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My apologies for not publishing a post this past Tuesday; I just couldn’t get it done on time.😔 For the month of February (at least), I’ll be following a Saturday posting schedule.
Last week I had posted my first Company Analysis report which covered one of India’s largest companies — HCL Technologies Limited. If you’ve missed it, here’s a link.
Today’s article (background music 🎧) talks about how the financial services landscape has changed, and how we as investors should adapt.
Has anyone ever tried to sell you an insurance policy or a mutual fund?
Yes! (I’m assuming)
Though entities (like Franklin Templeton Mutual Fund or Tata AIG General Insurance) that make these financial products, sell them directly as well; often, they’re sold through intermediaries. Middle-men if you will.
But all intermediaries aren’t the same — there are distributors, and there are advisors. Distributors earn a commission (from the financial institution) on every unit they sell; and advisors charge the customer directly for their expertise.
It might not seem like it, but this is a huge difference.
Say X seeks Y’s advice on which mutual fund to buy out of P, Q, and R. X assumes that Y will suggest the best one of the lot… the one that best serves X’s needs. But, Y receives a much higher commission from the company offering Q, as opposed to the other two. So, chances are that Y would recommend Q; irrespective of whether it’s most suited.
If I’m a customer, I’d much rather have the person influencing my decision be on my side. The odds of that are higher if their earning flows from me, and more importantly, nothing flows to them from the supplier.
So, while investing in mutual funds, one should seek out high-quality investment advisors (so that their interest is best served), rather than mutual fund distributors; pay them advisory fees, and then, invest in direct schemes instead of retail schemes. Let me explain. Say you’re thinking of investing ₹1,000 in mutual funds. The fund charges some money to pay for its expenses, like staff, rent, office equipment, etc. Let’s assume it to be 1% (this is called expense ratio). Now after deducting such an amount for their expenses, they’ll invest ₹990 on your behalf. On the other hand, if the fund has to pay the distributor a commission of say 0.25%, the expense ratio would increase to 1.25%. So now an even lesser sum of ₹987.5 would get invested on your behalf. The higher the distributor commission, the lesser is invested on your behalf. And that too, in addition to their decision-making bias as explained above.
The scheme in which ₹990 is invested is called a direct scheme (since there are no distributor commission), and the scheme in which ₹987.5 is invested is called a retail scheme (where the distributor gets a commission). This, eventually, impacts one’s returns significantly.
Though in the investing space, the regulator make a clear bifurcation between a distributor and an advisor, that isn’t the case in insurance. In insurance, both kinds of intermediaries — agents and brokers — earn through commissions. This is theoretically a great business; commissions are high, and claim servicing is not required every year. But, the issue of cash-backs run rampant in the industry. When a large company pays say ₹1 Crore in insurance premium in a year, say the intermediary involved receives 10% commission, ₹10 Lakhs. The department handling this from the company’s side (usually the finance department) often negotiates a kick back in cash. This, unfortunately, happens all the time. In individual and corporate policies alike. This not only robs the intermediary of the opportunity to grow, and hone their expertise, it also has a dampening impact on their integrity.
To solve this problem, I would much rather that, similar to the mutual fund system, retail and direct schemes be started in insurance as well. This would allow actual experts to thrive, it would kill the side-incomes of the wrongdoers, and would enable cheaper prices; all of which would benefit society.
Yes, on a regulatory level, these changes are required. But we too as a society need to appreciate and learn to pay for high-quality advice. When we shortchange a professional, whose only differentiation is their knowledge, we deny them the opportunity to grow and hone their craft more and more. Then, they too are compelled to resort to becoming distributors.
In an economy where making supply reach demand is difficult ⇒ distributors are key! And in pre-internet times distribution networks, brokers, etc. were of huge importance. But now, when demand can easily interact with supply (thanks to the internet!), distributors have lost their importance. In fact, lofty earnings of large players is regularly frowned upon. In such an economy, supply gets commoditised and demand is spoilt for choice; and here, an expert advisor, a professional, garners greater importance. (I’d written about the difference between a differentiated product and a commodity in this article)
Financial services, as an industry, is driven by the gap in information. The internet has made all the information available on search. But, only the expert (because of all the time they spend on the one topic) knows which information is useful and which is useless. Years ago, providing information was a key part of being a consultant, but now, only interpretation matters. Information, like ideas, has become cheap. Interpretation, like execution, makes all the difference.
Thanks for reading! I’ll see you next week. :)
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