The following article was published in ‘Moneylife’ online (click here for the article on-line)
SEBI has just come out with draft regulations for investment advisors. Unfortunately, the proposed regulations will be of little consequence. It will mean little to investors and mis-selling may continue as before and with appropriate disclosures! An analysis of the proposed rules…
Investment advisor regulations have been discussed on and off for the past five years. In 2007, the Securities and Exchange Board of India (SEBI) published a consultative paper on “Regulation of Investment Advisors”. In 2008, the Swarup Committee re-examined the issue and submitted its report in 2009. The report was revolutionary in its thinking prescribing all financial products have to become “no load”. Opposition to this report was vociferous. After much heat and dust, including dharnas and morchas by a section of soon-going-to-be-affected persons, the report was buried deeply and quietly. In September 2011, SEBI published another concept paper on the regulation of investment advisors, which led to much debate. And now, in September 2012 the draft regulation on investment advisors in India has come out. How significant are these draft rules? Will it change the way people buy and sell financial products? Will conflict-of-interest be reduced?
SEBI’s concept paper had explained passionately the causes of conflict-of-interest, lamenting lack of financial literacy “in a country like India” and uselessness of disclosures when investors are financially illiterate. The concept paper proposed to set the things right by portraying work qualifications such as Chartered Accountants and Master in Business Administration-Finance as free from conflict-of-interest. SEBI highlighted the low level of financial literacy in India and the consequences thereof. It also mentioned about inherent conflict-of-interest in the prevailing agent-cum-advisor model of business practice. The concept paper advocated very strongly, the setting up of a Self-Regulatory Organisation (SRO) to regulate investment advisors. This writer participated in the debate actively and sent detailed comments to SEBI. The draft regulations appear to be a skeleton of what the concept paper set out to achieve. Here are some facts that come out:
SEBI has avoided turf war by restricting the licensing requirements of securities products, excluding insurance, real estate, commodities and pension products. If you look at any upper middle-class household, a chunk of savings is compulsory through employment (provident fund and superannuation fund). Next, big commitment is towards house purchase/construction and this area is not going to be covered through this regulation. What finally gets covered is a very small part of the savings—investing in riskier assets. So, on a weighted average basis, the effect of this regulation on a typical upper middle-class household is minimal.
The regulation appears to be enabling and not disabling. No one is going to be affected negatively and they may continue to do what they are doing. However, this negates the very object of the regulation—that of removal of conflict-of-interest involved in financial advisory and product sales—as the focus is very narrow and limited to the act of giving advice.
Most of the clearly identifiable conflicted practices are left untouched. So this regulation is not applicable to a host of financial service providers such as stockbrokers, mutual fund advisors, pension advisors, insurance agents or brokers. It is also excludes advice givers who are advising in good faith, free of cost.
In a complete turnaround, this regulation now tries to remove the conflict-of-interest through a mere disclosure. Look at the following wording: An Investment Advisor shall try to avoid conflicts of interest, and when they cannot be avoided, should ensure that appropriate disclosures are made to the clients and that the clients are fairly treated.
In another major effort at watering down, an investment advisor may have the cake and eat it too. Just read this provision—“An investment advisor shall disclose all consideration and rewards that it will receive if the client chooses the recommended security or investment.”
Financial planners, fund managers who are employees of mutual funds and asset management companies (AMCs) and alternative investment funds (AIF) are covered under the regulation. Entities other than an individual have to set up “Separately Identifiable Department or Division”. It is not a “Chinese Wall” but only an internal department or division.
Qualification of advisors now also includes post-graduate degrees or diplomas in most of the related areas such as finance, accounting and so on. Certification requirement is expanded to include “CERTIFIED FINANCIAL PLANNER” awarded by Financial Planning Standards Board India. A two-year time is also given to obtain these certifications including the one offered by NISM.
Capital adequacy for body corporate is set at Rs25 lakh and Rs5 lakh for individuals. Young professionals may feel the entry barrier is high. It would be advisable if the capital adequacy is waived off for individuals.
Registration fee is a steep Rs10,000 for individuals and Rs100,000 for body corporate for a period of five years. This will hurt many two-person dejure body corporates created by husband-wife, father-son, friends and relatives, which then work as de facto individual-run organisations.
Till such time an SRO is set up, SEBI will handle the licensing process. Does it have the bandwidth for this?
Who will be afraid of this regulation? None, because this regulation does not stop any of the existing practices, with perhaps financial planners being the only exception.
