17 January 2018

Segregation of advice from distribution - simple, attractive but wrong

I have a piece in today's Economic Times where I argue that the complete segregation of advice from distribution of mutual funds and financial products is neither possible, nor desirable. Here is the link and below is the full piece:

Segregation of advice from distribution – simple, attractive and wrong

SEBI has come out with a third consultation paper on segregation of advice from selling of mutual funds. The fact that SEBI has not implemented the first two proposals is a good sign that the regulator is thoughtful and open to suggestions. It needs a bold step to altogether abandon the project of segregation of the two functions, which is simple, attractive and obvious. But wrong.

The context of the paper is SEBI’s current position where it allows distributors of mutual funds to provide incidental advice without a separate registration as an ‘investment advisor’. The current paper, which from its grammar seems to override the earlier more detailed proposal, proposes a clean segregation of advice from distribution of mutual funds. An advisor represents the investor and should not get a commission from the mutual fund. A distributor by contrast is an agent of the mutual fund and is entitled to a commission from the fund for ‘selling’ it.  The paper seeks to prohibit the advisor from selling and the seller from advising. This prohibition includes relatives for individuals and affiliates (including subsidiaries and parent companies) for corporate entities. The paper also suggests that the distributors continue with their current obligation to ensure sale of appropriate products to investors.

There are 5 birth defects with implementing the proposals. First, investment advice as a stand alone business is not viable in the Indian context. Of the few hundred who are registered as advisors, nearly every one of them, has a separate distributor license housed in a corporate entity or with a close relative. Mandating an absolute ban on advice would almost certainly mean that registered advisors will abandon their registration and retain their distribution license. This will be a disservice to investors who will be deprived of proper advice. Banks and other large institutions will probably abandon advice as the fee income is negligible compared to their commission income. This may change in another decade, but it is a very distant reality today.

Secondly, the prohibition on relatives, from undertaking advice when another is providing distribution will almost certainly be unconstitutional. It is difficult to imagine any court upholding a ban on a profession merely because a husband or a brother in law is carrying out another legitimate business which SEBI finds to be somehow in conflict even though both are completely independent. Indeed, many distributors today have husband-wife combinations for providing advice too, but prohibiting one when both are qualified, registered and regulated would be impermissible.

Thirdly, the very definition of suitability, which SEBI seeks to continue to impose on distributors, will mean advice. Thus prohibiting advice while mandating suitability is a contradiction in terms. A good advisor would always first find out the profile of the client, for instance the age, income, risk appetite, retirement plans, insurance needs, education of children goals, tax impact and many other things before advising the client. Once this is done a good adviser will advocate a diversified portfolio, diversification of assets being one of the only free lunches in the financial world. In other words, there is no such thing  as a mutual fund advisor. One can only be a good financial advisor if one allocates assets between equity (mutual fund, listed, unlisted securities), debt products, insurance, real assets, gold etc. If SEBI’s aim is to mandate advising only with respect to mutual funds, it is doing a great disservice to investors. All holistic advice must necessarily advice investment in different asset classes, different time horizons and different assets within each asset class for it to qualify as being suitable and in investor interest. This remains true whether such advice is provided by an advisor, a distributor or other persons who provide  incidental advice.

Fourth, connected to the previous point, it is impossible to sell any financial product without conducting a suitability check and provide some level of advice. A distributor today reaches out to remote towns, does the leg work of KYC and other documentation, provides risk profiling and basic advice before an investor is willing to invest in funds. A prohibition to provide advice to distributors would almost amount to regulatory mandated mis-selling and fraud in financial products. Not a goal SEBI is seeking to achieve.

Fifth, and very importantly, the concept of pure advice is a highly elite product. Even upper middle class investors rarely use such advice. Smaller investors almost by definition cannot afford a Rs. 5,000 per year or 20,000 per year advisory fee when they are starting a monthly systematic investment plan of Rs. 500 per month. The product is mainly suited for HNIs or Ultra HNIs. The only country in the world which has experimented with a segregation of such kind is UK, a developed and rich country. Even there, the regulator’s own study of the move after 3 years shows how millions have been left unattended and orphaned of advice  because of the segregation of advice.

The unintended consequence of this ‘removal of conflict’ will in fact be a removal of all advice in India, a steep increase in actual and opportunity costs, mandatory misselling products to clients. The approach proposed should be replaced instead by a robust enforcement against mis-selling by SEBI, which is in fact not prevalent. Almost the entire misselling occurs in insurance based investments and in selling of stock derivatives, both of which have attained epidemic proportions. SEBI should follow the advice of its own International Advisory Board as also the Sumit Bose Committee which have recommended against implementing this move in the near future. In fact, it should work towards expanding the scope of incidental financial advice, as there is no such thing as mutual fund advice. In this case, SEBI should avoid the Occum’s razor that the simplest explanation is the best suited.

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