Know your financial advisor’s incentives

Published in The Hindu - Sunday Magazine on Jun 28, 2009

Financial services companies have mandatory “Know your customer (KYC)” guideline; It’s time investors have a “Know your Financial Advisor (KYFA)” guideline.

Last weekend a doctor couple met me for advice on planning their finance and investments. After hearing about the mess that they were in, I could not resist but ask why they had not sought professional financial advice earlier. The reply threw me back – apparently every single investment decision was made only under the guidance of their financial advisor – who surprisingly never charges a penny. What? Who is this “brilliant” Good Samaritan? – was my retort (forgive my callous sarcasm). It turns out their “advisor” was an “agent” – meaning his primary source of income is the commission that he makes from the investment products he sells. So what? You may ask. Well…I am sure there are well meaning agents out there but the issue is – “independence”.

The fundamental conflict of interest

To help my clients understand this better I posed them with an analogical question- would you go to a doctor who works pro-bono but gets paid only from the medicines that he gives you? “Of course not” was their reply. “Why?” I asked. “Because then the doctor would not only be tempted to prescribe more medicines than required but also resort to prescribing the more expensive ones”. Fine, what if the doctor gets a percentage cut from the pharma company, on the medicines he prescribes? I probed further. “Hmm…” they said – “The pharma companies would love to implement this, because doctors would turn into direct selling agents and they can do away with medical reps.”.

Unfortunately something that is so obviously a conflict of interest in the medical context is most easily overlooked when it comes to the financial services industry. Infact I think I can safely (and sadly) state that conflict of interest has become industry practice in financial services. We don’t seem to hesitate even once before taking “advice” from agents, who get commissions from the very companies whose products you choose! Be it your stockbroker, real-estate broker or the insurance advisor – all of them are agents who earn commissions based on what product you invest in, how much you invest, how often you buy and in the case of stockbrokers - also based on how often you sell. Why, even the investment banker who advices on Mergers & Acqusitions is an agent who gets paid a “success fee” that is proportional to the size of the transaction – only if the client is successful in buying or selling. It's in their interest to do whatever it takes for the deal to go through, because that’s when they get paid big bucks; the bigger the acquisition the better. Strangely despite this incentive problem even large companies look to investment bankers for “advice” on M&A. Do you think they are going to say no to billion dollar acquisitions like Tata-Corus or Hindalco-Novelis simply because the transactions are inherently risky and involve taking on a lot of debt that may put the entire company at risk of collapse? It's hard to say but I don't think they would! In fact they are likely to convince the company to go ahead with the acquisition so that they can earn their big fee. Because their incentive doesn’t encourage them to be concerned. The same predicament exists for your agent, when he plays the role of a financial advisor.

Stocks

You may be ogling over how often your stockbroker (online or offline) provides you with free “research” based advice (“recommendations” or “calls” in industry parlance) - some broking firms even tout the frequency and the quantity of such recommendations as their USP. But not many people realize that the monthly, weekly, hourly, (minute by minute?) buy/sell recommendation is aimed to fulfill the broker’s requirement of generating commission income, which incidentally is earned only when you execute a trade (buy/sell). Remember investment “recommendations” from a stock broking firm is not some kind of “value added” service or advice; it’s merely a marketing tool to induce you to trade.

Mutual funds and other investment products

The new proposal by SEBI - mandating mutual funds to remove entry loads, which is used by the funds to pay the distributing agents, is a step in the right direction. If the revised proposal is implemented, investors need to directly pay a mutually agreed commission to their agent - which is a good thing because at least it makes the process more transparent. But still a couple of larger issues remain un-addressed. First is the case of ULIPs, which despite becoming an extremely popular investment class of-late, have very little regulation in terms of fee structure to agents (may be that’s why they are popular in the first place!). Second, there are no signs of finding a solution to the more fundamental problem of agents turning into financial advisors and hard selling investments, purely for their own benefit (“incentive”).

Way forward

My opinion - as long as financial advisors are agents who earn their fee only when an investment product is sold, their incentives increase the risk of mis-selling by supplanting investors’ need. The only way to protect yourself from this is to know exactly “how” and “how much” your financial advisor will get paid (what’s in it for them?) - before you make your investment decision.