There is a saying in my mother tongue which when loosely translated means that “one caught a small rat after digging a big hill”. I have the same sense about this draft regulation. The list of excluded services is much longer than the included ones. If these provisions are gazetted as they are, the regulation would remove none of the existing conflicts-of-interest. Body corporates would be glad that they can now have one more vertical to attract investors—a mere “separate department” and ‘disclosure’ is sufficient to run the racket.
Not being a super-regulator, SEBI has restricted the applicability of this regulation only to a small sub-set of existing players and clearly precluded any future turf-wars. At the end, all are happy continuing to do what they are doing at present. From intention of the concept paper to the draft regulations, a lot of regulatory zeal has evaporated.
Those who are practicing as fee-only financial planners/advisors would be moderately elated to realise that they now have a regulatory framework to lean on. But they will be frustrated after knowing the costs involved in complying with the regulation in toto. They will not have any ‘exclusive’ tag as other so-called conflicted entities can also be investment advisors.
In other words, entities with conflicts-of-interest would be very happy to know that life can continue as usual and in fact may get even better with an additional label to sport—“Investment Advisor”. After discarding the disclosure route in the concept paper, the regulation now requires mere disclosures to comply with.
What Is Good In This Regulation?
Young graduates and post graduates whose hands are not yet bloody with legacy products and practices can think of setting up a free-of-conflict profession (from the regulatory point of view). However, this enthusiasm may yet be dampened with socialist era provision such as “Investment Advisors may charge fee subject to the ceiling specified by the Board, if any”. Even the existing conflicted service providers/intermediaries can think of redeeming themselves by complying with the provisions in letter and spirit.
How Can an Investor Benefit?
My experience says that there are as many mis-buyers as there are victims of mis-selling. Pass-backs even when banned are demanded and received gleefully. There are investors who are well-versed about minutest options in their pads, pods and tablets but not their investments. The gap between general literacy and financial literacy is too wide for one advisor’s lifetime to bridge. Investor Protection Fund, instead of diminishing in size, is increasing. The existing IPF corpus is good enough to start at least half a dozen good universities in India.
Given the economics of becoming an investment advisor, what category of investors would benefit from this regulation is a question that will be answered by the behaviour of the investors. An investor who is willing pay separately for advice is the intended beneficiary of this regulation. How many such investors are there is anyone’s guess. I am not cynical though because there are small yet growing numbers of people who are willing to entrust their financial future to someone such as a “CERTIFIED FINANCIAL PLANNER”. They do trust but also test. They would be pleased with this regulation for sure.
Am I Happy To Become An Investment Advisor?
Answer is yes and no. As a “CERTIFIED FINANCIAL PLANNER”, I comply with fiduciary responsibilities at much higher levels. But now to do it, I have to incur more cost and this is a negative. On the positive side, I have regulatory backing and can be regulatory-proud, if I can present as such to my clients. One thing, however, I am much pleased to notice is Annexure E—Comments. I am seeing for the first time that the regulator has listed down comments/feedback received in a summary format. Though it not on par with the efforts of countries such as UK and Australia, it is a good beginning. Also, Indian investors or a small set of them can be proud of the fact that they are now either on par or ahead of many developed countries when engaging an investment advisor.
Mutual funds are good instruments to put your money in. Many investors know this and use it to their advantage. Some investors, however, consistently do not succeed when they use mutual funds as financial instruments. Out of my experience, I can list few important reasons why some people fail when they use mutual funds. If you are the one who has lost money consistently in mutual funds, take heed of the following
Not Knowing The Difference Between Saving And Investing
Both these financial activities are different from one another in their intent and purpose, time horizon, choice of instruments and risk and reward equation. If you confuse one to another, you end up with wrong instruments and consequently lose money. Talk to your financial planner to understand whether your goal is a savings goal or investment goal and choose the funds accordingly.
Not Understanding The Nature Of Underlying Assets
Can you compare oranges and apples? Only to the extent that they both are fruits. Both fruits are vastly different genetically. Orange is citrus and Apple is a rose fruit. Similarly, not all mutual funds are same. They differ from one another in their investment objectives. Since you are putting your hard earned money in to a mutual fund, take some time to talk to your financial planner and understand the objectives of the funds. It would be good for you if you spend at least as much time in knowing the fund you are going to put your hard earned money in as you spend on let us say selecting vegetables in the supermarket.
