Chairman of the FOUNDATION OF INDEPENDENT FINANCIAL ADVISORS
Evolution and Regulatory Challenges – Lessons from India
The Foundation of Independent Financial Advisors (FIFA) is a body representing Advisors and Distributors of Mutual Funds in India, commonly known as Independent Financial Advisors (IFAs).
During my recent meeting with FECIF I realised the common vision that both associations have for their members, investors, consumers and the industry. Financial intermediation is facing a regulatory backlash on a global scale, which is generally unwarranted.
Excessive and unwarranted regulatory backlash
Post the 2008 global financial meltdown, regulators across the world have been pushing forward a number of regulatory changes aimed at eliminating conflict of interest, providing greater transparency and enhanced disclosures. Unfortunately, what has been lost sight off is that the problems that led to that meltdown were from different segments of the financial markets; namely the housing/mortgage market, alternative investments and excessive leverage by the large investment banks and financial institutions - not the advisory sector or mutual fund industry.
Even in India, the mutual fund industry emerged relatively unscathed during the global economic crisis and was able to weather the effects of the global meltdown and fulfill all of its obligations to its customers. Despite having no material evidence of any wrong doing by our industry or miss-selling by intermediaries, post 2008, the Indian regulator (Securities Exchange Board of India – SEBI) also pushed for a number of significant regulatory changes with a view to micro regulation of financial market intermediaries.
Mistaken belief that fee based advice is the only way ahead
According to SEBI and some other global regulators the client engaging with the advisor is in the best position to properly assess the value of that advisor’s services and pay him accordingly. They also believe that financial intermediaries remunerated by commissions which are embedded in the cost of the products do not provide the right advice because of a conflict of interest. Regulators have an apprehension that the presence of a commission-based fee structure has led financial institutions and intermediaries to focus on maximizing commission incomes at the expense of the investor. Globally regulators have formed an opinion that there is a conflict of interest when an advisor receives commission from the product provider rather than receiving a fee directly from the investor and this has to be eliminated rather than managed.
Thus SEBI and a few other global regulators are considering a ban on commissions and are working towards only allowing a fee based service.
September, 2016 Consultation Paper
In September 2016 SEBI published a consultative paper proposing migration to a fee based system from a commission based one by banning distributors from giving advice to investors. There was a clear objective to unbundle mutual fund products, and migrate from an embedded, ‘commission-based’ distribution scheme to a non-embedded, ‘fee-based’ intermediation. The paper proposed a time period of 3 years for the intermediaries to compulsory migrate from being commission based advisors/distributors to become fee based advisors.
FIFA was at the forefront in engaging with all stakeholders and making representation on this subject.
Our representations highlighted the likely negative outcomes on a total ban on commission based distribution:
- Advice gap - retail investors will be orphaned.
- 0.75% p.a. increase in the total cost to investors.
- Dramatic fall in the number of intermediaries
Increase in cost to investors
This is evident from FIFA’s study of expense ratios of 25 countries. The findings of this study have previously been presented to SEBI and highlight the fact that the average expense ratios in countries with a fee model is 2.77% whereas it is 2.02% where commission models still exist. Thus an increase in cost to the investor of 0.75%!
Similar plans to herd and regulate advisors under a single regulatory regime in the UK, the Netherlands, and Australia have witnessed a contraction in the distribution channel and a migration of remaining advisors/ distributors towards the wealthier clients.
International Advisory Board
SEBI has an International Advisory Board (IAB) whose role is to guide SEBI and, in doing so, bring in the global experiences and rising developments and challenges. In the meeting of the IAB in January 2017, it recommended that commission-based as well as a fee-based approach to investment advisory should co-exist for the time being. The transition from commission to a fee based approach has to be gradual and after a thorough impact analysis. It urged SEBI to study the impact of migration to fee-based advisory models under RDR (Retail Distribution Review) in the UK, FOFA (Future of Financial Advice) in Australia, and robo-advisory models.
The compulsory migration of commission based advisors/distributors to become fee based advisors was then put on hold.
However, in July 2017 SEBI came out with fresh proposals to separate the advice and sales/execution function, with fee based advisors entitled to give advice and commission based distributors only able to sell and execute but not give advice.
Proposed regulations ignore reality
These current and proposed regulations ignore the ground realities and the way the advice profession has been structured globally and in India. The investment advisory profession is predominantly a comprehensive service of advice, sales and execution. Execution would include purchase of the appropriate products. It also requires an ongoing service and hand holding. Currently In India, and across many countries, most intermediaries are remunerated through embedded commissions which are paid out of the cost that investor incurs on his investment rather than paying fees separately.
In India individual intermediaries are known as Independent Financial Advisor (IFA) and they are independent of any one product provider. It is essential to understand the dual role that an IFA has been performing. A role which includes an investment process of advice, sales, and service. For his services he is compensated by the product provider from the cost that is charged to the investor.
In India, since the introduction of the RIA regulations, only 730 entities have registered, clearly indicating the lack of adoption of the fee-only model. Today there are some 86,000 entities registered with AMFI providing advisory services, a majority of them (more than 80000) categorised as IFAs.
Reports indicate that nearly 80 percent of IFAs sell other financial products in addition to mutual funds - for example, life insurance, small savings, general insurance. Most IFAs typically sell the mutual funds of five or ten asset management companies (AMCs).
Financial intermediaries also include the national and regional distributors who typically have a more organized and formal setup compared to IFAs with many of them having their own branch network, sales force, and online channel. In addition, many of them aggregate some of the sub-brokers' business.
It would seem that the small number of registrations of Registered Investment Advisors is leading to measures by the regulator to force people to shift. Our concern is that the shift will be negative for the industry at large.
It is necessary that regulators the world over must evaluate the cost they are imposing on investors on account of their perception and fear of miss-selling because of conflicts of interest. What needs to be acknowledged first and foremost is that the financial intermediary enables the investor to achieve his financial goals. The focus has to shift on achieving investor outcomes and away from the mode of intermediary compensation.
To truly empower the investor they must be given the choice to invest on their own or through a financial intermediary. If they opt for the latter they then need to be given the option of how they remunerate the advisor, whether by way of fees or embedded commission.
Similarly advisors must be given the freedom to offer the investor a fee based or an embedded cost based service.
The regulator should not be making these choices or eliminating any of these options. Reducing the available choices to the consumer is never in their interest in the long run. The free market system will allow the most efficient model to grow and prosper.