June 19, 2014

Five Key Gaps in Advisory Practice that Advisors have to Overcome for Success

Rajendra Kalur
Chief Executive Officer

Ever since SEBI notified the Registered Investment Advisor guidelines attention has been focused on what constitutes ‘Advisory Practice’.

Much of the focus has been on the regulations and the various ways in which existing business models can be force fitted into the new regime. To me, this is a classic case of putting the cart before the horse. Instead I believe that the SEBI guidelines provide us an excellent opportunity to reshape our business and greatly mirror the client expectations.

Prior to 2008, the regulators were focused on the primary users of capital – the corporate sector or intermediaries more directly involved in capital raising like the Investment Bankers or Stock Brokers. Financial Advisers, the principal allocators of investor capital, were never much in focus as they slipped through the regulatory gap. Post 2008, attention shifted to causes behind mis-allocation of capital. With it came the realization that capital is allocated basis recommendations from the investment advisers. The regulators extended their gaze to the adviser community as several investment products turned toxic. The CDOs & Mini Bonds took a heavy toll on investors’ wealth even as the economic collapse wrought havoc across investors globally.

The key gaps in Advisory that threaten to destroy the credibility and trust in the industry stems from the lack of objectivity and independence while giving the advice. Here are the specific areas where the gaps were observed:

1. Inappropriate Risk Profiling

Risk Profiling is integral to advice and any advice should take into account the risk tolerance levels of an investor. Almost every Wealth management firm uses this as a cliché but in practice either the test is not applied properly or if applied, its findings are not used appropriately. Paul Resnik, the founder of the globally acclaimed risk profiling tool, Finametrica has identified 6 key ingredients of an ideal Risk Profiler and wonders why good advisers use flawed risk tolerance tests.

On the ground, Risk Profiler is used in a perfunctory manner to satisfy compliance or statutory requirements. However, if applied properly to clients goals and link it to the Asset Allocation, Risk Profiler can be a great client acquisition and retention tool.

Without a Risk Profile, the entire bases on which assets are allocated become subjective and flawed.

2. No Clear Rationale for Recommendations

Most investment recommendations today are vulnerable to availability bias. In effect the products that are available on the shelf are the most recommended. This in effect turns the advisory on its head. Rather, proper advice should be seen as scouting for solutions that may not be immediately available.

“Buying straw hats in winter” is one of the off quoted adages that signify investment wisdom. There is a replete of instances wherein investment recommendations are made from the cosy rear view mirror of lagged data points. Chasing performance is the norm rather than constructing a portfolio for the need of the client.

3. Absence of a Suitability & Appropriateness Test

While the Wealth Management Industry could have patted itself on its back if only it could have innovated on client centric models & improving competence of its manpower, it shot itself in the foot by its over indulgence to products. In many cases, the only innovation we saw was in the development of products – each increasingly complex and toxic. Most products were a black box and only the very sophisticated could decipher the features of these products. Not surprisingly these would have failed to meet the most basic of the suitability & appropriateness tests.

Unfortunately, the liquidity driven Bull Run drove advisers to outbid each other in the frenzy to offer such products. When the music died down, lot of these products failed to perform leading to a loud outcry from stakeholders across the spectrum. Many firms were fined for mis-selling. This could have been mitigated by administering an appropriate suitability & appropriateness test on a client before introducing products into the portfolio. In this regard, one must commend the erstwhile Financial Services Authority in UK, now renamed as the Financial Conduct Authority (FCA) which has taken the lead in determining a proper Suitability test based on product complexity.

4. Irregular Monitoring & Review Process

In the absence of a periodic review & monitoring process, investment decisions become reactive & ad-hoc. Therefore a regular monitoring & review process needs to be agreed upon between the client & adviser in order to reinforce the importance of goal based investment planning rather than the more commonly prevalent noise based investments. Goal based investment review mechanism helps remove or mitigate investment biases and the decisions are made in a more rational framework. This also helps in setting up proper portfolio benchmarks and develops criteria for performance evaluation.

5. Absence of an Objective Revenue Models

Very few fee only planners exist in India. Most models today rely on revenue linked to transactions. Thus, investment decisions become transaction led and lack the strategic perspective that a fee only model can provide. SEBI has mandated that Advisers be remunerated largely through client fees and not through brokerages is a step towards promoting advisory integrity. However, user pay models even globally are still evolving. While clearly this is the way fiduciary practices are remunerated, Investment Advisory practice is still in a nascent stage when we look at the number of firms that are fee only.

However, if one is convinced about the long term sustainability of the Advisory practice, it really needs a few building blocks to create a “best in class” advisory practice. As is often said “wisdom is knowing what to do next, skill is knowing how to do it & virtue is doing it” (courtesy – David Star Jordan)

Based on the above gaps, the Secrets to a Successful Advisory Practice are:

  1. An independent, objective and scientifically developed Risk Profiler.
  2. An Asset allocation Model that takes into account the various data points as well as recognizes the behavioral biases that lead to flawed decision making.
  3. A structured financial planning process that takes into account each client’s vision, value and goals before reducing them to figures.
  4. A regular monitoring & reviewing schedule – ideally one comprehensive review every quarter
  5. A transparent fee based model that is linked to the amount of time required and complexity of issues rather than a AUM linked or a transaction led model

The essential building blocks of a sound advisory practice are available with us – the challenge is having the conviction of putting this all together and making ourselves “Future Ready”.


Authored by,

Rajendra Kalur

Chief Executive Officer
TrustPlutus Wealth Managers India Pvt Ltd

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