The Philosophy Behind Fee-Only Advisory

Before understanding the 3 cohorts and why the 1st cohort constitutes such a large % and why the 3rd cohort is almost negligible, it is important to understand the role of an advisor and what are the pre-conditions for a good advisor.

Role of an Advisor

Simply put, it is to give advice which is in the best interest of their client (ie you). No other consideration should matter, except what is right for you. And if there are other considerations, it should be declared upfront so that you can weigh the pros & cons clearly.

What Are the Pre-Conditions & How Each Cohort Measures Against Them

How the Advisor Earns

Ideally, the advisor should ONLY earn from you. As only then there is a mutual alignment of interest. The advisor is expected to protect your interest and you are protecting their interest.

Cohort 1 — they earn from the products or services you buy through them, by way of a commission from the product/service provider. Their commissions get loaded on the cost of the product/service. There is this misconception that since you are not directly paying them any fee, there is no outgo from your pocket. The reality is that you are only effectively paying them the commissions. Since the commissions might vary from product to product (or from service to service), there is a likelihood that their advice might get influenced. For example — Equity products typically have a higher element of commission than debt products (more than 2 times). And within equity products, the new launches and the small & mid-cap equity products have a higher element of commission. So there is a likelihood that your advisor nudges you to do more equity (than what you should) and within equity, do more mid & small cap. Then, there are product manufacturers who in order to push their sales, offer higher commissions. Your advisor might nudge you to invest in these products even though the product may not be doing that well.

Cohort 2 & Cohort 3 — they earn from you, by way of a negotiated fee. As per the law of the land, they cannot earn from any other source. Since what they earn from you is fixed, there is no incentive for them to nudge you into doing things which are not in your best interest. Importantly, since they do not make any commissions, the product/service do not carry the load of the commissions.

Cohort 1 clearly fails to pass the muster on this criteria. Hence, let us now compare Cohort 2 & Cohort 3 on other pre-conditions:

What Is the Structure of the Firm

Ideally, the eco-system in which the advisor operates should also be such that it does not in any way, create any conflict of interest.

Cohort 2 — they have multiple lines of businesses, besides investment advisory & distribution of products. Namely — fund management, in-house product manufacturing, lending, forex conversion, broking, trusteeship services, investment banking, treasury operations. Each of these businesses, like any business, must be profitable and maximise its revenue. And naturally, there would be cross-sell targets within the different teams. So when you become a client by engaging one such firm for fee-based advisory, it is important to understand the incentive structures / target of the set of people managing your account. Invariably — they will have cross-sell targets and revenue credits from the multiple businesses.

For example — while your advisor is technically aligned since you are paying a fee, if the firm they represent has their in-house products/services, there will be both a structural and commercial bias towards in-house products/services. Hence, even if a better or cheaper product/service might exist outside, your advisor will be either constrained and/or incentivised to nudge you towards in-house products/services. Say you are taking a home loan — a fairly commoditised product. The advisor should ideally get you the best available home loan product in the market. This argument can be extended for every strand of advice you lean upon your advisor for.

Even if the firm has only two sources of revenue — fees & commissions, what is seen is that the % contribution of the commissions to the revenue is far higher than the fees. What this does is that if there are good funds or products in the market who do not agree to the commission structure demanded by the firm you work with, OR funds or products who do not have a policy of paying any commission, such funds or products might not form part of the recommended list of funds or products. The fee business might end up being second fiddle to the commission business.

Cohort 3 — they have a single line of business which is advisory. So the only product they have on offer is "advisory" and the only source of revenue is the fee you pay them. Hence, they are driven only by what is in your interest and wherever the best product, service, solution, platform exists — they should put those in front of you. You can be rest assured that their advice is not beholden to any other consideration.

How Focused Is the Leadership on the Fee-Based Advisory Business

Ideally, the leadership should be fully focused on ensuring that your interests are the only priority, that your interests are being fully protected from any conflict of interest and there is constant drive to improve the quality of advice & market coverage.

Cohort 2 — the multiple lines of businesses and sources of revenue lead to dilution of focus and imply that your interests are one amongst many competing priorities. It is natural that the leadership would want to grow every line of business and for all the other businesses, you effectively become a target customer.

Cohort 3 — given that fee-based advisory is the only line of business, the focus is only on growing that business.

What Explains the Skew

Five key reasons:

• Investor awareness: as explained earlier, investors believe that they are not paying for Cohort 1 and the advice is available for free.
• Reluctance in paying for advice: this is linked to the above. As there is greater awareness that in Cohort 1, one is paying for advice (which as explained above has conflict of interest), more and more investors would demand a fee model.
• Reluctance of the larger firms to discontinue commission business: this applies to both Cohort 1 and 2. The incumbents do not see the need to actively educate investors about the conflicts. Even newer players with deep pockets are not attempting to change the status quo and are happy to go with the flow.
• Compliances: the compliances for the fee-model are far more stringent than the commission-model. In fact the regulator as of now, does not recognise the commission model as a legitimate business to dispense advice. They prohibit them from giving holistic advice.
• Lack of resources: building investor awareness requires a lot of resources to be invested over years with no guarantees of near term rewards. This needs people not just with high degree of conviction but also access to deep pockets.

At Serenity, we are fully convinced about the future of Cohort 3 and look at the current skew as an opportunity. We have been slowly yet steadily building our practice and will continue to do so.