Churning Profits over Wealth: The Juxtaposition of Advisory-Distribution Services

[Darshan is a student at Ramaiah College of Law.]

In a recent informal guidance, the Securities and Exchange Board of India (SEBI) has iterated that investment advisers must segregate clients, categorised under either advisory service (fee-only) or distribution services (commission-based), without availing both services from the same investment adviser (IA) group entity. It was also clarified that a switchover is not permitted post the on-boarding of the client, within the same group. At the outset, this flows from the SEBI’s established stance, one that has not addressed the blurred line between the very nature of the two services and conditions that set them apart. Moreover, investors who genuinely intend to shift, owing to the quality and repute of an IA are absolutely proscribed from doing so, which has placed their individual interests in a regulatory void aggravating the unaddressed schism between both the services.

This piece argues the need for remedial measures in the (eventual) backdrop of increasing number of MFDs (may or may not be SEBI registered) acting as advisory agents enjoying continued inclination of retail investor sentiment, to uphold investor intent and ease while balancing SEBI’s protective tendency. It calls for the latter’s timely positioning of the advisory and distribution services to effectively assess their true impact on market integrity and distinction in professional judgement.

Tracing Regulatory Roots: Advisors and Distributors

A registered investment adviser (RIA) is a SEBI-registered entity which renders personalised guidance to clients based on their financial goals, risk appetite, and market conditions, which mainly includes portfolio construction, financial planning, risk profiling and asset allocation. Unlike mutual fund distributors (MFDs) who earn commissions from mutual fund sales of products posited by an asset management company (AMC), RIAs charge fees directly from clients. They enter into regular plans and direct plans respectively. Owing to complaints of charging exaggerated fees from clients with false promises of handsome returns and mis-selling of products by IAs contrary to the risk profile of the clients, the SEBI amended the IA regulations 2013 to introduce an explicit mandate of “segregation” of clients receiving advisory and distribution services wherein, a client cannot be offered both services within the same IA group entity. Furthermore, the guidelines issued in this regard provide that existing clients availing distribution services are not eligible for availing advisory services within the group/family of the IA. The same applies to the other way around, regardless of the fact that the client is an individual or not. The fresh clientele will  be  eligible  to  avail  either advisory or distribution services within  the  group / family  of  IA, and an individual IA is not allowed to render distribution services. However, the catch here is that the option to choose shall be applicable to such client at the time of on-boarding and not thereafter.

Scaling the Implications: A Factual Analysis

The inherent lacuna is the absence of considering the evolving investment needs arising upon utilizing distribution services from an RIA. An investor would naturally proceed to avail advisory services from the same entity due to acquaintance and expected ease of trade. Pursuant to being legally barred, it has resulted in MFDs, registered with the Association of Mutual Funds in India (AMFI) rendering advice under the garb of permitted basic services ‘incidental’ to product distribution besides benefitting from, commissions invisibly embedded in the mutual fund expense ratio (ER) and, multi-AMC agency status. Empirical data demonstrates a clear preference for distribution-led investment channels with nearly 70% of equity investments routed translating to over 3 lakh mutual fund distributors, a dominance driven not merely by cost considerations, but by the extant trust established with them. The ensuing impact in the advisory sector is glaring, as RIAs in the country have depleted, from 1300 in 2020 to 1000 at present prompting the SEBI to design a working group and revisit the regulations governing IAs and MFDs. The working group contemplates enhanced commission disclosures, clearer boundaries around permissible advice, higher qualification standards, and a licensing structure that allows limited advisory activity without full RIA recognition. 

This development shows that investor behaviour has outcompeted the regulatory ecosystem and has created a bizarre situation for registered IAs in light of the switchover block especially with the latest trends highlighting the rise in direct investments through direct plans, due to the increase of online channels and digitally inspired activity.

Renewal of Pure Investment Advice: Measures and Recommendations

The aforesaid dearth can be tackled with a gradual three-fold process. Firstly, a partially hybrid model can be adopted, in which those MFDs and SEBI registered IAs (together referred to as distributors) who provide incidental guidance that tantamount to investment advice may be allowed to do so to the extent of certain areas that strictly exclude those that are to be rendered by the advising RIAs. This is due to the conveniently slimmed line between both services.

For perspective, FAQs issued by the AMFI provides that ‘incidental advice’ does not include ‘detailed’ financial planning and holistic investment advice, but rather includes risk profiling to devise an informed assessment of the client’s risk appetite. Interestingly, the term ‘detailed’ has not been adequately addressed and financial planning per se, is deemed to be ‘investment advice’ in regulation 16 of the regulations, clarified in the FAQs as well. Risk profiling and portfolio monitoring (periodic tracking/review) too have been claimed as perks of consulting an RIA. So, relevant changes must be made to exactly define the contours of incidental advice and ‘un-personalised investment advice’ that a distributor is confined to, stimulating simplified trade for fledgling investors who need assistance. 

Comparative experience can aid this process. The Securities Exchange Commission in the US provides for individual codes of conduct and standards for both brokers (MFDs) and RIAs to be adhered to by a person who performs dual roles. It also notes that an entity that offers both services (fully hybrid) must be careful in evaluating the appropriateness of the services involving factors such as the amount of monitoring, trading and supervision conducted on behalf of the client and the costs of such service. Distributors may offer a wrap-fee program where both services are served at a single consideration, being part of the ER with a breakup of the costs incurred in both services (X+Y), apart from the fund management cost (Z) levied by the AMC (X+Y+Z= Total ER). This way, the remit of a distributor’s handholding is determined.

Second, the SEBI must allow for a switchover to pure RIA-oriented advisory within the same IA group only after the expiry of a period (say 3 years) enabling amateur investors to comprehend industry winds under the MFD’s limited yet requisite guidance so that they can shift to specialized advice from an RIA on core areas, as against stifling such a possibility altogether. 

Third, as an impetus to the continued expansion in the direct investor base, the commission charged may be standardised. RIAs in India operate primarily on an upfront or recurring fee model unlinked to product commissions, whereas mutual fund distributors earn embedded trail commissions also known as annualised commission, without any upfront payments, that compounds with the number of years of investment. The commissions vary with schemes and funds, and accordingly a distributor sells the product to clients. To neutralise the effects of profit churning, all distributors must be mandated to charge the same rate of commission, for all regular plans in a particular fund, which can be equity or debt. With this in place, there will be no frequent switching of schemes, reducing the possibility of fragmented portfolios and diminished investment outcomes. This forces distributors to promote more performance-oriented rather than commission-incentivised schemes, helping investors analyse market sentiment, consequently pushing for a switchover to RIAs to seek core advice. 

Way Forward

The adoption of the suggested measures can yield steady positive results, reducing the over-dependence of investors on distributors, and encouraging professionals to register with the SEBI as advisory IAs and tend to the clientele with clarity and insight. With an aim to complement the inputs of the working group, these measures envisage a spike in IA registrations that significantly enhances the import of investment advisory while parallelly retaining distribution as an initial resort.