investor or both.
Income from product provider: This has traditionally been the favoured and easy route as it is easier to implement and cannot be argued over by investors. However, it has two major problems—excessive conflict of interest and consequently not sustainable in the long term; and it is highly susceptible to regulatory changes and also dependent on the whims and economics of principal (product provider).
Many advisers may argue that trail commissions offered by product providers are good as they do not encourage churning and hence eliminate conflict. This is not the whole truth, it motivates advisers to tilt portfolios towards schemes/asset classes that pay higher trail commissions.
For advisers, sole dependency on trail commissions may be high-risk affair as it is controlled by the product provider. The producer has the discretion to alter or remove it either due to regulatory changes or competitive pressure. It is for the adviser to charge his client similar to other professionals such as doctors or else it can spell trouble.
Income from client: This potentially is the ideal business model. Currently it seems difficult to implement and the major hurdle is inbuilt commission in many products. They cannot be stripped of commissions and the benefit cannot be passed on to investors. To overcome this hurdle, some advisers set off commissions earned against fee charged.
The downside here is cumbersome accounting and blurred legality. Otherwise, this seems to be best suited currently as it gives control of income to an adviser.
Income from both: This is an interim arrangement which many advisers are trying to pursue. This is problematic because it is equivalent to being caught between the devil and the deep sea. It neither removes conflicts nor does it leave the adviser in a position of strength to demand fees from clients. Such duality can neither be scalable nor very successful.
Basis of income
Compensation can be structured as transaction fees, assets under management (AUM) fees, lump sum fees, time-based fees or performance-based fees.
Transaction fees: It is the most common method of receiving compensation especially in equity broking. Adoption of this mode means that business is more focused on the transaction. There is no obligation on the adviser for ongoing monitoring and is most suitable for execution platforms. This system of compensation may be suitable for clients who are either self-directed or do not require ongoing monitoring. However this model is not aligned with the random outcome that the client may experience due to specific transactions.
AUM fees: Many advisers have built their business model on trail commission from mutual funds. This is one of the powerful ways of building business. It provides higher long-term engagement and alignment with client. However, it may not be suitable for investors who are self-directed. In fact in the US, there are regulations that prevent advisers from charging AUM-based fees.
Time fees: These are charges decided by the quantum of time spent in advising, very similar to fees charged by lawyers or accountants. Some of the financial planners use this method. It is simple to implement, but it is not scalable as there are only 24 hours in a day.
Lump sum fees: Such fees are common with financial planners to make a financial plan. Implementation of this plan also may generate extra revenue.
Performance fees: In this case, adviser charges some extra fees if the returns are higher than the predetermined hurdle rate. Typically the fees will be defined as a portion of excess returns. From investors’ point of view, selecting an appropriate benchmark is critical. Since there is no free lunches in pursuit of higher returns, there is a danger of taking on excessive risk. One can select hurdle, which is linked to financial goals to achieve perfect alignment of interest.
Rajan Mehta, executive director, Benchmark Asset Management Co. Pvt. Ltd.
Your comments are welcome at firstname.lastname@example.org