The question of how an investor should compensate the distributor took another turn last week, with reports about a transaction fee of Rs 100 being considered. A fixed fee per transaction is a bad idea, not only because it is a flat fee having a higher incidence on smaller sized transactions, but it can also be manipulated. Mutual funds, which used to pay such a fee long ago, would tell us how large applications were sliced into several smaller ones to earn the transaction fee. Beyond increasing the paper work, the fixed transaction fee may achieve little. The larger problem lies elsewhere.
The mutual fund distribution problem can be understood somewhat better if one were to compare it with the health or educational services consumers routinely use. Decisions about health and education are equally complex for a household because, like an investment decision, the benefits start coming in much later. When it comes to financial products, the big difference is that their need is not felt as widely as it is for education and health. While getting the child immunised and sending him/her to school is a default decision in a household, starting a savings plan for his/her education is not. That is the policy challenge to be met with the highest priority.
It is not as if health care did not go through periods of turmoil. One-and-a-half century ago, the world was yet to find cures for killer diseases and the risks of infant mortality were very high. But, the dramatic advances in medical research and the consistent effort of governments to create awareness about prevention and cure have altered these risks. What is the equivalent we have in the financial services space? If the risks from mis-selling and choosing wrong financial products are harming the financial health of households, what has been done? Telling the investor to take action is clearly an inadequate response.
Asking investors to choose what they like and pay the financial advisor based on their assessment of the service is also not the logical first step. The first act to clean up is product proliferation. Mutual funds made the strategic mistake of seeking product differentiation as a tool to fight competition. The only tenable differentiator in investment management is the portfolio’s performance. Nearly 25 years of experimentation have resulted in poorly defined and differentiated products. There is a need for a clearly defined hierarchy of products on the risk-return space, from which advisors can choose for investors.
If the products are well defined, it is possible for distributors to align their services according to the type of product they can sell. While those such as index funds will require low levels of selection expertise from advisors, sector funds will require the ability for tactical allocation and timing. Just as we would not allow a general practitioner to perform a complex surgery, we would not like an ill-equipped distributor to introduce a structured product or a unit-linked insurance plan (Ulip) that harms our portfolio. Advisors and distributors should be allowed to deal with defined levels of complexity in managing personal finances, based on their qualifications and proven expertise. A basic qualifying exam is a good start, but is not adequate to differentiate intermediaries. Though simple products will earn only a small commission, they can be grown in volume. Over time, investors will choose these products on their own, forcing distributors to move up the value chain. After all, there are no distributors or commissions for bank deposits.
While distributors will serve producers and generate volumes for standard products, advisors will focus on investors and manage their wealth. It is possible for institutional intermediaries to choose those specialising in advisory services as well as automating the distribution function through electronic platforms. This will enable them to increase volumes and reduce costs. Unless we are able to create an ecosystem that reaches investors, includes a large number of them and fosters multiple service providers, we may not be able to answer as to who pays how much of the fee to whom. That is only a small part of the larger problem.
The writer is MD, Centre for Investment Education and Learning