Looking Through The Tax Exemption Prism
Tax exemption is good to get but it should not be the sole purpose of your investment objective. Tax exemption comes with the constraint of lock-in. This means, tax planning schemes of mutual funds, popularly known as ELSS, are inflexible till they are locked-in. If you chose to invest through Systematic Investment Plan (SIP) in such schemes, the period of inflexibility increases because each instalment of SIP would have 3-year lock in. During the lock-in period, you will be just staring at the valuation, either negative or positive, with no option to take any action. If you are investing in tax exemption schemes, adjust your time horizon suitably and have good patience. Stock market is neither in your control and nor at the control of your financial planner. Only way to beat the stock market is to have patience in abundance.
Driving Looking At Rear View Mirror
Past performance is a good indicator but not the sole indicator. Don’t override the choice of your financial planner because you track the fund rankings through free websites or bloggers’ dens. Please remember the publicly available information about a fund is stale and expired. One of the most important value your financial planner can add is the information culled during the interaction she has with the fund house/fund manager regularly. No blogger or ranking website can provide you this. Most of the good financial planners and investment advisors can pick up the phone and talk to the fund managers directly.
Mutual Funds Are Not Shares
It is not an amusement to a financial planner, in spite of spending enough time with the planned, the fact that she is unable to germinate the thought that mutual funds are specialised instruments designed to invest in various types of assets including shares and stocks and are not in themselves that. Mutual Funds are not the instruments to trade but to save or invest. Mutual funds are driven by investment objectives as stated in offer documents and not meant for maximising the profits to promoters or shareholders of the companies in which they invest.
Oranges And Apples Are Fruits But All Fruits Are Not Apples And Oranges
Mutual funds are not ‘only’ about shares and stocks. They are also about cash and other types of assets/financial instruments. You can create a vast array of choices using various combinations of different types of funds to meet your goals and needs. For this to happen, you have to spend enough time and energy either yourself or with your financial planner. Your goals and needs should drive the choice of funds and not the other way round. Chase four or five stars blindly and when the day dawns there are none left except the only one.
Choosing The Wrong Time
You can call this as the curse on individual investors, especially the unguided. Money is highly emotional subject and your basic emotions sway your decision making process. You invest at market highs and exit at lows. Fear and Greed rule the roost. If you are of this mindset, my dear friend, mutual funds are not the best choice for you.
Are you past or present or future oriented? Your time perspective has a major bearing on your ability to create wealth.
According to the research done by psychologists, if you have future time perspective, you will be more successful. People with future time perspective (futures) get more education and they earn more money. Also, they spend less and save more.
Psychologist Prof. Philip Zimbardo identified several personality types in relation to time orientation. People can live in different time zones
- Past positive: you are nostalgic and think of good old days gone by
- Past negative: you are regretful about the past and think of failure, all the things that went wrong
- Present hedonistic: you live for today and seek pleasure and sensation
- Present fatalism: your life is governed by external forces and you abhor planning.
- Future: your focus is on learning rather than play. You are goal orientend and amenable for planning
- Transcendental Future: you believe life begins after the death of the mortal body
It should be no surprise to find that future oriented people tend to be wealthy because to become wealthy you can’t spend more money than you earn. In fact, you should save and invest wisely.
Here are Prof. Zimbardo’s recommended five steps toward achieving financial freedom:
(1) The present is the best time to start investing.
(2) Time in the market is more important than timing the market.
(3) Know when your time will be up; those with a long time ahead of them can afford more risky investments.
(4) You can’t time the markets.
(5) A pleasure-seeking time perspective is an expensive habit few can afford.
Simple, aren’t they?
Link to Prof. Zimbardo’s video “The Secret Power of Time.
It is important that you make money when you invest. For the sake of simplicity, let us remove theone off investments such as purchasing or constructing a house property or buying a farm house from the scope of discussion and consider only the regular investments you make every day such as bank deposits, bonds and securities, shares and stock and so on. Especially when it comes to investing in financial instruments, it is important that you consider the role of asset allocation. If you think investing in a volatile asset is riskier, the only way you can have the cake and eat it too is by doing asset allocation.
If you consider the returns you can get by investing in bank may not fetch you higher returns after adjusting for tax, you have to consider adding other assets such as equity and gold to your portfolio. Similarly, if you consider investing in shares and stocks is a very risky thing to do, you must add investments such as bonds and fixed deposits to your investment portfolio.
