Who really makes the money?

The age-old dilemma faced by almost every investor never fails to rear its ugly head from time to time. Rightly so, given the continuum of negative news concerning the misappropriation of the trust that average investors place in their chosen financial advisor, be it an individual, a bank or any institution in the business of managing a client’s wealth.

Examples of this are dime a dozen. One doesn’t have to look further than a few years back, when a prominent UK headquartered bank was fined a then record £10.5m and had to pay £29.3m in compensation to thousands of elderly and disabled UK customers – average age 83 - who were mis-sold complex financial products with a five-year investment horizon designed to pay for long-term care. And more recently a major US bank’s two-year old debacle, where their Wealth Advisors were pushed to encourage client investment in high-fee products to generate wealth for the bank.

The wealth advisory business is essentially a simple 3 step process; 1) drawing up a financial plan based on the client’s financial goals, 2) proper asset allocation to give the portfolio the best chance to achieve these goals, and 3) encouraging client behavior towards patience, thereby allowing markets and the power of compounding to play their part. And if done with the degree of diligence and trust the stewardship of someone’s life savings deserves, the odds of success - and a long-lasting relationship - are high. The advisor is remunerated either through commissions (details of which the client can demand, and should be advised) or fees, or a combination of both, and everyone ought to go home happy.

But every party has a pooper. Make no mistake, Wealth Advisory is a business, and like any other business this too sounds the clarion call for ‘profit’. Nothing wrong with that. But ever so often an advisor comes under pressure to deliver profits for the firm and justify his/her cost. How is this done? Simple; by increasing the revenue on every rupee being managed. Assume an advisor has AUM (assets under management) of Rs 100 Cr. Given an average distribution commission of 1% (a round figure taken simply for ease of illustration) this would generate revenues of Rs 1Cr per annum, received over the year. In line with the remuneration structure of the firm, the advisor shares a percentage of this revenue. This is perfectly reasonable.

But the trend has shifted, rather sadly, to wanting ‘more’, and ‘now’. And from this more and now has the double-horned monster ‘Structured Product’ taken birth. Beautifully packaged and sold, complete with bells and whistles, the best thing since sliced bread. Catch phrases such as ‘multiply your returns two-fold’, maybe even ‘earn three times your principal’, and occasionally the jackpot ‘four-fold’ opportunity. With lots of jargon, conditions, and fine print that the average investor neither understands nor has the faintest inclination to read. Because advisors are trusted to act in the investor’s best interest, first and foremost.

Investing in Structured Products can be a wealth creator for the investor just as easily as it can destroy an investor’s wealth. This is simply a factor of how the product is structured and how the financial markets pan out during the term of the product. But no matter what a structured product does for the investor, it always makes shed loads of money for the maker and the seller. Please read the previous sentence as many times as it takes for the message to sink in – it states an indisputable fact. And this is why a hefty chunk of your investment portfolio has found its way into such products, with a radiant smile and a brilliantly practiced sales pitch that has been honed to silky smooth perfection.

You’d be forgiven for not knowing the possible risks of investing in structured products. After all, they are pitched as the magic bullet. Is the issuer credit-worthy? Who has certified this credit-worthiness? Where is your money invested? In loans to strange borrowers, at exorbitant rates of return that by definition make these loans risky? Does the issuer have the financial muscle to pay you back if something goes wrong? How do you know what contracts (using derivatives that you don’t understand) have been entered into on your behalf by the advisor to enhance returns? Have you seen a formal contract note, rather than an internally generated piece of paper that doesn’t show you the accurate details of the derivative trade? Who regulates the issuer of a structured note, and do the regulators really understand these products and the inherent risk they carry? Are you even remotely aware of the commissions that are built in? Does 5% to 10% get your tail up? And when you want to exit these products before maturity (assuming that you can), are you at the complete mercy of what the advisor charges you by way of unwinding costs (which again has to do with derivatives)? Now that Pandora’s box has been opened, is it any wonder that your advisor has been stuffing these down your throat so enthusiastically?

All this has more than likely got you thinking, dear investor, and rightly so. Now ask yourself the question once again – who really makes the money? Then choose your advisor very carefully; it could very well be the most important choice you make in your life.

Jehangir Tankariwala

Behavioral Financial Counsellor

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