Regulations with respect to Research and Investment Advise

Outside of finance, there are few fields where there are so many intermediaries who try to provide solutions for every aspect of one’s finances be it personal finance or corporate finance.

In the United States, you have Mutual Funds, Registered Investment Advisors and Broker Dealers who perform activities with regard to providing advice to clients with respect to investments in the financial markets. 

India has a much fragmented ecosystem with Mutual Funds, Portfolio Management Companies, Registered Investment Advisors, Research Analyst and Mutual fund distributors performing the same functions.

While only Mutual Funds are Product sellers in the US, here PMS can also be categorized as product sellers with the rest being service providers. 

A couple of days back, SEBI through its settlement order seems to have suggested that Research Analysts cannot offer Model Portfolios. In a way, this order unless challenged and changed would mean that a Research Analyst can at best offer Buy / Sell on stocks but not provide the client any information on how much to risk.

If one were to look at any sell side research, the reports are what SEBI seems to believe is the way for a Research Analyst to act. While even Sell side these days showcase Model Portfolios, the majority of Sell side is basically about providing a Buy / Sell call on a single company with a detailed report to back up their viewpoint.

The issue though is that a big sell side organization can have a Buy on as many as 100+ securities. There is no way someone can follow this up and build a portfolio of stocks whose aim is to ultimately get returns better than the benchmarks.

So, who is an investment advisor?

If you were to look up the meaning as per US Laws, its;

“Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities

Sell Side Research which is freely provided to investors in theory should not come under Investment Advisor since he doesn’t directly receive any compensation for the fees even though the firm may indirectly benefit from getting more business from clients who wish to have access to their research team.

On the other hand, any one suggesting someone to buy a stock, mutual fund, PMS or any other financial asset where the person who recommends is compensated in one way or the other can be seen as Investment advisor.

But let’s back to the core issue – Model Portfolios

The basic idea of providing a Model Portfolio is simple – an investor has a sum of money he wishes to invest. The advisor provides a set of stocks where the said sum of money can be invested. If you think deeply, this is the same that happens when you buy a Mutual Fund or invest in an PMS. 

The amount you invest is “theoretically” invested in a set of stocks. While we may not know in advance the stocks and the proportion that is invested in Active funds, we can approximately guess as to how our investment will be invested. This works best for the vast majority of investors for it makes things simple.

When you buy a fund today, you have no choice on what stocks will be invested. If you don’t want to have say the Reliance group or the Adani group, you have very little choice in that matter.

When you hire an advisor and he recommends a portfolio of stocks, there is no compulsion into investing into all that. Let’s assume the advisor recommends buying Mc Dowell but you don’t want to buy into “Sin” stocks. You can easily overcome that by just not executing a trade in McDowell.

The right certification to recommend a portfolio we are told today is that of an Registered Investment Advisor (RIA). But there is a problem. The reason a Registered Analyst (RA) is not allowed to provide a Model Portfolio is because an RA doesn’t do any Risk Profiling of the client and the same portfolios are offered to clients about whose Risk taking ability the advisor seemingly has no clue.

But the way Model Portfolios are built and sold have little understanding of the intention of why SEBI framed such and such a law.

Assume I were to take a Risk Profile questionnaire and the output is that my risk profile is Conservative, should I be able to buy a Small Cap Portfolio?  If I can buy, what is the point of taking the Risk Profiling questionnaire anyways.

Is the Investor is Naïve

Thanks to information arbitrage, the retail investor for long has been naïve and have many a time been taken for a ride by unscrupulous dealers. The objective of SEBI was to ensure that the small investor got a fair deal and in many ways they have been able to get that right.

Since SEBI came into the picture, stock markets have become safer and better managed. While we even today have a broker default or two, the numbers are a rounding off error when one compares the number of brokers who used to default in the past.

But this heightened surveillance has also meant a more concentration of market share. So while a broker defaulted a couple of decades earlier did not cause risks to millions of investors, the same cannot be said today.

The way rules are getting framed, I wonder if the only way a small investor can be saved is by killing them beforehand. 

If you are active on Social Media, it’s tough to not have read an article or a book by one of the guys who work at Ritholtz Wealth Management. But for all their talk on how investors should act and behave, if you are an investor whose investment is less than a $1 Million, they have no interest in providing you with their service.

All investors require a certain degree of handholding. But if the advisor community is shrinked, there are only so many capable players who remain in the game. Will they wish to have small investors who demand as much time and attention as large investors as part of their clientele?

Once upon a time, India had more than 25 stock exchanges and thousands of stock brokers. Onerous regulations combined with changes in technology has meant that 90% of them have stopped being in existence. While there is a good side to it, the negative is lack of support for anyone who is not tech savvy.

Brokerage rates for investors have fallen to Zero but someone has to pay and this has meant that brokers today try to have more traders as part of their fraternity than investors. Having seen enough people lose in trading, I don’t see how this can end well to the vast majority. 

As India grows, the percentage of people who wish to be associated with the capital markets shall grow. What we need is regulations that ensure that the advisor community shall grow to meet the needs and this doesn’t have to stop at just having more Mutual Fund Distributors. 

Wish SEBI comes with clear regulations with respect to what and what not a Research Advisor can provide his client with for no small advisor wants to have a Sword of Damocles hanging over their head by way of massive financial penalty. Better not to do business than take that chance.