Three simple tips to choose the right financial advisor

Published: May 30, 2019 at 9:31 am

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Here are three simple tips to choose the right financial advisor for you with no conflicts of interest (fee-only registered with SEBI). If you wish to outsource money management, either because you cannot do it yourself for want of time, confidence or expertise or because you prefer outsourcing, a trusted financial advisor is necessary. More and more freefincal readers are working with my list of fee-only financial advisors registered with SEBI. If you are on the fence then this article will help you choose the right financial advisor.

In general, it does not make sense for a financial advisor to discuss this as there would be a conflict of interest. However, fee-only SEBI registered investment adviser (RIA) Avinash Luthria has an unmistakable earnestness about his approach to financial-advisory that will make you sit up and take notice.  In this article, the term financial advisor shall only refer to SEBI Registered Investment Advisors.

I respect Avinash’s realistic views on investment risk and reward and I especially agree with his points here. Even if you are a DIY investor, you can always discuss with a fee-only RIA to check if your ideas and plans are along the right track. You can read his previous guest articles here:

If you wish to work with Avinash use the contact info at his website: Fiduciaries. Avinash previously was a Private Equity & Venture Capital investor; His articles have appeared at Business Standard, Mint and The Ken. See: publications 

Three simple tips to choose the right financial advisor

How should you select a Registered Investment Adviser (RIA) to engage with?

Your registered investment advisor’s (RIA)s fees should be proportional to the RIA’s time/effort. Fees should not be primarily proportional to the client’s assets under management nor net worth nor income

Since I am an RIA and I have a conflict of interest on this question, I will try to point to answers by other people who are credible. Applying Warren Buffett’s framework to this question, the most important aspect is the RIA’s integrity. The second most important aspect is the RIA’s intelligence. And the third most important aspect is whether you are likely to get value for your money. ‘Whether you are likely to get value for your money’, is a conceptual point and most people would like a more concrete answer.

To know ‘whether you are likely to get value for your money’, instead of reinventing the wheel, since the US is decades ahead of India in all such matters, it is easier to mimic the answer in the US. The answer in the US (to ‘whether you are likely to get value for your money’), is “engage with an ‘Advice-Only’ RIA”. ‘Advice-Only’ is a sub-set of ‘Fee-Only’ i.e. only some ‘Fee-Only’ RIAs are ‘Advice-Only’ RIAs. This credible website explains ‘What is Advice-Only?’. In India most people have not yet heard of the term ‘Fee-Only’. So, to avoid confusion, in this article, I am not using the term ‘Advice-Only’. But I will summarize the three most important guidelines (from the website mentioned above), in descending order of importance. The executive summary is: Your RIA’s fees should be proportional to the RIA’s time/effort. Fees should not be primarily proportional to the client’s assets under management nor net worth nor income

To make these points more intuitive, I will use the analogy of a doctor or lawyer. This makes some sense because the law/regulations expect RIAs, doctors, and lawyers to act as fiduciaries i.e. to put their client’s interest ahead of their own interest. These analogies are only to help think through a point and an opposite point of view. It is easy to misuse analogies to support false arguments so these analogies should not be treated as a poof (“Proof by analogy is fraud” – Bjarne Stroustrup, the creator of the C++ programming language).

Important Caveats

Before discussing the guidelines, it would be useful to clarify three important caveats.

First, SEBI’s RIA regulations already provide several dos and don’ts and those are far more important. Most of the guidelines mentioned here go beyond what the regulation requires i.e. RIAs who do not follow them may still be compliant with the regulations. As an analogy, let’s consider a patient on his deathbed who is demanding an extremely painful and expensive medical procedure. The law may not require a doctor to counsel the patient that such a procedure may only extend his life by one day and hence may not make sense. But it would be a best for the doctor to counsel such a patient (while still leaving the final decision to the patient) even though that might reduce the doctor’s income (and the doctor may have an education loan to pay off or a family to feed).

Second, these guidelines do not apply to RIAs who are not financial planners at all but they instead focus only on a specific niche, for example, advising only about direct equity investments. One reason is that such an RIA is not doing any up-selling or cross-selling and is, in this limited sense, similar to the manager of an active Mutual Fund (MF) or a Portfolio Management Scheme (PMS) or an Alternative Investment Fund (AIF).

Finally, this is not a judgment about RIAs that do not follow these guidelines. It is just a suggestion to investors that these guidelines are in their best interest.

With these caveats in mind, these are the three most important guidelines in descending order of importance:

1 The RIA should not explicitly / implicitly earn any referral fee from a Distributor or anyone else

You do not want your doctor to have a conflict of interest by earning a referral fee from:

  • Manufactures of medicines (and hence unnecessarily recommend higher cost medicines)
  • Manufacturers of implants (and hence unnecessarily recommend surgery or a higher cost implant)
  • Medical diagnostic services companies (and hence unnecessarily recommend that you undergo various tests)
  • Other doctors such as a specialist (and hence unnecessarily recommend that you consult a specialist)

Similarly, engage with RIAs who neither explicitly nor implicitly earn any referral fees. Since referral fees from Distributors (of MFs, Insurance products, Fixed Deposits, PMS, AIF, Structured Products etc) is the most common problem, let’s deal with that first.