Are you the one to wake-up late and make your tax planning investments only after your employer starts sending reminders? There are several advantages if you plan ahead, right now in the month of April.
a) Family budget is a powerful tool available to you that helps you manage your money better. It helps you plan your cash outflows accurately. It also helps you to balance (i) your need to save and invest and (ii) your regular expenses and outflows.
b) You can take your time and research the products well, ask right questions and be a well-informed buyer. If you are of do-it-yourself type, today internet is a veritable host to myriad options. However, be cautious about information overload and vested interests.
c) If you chose to invest in those instruments with underlying volatile assets such as ELSS schemes, you can do rupee-cost averaging through Systematic Investment Plan (SIP) or Systematic Transfer Plan (STP).
d) Have you noticed that some financial products are taken off the shelf usually on the last day of the financial year and such announcements are made usually in the month of January? This marketing gimmick is adopted quite successfully by Life Insurance providers. Such ‘last’ dates always create an urgency in the buyer to latch on to such products under the assumption that ‘if it is going off the shelf, then it must be good’. This is not always true. Even if the product is good, is it good for you? Sales persons are trained to ‘be closing always’ and they have a vested interest in closing a deal as early as possible. “Going off shelf” is usually a marketing gimmick to help sales persons.
e) Most of the employers in Bangalore have mid-December or mid-January as the last months to provide them with ‘proof of investments’. Many a times, your last minute effort is not good enough to get ‘proper’ proof of investment that is acceptable to your employer and thereby you are denied of the exemptions. Seeking refund from income tax authorities, though is an option, is quite long draw out process.
f) Your financial plan deserves all the help from you in allowing it to plan your financial affairs. Help your financial plan and help yourself greatly.
As Napoleon Hill says, procrastination is the bad habit of putting of until the day after tomorrow what should have been done the day before yesterday. You will end up with either ill-fitting or costly financial product in your portfolio with last minute purchases.
It is the famous English poet Samuel T Coleridge who coined the formula “willing suspension of disbelief” when he asked the readers to willingly suspend the disbelief for the moment and appreciate the vision of the world created by the poet. In many art forms willing suspension of disbelief is essential to narrate the story. We keep seeing this concept oftentimes put to use very effectively in fantastic stories or movies to great commercial success. We willingly suspend our disbelief when Toofan (Amitabh Bachchan) just blows away the enemies or a Coolie (again AB) beats the rich baddies to pulp single handed. We also enjoy tree-song-dance routine where our hero and heroine romance across the continents in a matter or few minutes.
As a financial planner, it would be better if I confine myself to the area I am familiar with. So, what has the romance of willing suspension of disbelief got to do with your money?
Today, my associate called me to inform that a client he met had ‘invested’ in an insurance policy: invest Rs.25,000/- every year get an ‘assured’ return of Rs.8.5 Lakhs after 10 years. He wanted to know if this for real? A quick calculation using Excel RATE() function indicated that annual return has to be a whopping 25.45%! I asked him to cross check the figures once again. He promptly replied that the client has been given an ‘assurance’ by the agent that the product is going to deliver such a return. I asked my associate to ask the client for a copy of the contract so that we can ensure the correctness of the assertion and if found correct stop all activities and stand in queue to buy the policy to ourselves first (just joking). I am sure that the client in question would receive the policy only after the expiry of the ‘free look’ period.
This brings us back to the first concept of willing suspension of disbelief. My experience says that this is a normal phenomenon when an investor deals with a financial product. The more outrageous the assertions are the stronger would be the belief. Several examples abound: investing in farm land, time sharing business, franchises, insurance policies with bizarre rates of return, mutual funds that have performed well in the past – and the list is endless. Recently I read a news item about investing in Emu birds in anticipation of exorbitant (and unrealistic) returns. I am not a psychologist so I can’t say for sure if it is greed which drives someone to such investments.
However, I have noticed that people invest both small and big amounts without properly verifying the facts.
My experience says that:
a) It is easier to convince a prospective investor to invest in a higher expected rate of return product than a lower one.
b) It is difficult to convince a client with facts and analysis when he or she is bewitched by ‘guaranteed’ returns. I had to almost lose an existing account when I sent a detailed analysis about an insurance wrap retirement product, recommended by a rogue agent, which had a ‘guarantee’ feature and the reality was entirely different.
c) Investors trust brands implicitly under the assumption that such brands can do no wrong.
d) If the product seller is least knowledgeable, investors do not ask too many questions. This issue comes out very clearly when we discuss the past experience and ask the client to explain the rationale of having such unsuitable and costly products in his/her portfolio. Most of such products would have been invested in due to ‘ignorance’ or ‘belief in the person who recommended’.
