Gains from paying for financial advice

The transparency that results when the investor pays for the advice directly would drive a shift towards professionalism in the industry.

There has recently been a lot of heat and noise about the abolition of the entry loads on mutual funds and the consequent pressure on retail investors to pay financial advisors for their services. Certain sections of the industry have been talking about the end of ‘free-advice' for consumers. The point being missed is that there never was any free lunch for consumers — they were always ‘paying'!

Earlier, the advisor was earning a commission from the fund house (out of the investment made by the consumer and referred to as the ‘entry load'), but today, following the ban on the entry load, the customer pays the advisor directly.

While the customer still pays, there are several reasons to say that the change in the mode of rewarding financial advisors is actually a customer friendly measure. And to that extent, this change should get a thumbs-up from all stake-holders, most importantly, the retail investor! When the investor pays for the advice directly, it helps bring about a significant level of transparency. Models of remunerating advisors that are non-transparent always have the potential to end up being costlier than models that are transparent.

Transparency also brings in a significant level of professionalism since it will take a professional to have the confidence and standing to be able to charge a fee for advice. We could thus be looking at a paradigm shift towards professionalism in the industry in line with what has happened in developed countries over the last few years.

Aligning Goals

Since the earlier regime was not transparent, it was always likely that the goals of the advisor and the investor would be at cross purposes. Since the advisor was getting commission irrespective of the service level and the quality of advice, there was seldom any pressure to deliver value. With different fund houses compensating differently there was also the likelihood of bias towards funds or companies that provided the best commission. Today, with the investor paying the fees, it gives them control and a right to expect better service and quality of advice. This aligns the goals of both the advisor and investor; resulting in rewarding advisors who provide better advice and service.

Broadly there are three types of models: Entry Load, Transaction based and AUM Based (AUM – Assets Under Management). Considering the drawbacks of the current entry load model, we believe that a model that charges based on the Funds Managed does align the goals of the customer and the investor in a better way. This will clearly ensure that good advice is rewarded and as the portfolio grows, the compensation of the advisor grows.

A larger return can result in significantly better monetary value for the investor even though this model would result in higher costs when the returns are significantly higher. Some advisors are also keenly looking at the profit sharing model.

Cost of Entry Load

Many distributors are today providing the Entry Load or AUM fee based pricing: One needs to note in the above table that AUM Fee is charged on the total assets where as entry loads are charged only on investments into equity in that year and therefore the above table may not provide an ‘apple to apple' comparison.

Entry loads will also be chargable on the switch made from debt to equity. For an investor who believes that it is a good idea to book profits in equities over a 2-3 year basis; when one eventually moves back to equity, this would result in an entry load again.

Hence, the entry load cost would depend on how much fresh investment and switches (debt to equity) happen in the portfolio in the long term.

Removal of the entry load structure and the requirement that the advisor directly charges fees from the customer is likely to bring about a paradigm shift in the Indian Mutual Fund Industry. It is likely to bring in professionalism into the industry as is evident from markets where this model has become operational. Of course, investors will need a change in mindset; paying for professional services rendered by financial advisors just as they pay for other professional services.

Source: http://www.thehindubusinessline.com/iw/2010/01/24/stories/2010012450911200.htm