The referral fee may not be explicit and may be implicit or hidden. If the RIA is an individual RIA, they should not refer you to a relative or business partner or close friend who is a Distributor. This is a nuanced point because it is possible that an RIA has a relative who is a Distributor but the RIA strictly does not refer any clients to the relative who is a Distributor (since the RIA cannot interfere in the relative’s right to a livelihood, this is ok and is not a problem).

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Similarly, if the RIA is a corporate entity, then it should not refer you to a different division of the company that is a Distributor. In case of a corporate RIA, it makes sense for you to be very suspicious if there is another division of the corporate which is a Distributor (because an individual’s right to earn a livelihood is not relevant in the case of a corporate).

The same logic applies in other cases as well. The RIA should not explicitly / implicitly earn any referral fee from referring you to a lawyer or a CA or another RIA, etc. To clarify, the RIA may refer a client to a lawyer or a CA or another RIA (e.g. if you would like to move your engagement to an RIA with a lower fee) as long as the RIA does not earn any referral fee.

One has to apply one’s discretion with these guidelines. For example, an RIA may refer a client to a Specialist Distributor for an essential product (such as an experienced and highly competent Distributor who specializes in an essential but legally complex product such as Health Insurance) as long as the RIA does not earn any referral fee and the RIA discloses that the Specialist Distributor for the essential product will earn a commission.

2 The RIA’s fees should be proportional to the RIA’s time/effort

A doctor’s fees should be proportional to the time/effort that the doctor has to put in. The doctor’s fees should not be primarily based on the net worth of the patient. But a doctor may use the client’s apparent affluence as an input to suggest a higher quality and higher priced implant or procedure. Similarly, a lawyer’s fees for due diligence about the title of a real estate property should be proportional to the time/effort that the lawyer has to put in. It should not be primarily based on the net worth of the client. But it is possible that a client who is purchasing real estate worth Rs 5 cr will want a more detailed due diligence (e.g. going further back in history and insisting that the seller provides every conceivable proof of ownership/document) compared to a client who is purchasing real estate worth Rs 0.5 Cr. If the lawyer puts in twice the effort for the higher value real estate, it is ok to charge that client twice as much, but it is not ok to charge that client, five or ten times as much. To clarify, naturally, some doctors/lawyers have a higher hourly billing rate than other doctors/lawyers.

Similarly, an RIA’s fees should primarily be a function of the time/effort that the RIA puts in. An RIA’s fees should not primarily be a function of the client’s assets under management nor net worth nor income. If the RIA is putting in more time/effort for a particular client, then the RIA is likely to charge that client proportionately more. The key word here is ‘proportionately’.

For example, let’s assume that Client A is a Resident Indian with a net worth of Rs 0.5 cr and a simple portfolio. And Client B is a Non-Resident Indian with a net worth of Rs 5 cr and a complex portfolio. Let’s also assume that during the initial engagement, an RIA has to put in 10 hours of effort for Client A and 20 hours of effort for Client B. Then the RIA may charge Client B fees that are twice as much as the fees for Client A. But an RIA should not charge Client B fees that are ten times (or say, five times) as much as the fees for Client A.

To clarify, an RIA may use a (potential) client’s net worth or assets under management or income as a proxy to predict the amount of complexity in the engagement and the effort involved. This is ok as long as the difference in fees is proportional to the expected effort/time (in the above example, the difference in fees between clients of 2x). On the other hand, if the difference in fees between clients is not proportional to the expected effort (in the above example, the difference in fee between clients of 5-10x), then that is not in keeping with these guidelines.

In practice, because this approach is very new in India, for now (i.e. as of 2019), most RIAs in India who follow these guidelines have simplified their approach to fees and some of them may charge Client A and Client B the same amount (in the example above, they may charge both clients for say 12 hours of effort and put in 10 hours of effort for Client A and put in 15 hours of effort for Client B). There are many nuances and variations between RIAs, for example, some RIAs charge Non-Resident Indian clients a higher fee (because of additional complexity etc) and a few RIAs provide a discount to some clients who cannot afford the engagement (such as clients who cannot afford any RIA or clients who are in financial distress).

A simpler approach to fees (for example, a single fee for all clients) has some minor negative side effects. For example, Client B would typically want to go into more details than Client A. So, a single fee of say Rs X thousand (during the initial period of engagement) for both clients creates some challenges. Client A may find the fee of Rs X thousand (paying for 12 hours of effort when he requires only 10 hours of effort and gets 10 hours of effort) to be overpriced and hence he may not engage with that RIA. And Client B may find the engagement (paying for 12 hours of effort and getting 15 hours of effort when he requires 20 hours of effort) to be superficial, being penny wise and pound foolish and hence he may not engage with that RIA. So over time, RIAs in India will have to find various ways to charge Client A and Client B different amounts but still charge them proportional to the amount of effort that the RIA is putting in for each client.