Willing suspension of disbelief should be a short-lived phenomenon, till you finish reading that fantasy novel or sit inside a movie hall watching a fantastic movie. You are normal afterwards and would not indulge in any such antics in real life. However, the issue of dealing with financial products seems to be an exception for this rule. Investors are willing to suspend the disbelief forever and repeatedly also. Consequent financial losses are far greater and impact is felt by the future generations as well.
When dealing with financial products it is better to adopt Deming’s adage always: In God I trust; all others must bring data.
Offer document is a document filed by the mutual fund with the regulator Securities Exchange Board of India (SEBI)
The Offer Document has two parts – Scheme Information Document (SID) and Statement of Additional Information (SAI). SID shall incorporate all information pertaining to a particular scheme. SAI shall incorporate all statutory information on Mutual Fund.
The Mutual Fund has to prepare SID and SAI in the prescribed formats. Contents of SID and SAI follow the same sequence as prescribed in the format. The Board of the Asset Management Company and the Trustee(s) exercise necessary due diligence and ensure that the SID/SAI are in conformity with the Mutual Funds Regulations.
Mutual Fund would also publish a document called Key Information Memorandum (KIM) and all mutual fund application forms have to be accompanied by KIM. KIM has to be updated once a year and shall be filed with SEBI.
SEBI regulation stipulates that all offer documents are readily available to the investors. Investors can access offer documents at SEBI’s website (http://www.sebi.gov.in/Index.jsp?contentDisp=Section&sec_id=5) or at the website of the individual mutual funds. Yours distributor/advisor also would provide you these documents.
As an investor, it would be prudent if you go through the offer documents, as advertisements indicate, carefully before investing.
When mutual fund advertisement say “Mutual Fund Investments are subject to Market Risk”, please take these words seriously. First step in managing the risk associated with investing is to understand what the risk is. So what is Market Risk? We can say that Market Risk is the possibility of loss caused by changes in the market variables. Market Risk is therefore the risk to the investor’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes. As an investor, you know it that risk and returns are interlinked. Higher the possibility of risk, higher is the return you expect from the investment. Market risk is such a risk which cannot be avoided. You can greatly benefit from the existence of market risk.
Asset Diversification – This means owning different types of assets. All assets do not perform the same way at any given point of time. If you own a diversified portfolio of assets, you possibly do not lose the same amount when you own a single asset portfolio. Example: You can have a portfolio consisting of diversified equity fund, long term income fund, gold fund and an infrastructure fund. How much to invest in each fund is dependent on your risk tolerance.
Time Diversification – Assets behave differently when time dimension is taken in to account. A good example is the way debt and equity investments behave across time. Equities tend to outperform other assets classes over a time. If you are long term investor, investing in debt may actually reduce your wealth due to the burden of tax and inflation. Example: When you are planning for your retirement which is 35 years ahead (this period we call as accumulation/growth phase) is the best time to invest in riskier assets such as equities. When you are in transition phase, you must move to more stable and less risky assets.
Rupee Cost Averaging – Another popular technique to reduce market risk is by investing a similar amount regularly. Over a period of time, because of the underlying price volatility of the assets you are investing in, your cost of acquisition is averaged. Example: The popular method of investing in mutual funds called “Systematic Investment Plan” and less used option “Systematic Transfer Plan” are the best examples of Rupee Cost Averaging.
Rupee Value Averaging – in periods of market declines, you contributes more, while in periods of market climbs, you contributes less. Example: Some mutual funds have the options under “Systematic Transfer Plan” to increase the amount invested when the bench mark index falls in value. You can also invest lump sum amount when value of the asset falls. What strategy would work for you better is dependent on your individual circumstances. When you talk to you financial planner, you will know the best possible options.
A family budget is a tool that helps you find out how much money you are left with at the end of each month (or whatever the period you employ). Importance of a family budget in financial planning is very significant. One may have less income but a steady surplus. On the contrary, I have come across many cases where the income is very high but a very little surplus at the end of the month. Overspending, excessive borrowing,… the reasons are many.
Even the best financial plan would not take off if there is not enough surplus. You will know the surplus only when you prepare your family budget. If you are planning regular investment methods such as Systematic Investment Plan (SIP), prepare your family budget before you start the investment plan. Ensure that you have even surpluses each month and commit yourself only to such an amount equal to your minimum monthly surplus and not ‘average’ monthly surplus. This way, your investment plan will not be distressed.