Why the Mutual Fund Trail Commission Belongs to the Adviser?

by Ms. Uma Shashikant, Managing Director, CIEL

There are always unintended consequences to policy & regulatory actions.

Turn into financial advisers

The ban on paying front-end commissions to mutual fund distributors threw a large number out of business but also pushed many to seek the next level, and turn into financial advisers.

The focus on goal based long-term investing increased since that ban, when distributors-turned-advisers began to seek a “solutions-based” approach that enabled clients to see value in what they were doing.

Financial advisers need the next big leap to entrench themselves further. They need both internal and external momentum to enable this.

If advisers see themselves as enabling a client’s financial goals, they should acquire the competence for portfolio construction.

Fund managers focus on selecting securities and building a portfolio that should ideally beat the benchmark index.

By design, they deliver relative returns on specified portfolios. This expertise only serves half the need of the investor.

An investor saving for his daughter’s education can not take the risk of a crash in the equity market in the year in which he needs the money.

That is where the adviser comes in.

Uma Shashikant,
 Managing Director, CIEL

When the financial adviser brings asset classes together to build a portfolio, he does two critical tasks: decide how much will go into what kind of assets, and select funds to meet the objective.

In that role as a manager of client portfolios, the adviser plays a role equivalent to that of a professional fund manager.

The adviser brings the next important layer in wealth management, by using ready funds and products, to build a portfolio that works for his client. This role is thus distinct and equally important to a client.

A financial adviser also bridges the client’s need and the product features. He is uniquely in the position to evaluate what his client may need and find products that meet that need.

If a client is saving for retirement at the age of 30 he would need more equity for growth than a client who is already 60 and requires income.

In choosing the assets, the financial adviser begins with the specific needs of the client for risk and return; he considers the specific saving capability and time period available to the client; and he works with the knowledge of assets the client already holds.

Without the adviser, clients will be left to the product pitching noises of producers and the difficulty of choosing from too many variants.

A financial adviser also stays with the client through the years of building wealth and meeting financial goals.

Unlike the distributor whose role is transactional, the financial adviser’s role is transformational. Routine review of the portfolio, ensuring that the client stays on track, enabling adequate funding of goals, and walking the client through the ups and downs of the market are also the responsibility of the adviser.

There is an inescapable soft element of managing client relationships in this profession.

Reading through these functions, it is obvious that while many distributors like to speak the language of the adviser, not all have the expertise to be one. From mere selling of a product, the leap to become an expert portfolio manager is quite big.

Economists have long pointed out that change can be tweaked through the correct alignment of incentives. That is where the financial advisory profession meets its guillotine.

The regulatory action of cutting off the upfront commissions in selling mutual funds was premised on the expectation that advisers would be paid by investors. The conceptual idea was that the adviser worked for the investor and should take a fee for his services.

Taking commissions from the producers brings in conflict of interest. This approach is right in intent, but wrong in design.

Behavioural economists have pointed out how consumers do not like to pay directly for services, but quite willingly accept indirect payments for the same service.

In the five years of pushing for “fee-based” advice we find the financial advisory profession struggling to find its feet and earn a stable revenue. Without adequate economic incentives, it would be tough to remain a top class adviser doing all the right things for the customer.

The financial adviser professional today is mostly a manager of family offices, or wealth manager of high net-worth investors. Not the most desirable social outcome.

What can be done?

A portion of the incentive to selling financial products is the trail commission. This is paid as a percentage of assets, and is influenced by the market value of the assets, thus rewarding good performance. A fund manager’s fee is also charged to the assets every year. Currently the trail is being paid to the distributor, thus making it more profitable to be a distributor than an adviser.

With adequate disclosures and consent, the trail should be restored to the adviser. A distributor only mobilises the money and receives an upfront commission for doing so.

An adviser selects a product, builds a portfolio and manages it, making decisions about how long the client would stay invested in the chosen product. The trail commission therefore belongs to the adviser. The investor can have the choice of not having an adviser, or investing directly.

Fee-based advisers can continue to make their pitch to earn directly from the investor. But a larger majority of aspiring advisers, who qualify themselves to be one, and are willing to invest in the profession, need the economic incentive to stay in business.

Failure to solve this issue of incentives has led to a dangerous outcome. 

Not only are distributors earning more than the adviser, they are also able to arm twist the producers to pay more as low economic incentives creates a barrier to entry in the profession.

In a country where not even 3% of the population participates in the securities markets, we need an army of advisers and distributors. It is only by clearly defining the roles and aligning the incentives can financial advice reach the large population spread so widely.

In a capital starved country whose aspiring population is earning more and more, it would be a pity if savings were not directed to capital markets where they are most needed.

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