3. The RIA should ensure that the client is not dependent on the RIA

A doctor should not try to maximize his income by prolonging the illness of a patient or unnecessarily asking the patient to keep visiting the doctor. But if the doctor believes that it would be good for the patient to do a follow-up visit, the doctor should suggest it. Similarly, a lawyer should not try to maximize his income by prolonging a legal case or prolonging a legal negotiation. But a lawyer may suggest to a corporate client that the next time they are doing such a transaction, to contact him earlier in the process to minimize problems. So, there is an element of subjectivity and judgment in this aspect.

Similarly, an RIA should ensure that the client is not dependent on the RIA and the client is free (both in letter and spirit) not to continue the engagement with the RIA beyond the initial period of engagement. The RIA should not upsell/push the client to continue the engagement. But an RIA may point out the pros/cons of continuing engagement and maybe even suggest what he thinks a particular client should do.

An RIA should make the client’s portfolio as simple as possible so that the portfolio can continue to work in auto-pilot mode. This is so that the client need not continue with the RIA beyond the initial engagement period (in India, the ‘initial engagement period’ is often one year but it could be just the time required to put together and agree on a plan of action which may be 1 to 6 months). This criterion means that an RIA who is a financial planner should not set up a complicated portfolio, for example by selecting specific equity shares.

Some proportion of clients may voluntarily choose to continue the engagement beyond the initial engagement period. But an RIA should not make the client dependent on the RIA i.e. the client should be completely free to choose (both in letter and spirit) whether to continue the engagement or not. There is an element of subjectivity and judgment in this last guideline and hence it has been listed as the least important of the three guidelines.

Conclusion

A majority of RIAs that charge a percentage of the client’s assets under management are usually able to charge that higher fee only by claiming that they can beat the stock market index. You cannot be sure that a particular individual (adviser or otherwise) will beat the stock market index either through direct selection of equity shares (as explained in the article ‘Avoid mistakes & minimize costs through index funds: Don’t waste energy fighting the law of no-free-lunch’ nor through the selection of suitable mutual funds (Indian mutual funds, as a whole, do not beat the index). Hence, any fees in excess of the fees of an equally competent RIA who charges you based on effort/time (and who covers the same essential aspects in as much detail) is wasted/lost.

The amount you could lose by paying excess fees to an RIA (who charges you a percentage of your assets under management) will vary from RIA to RIA. If you lose say 1% of your net worth each year either in commissions to a Distributor or in excess fees to an RIA (who charges you a percentage of your assets under management), then in 30 years, you would have lost roughly 26% of your net worth. Mental math shows that you will lose in the ballpark of 30% of your net worth and a calculator (ideally a scientific or financial calculator) or spreadsheet will provide the exact amount, which is that you will lose roughly 26% of your net worth.

Fee-Only is a generic term used in India. Most RIAs who charge you a percentage of your assets under management call themselves Fee-Only RIAs. And, most RIAs who follow these guidelines and charge based on the effort/time that they put in (and do not charge a percentage of your assets under management) also call themselves Fee-Only RIAs. So, you as an investor should dig deeper to figure out whether they follow these guidelines or not. After all, it may be 26% of your net worth at stake.

Avinash Luthria is Founder, Fee-Only Financial Planner & SEBI registered Investment Adviser (RIA) at Fiduciaries; He was previously a Private Equity & Venture Capital investor for 12 years and has a flagship-course MBA in Finance from IIM Bangalore; Views expressed here are of the author and do not necessarily reflect the views of FreeFinCal.

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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com

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8 Comments

  1. I agree with 1 and 3, but 2. is quite impractical. Clients would want businesses to be upfront about the charges in advance, and time/effort can be known only after fetching client details, and in some cases, after the whole work itself. A practical pricing strategy would involve bucketing based on the value of assets managed.

    1. Shyam,

      In the article, in point number 2, I am suggesting a ‘principle’ for fees (of the fees being primarily a function of effort). In the US it is possible to precisely implement that principle but in India one might be able to achieve only an approximation of that principle.

      I completely agree with you about the difficulty in estimating the scope and effort involved at the beginning of the engagement. And this does make it quite difficult for an RIA in India to try to approximate the principle of fees being primarily a function of effort.

      As a result, it is possible that an RIA in India might land up putting in 25% less effort or 25% more effort than the fees that the client paid and that is ok. The principle is that charging 5-10 times more for double the effort is not in keeping with these guidelines.

      Different RIAs in India may prefer different approaches to approximating that principle. As long as they are trying to approximate that principle, that is in-line with these guidelines.

    2. Shyam,

      In the article, in point number 2, I am suggesting a ‘principle’ for fees (of the fees being primarily a function of effort). In the US it is possible to precisely implement that principle but in India one might be able to achieve only an approximation of that principle.

      I completely agree with you about the difficulty in estimating the scope and effort involved at the beginning of the engagement. And this does make it quite difficult for an RIA in India to try to approximate the principle of fees being primarily a function of effort.

      As a result, it is possible that an RIA in India might land up putting in 25% less effort or 25% more effort than the fees that the client paid and that is ok. The principle is that charging 5-10 times more for double the effort is not in keeping with these guidelines.

      Different RIAs in India may prefer different approaches to approximating that principle. As long as they are trying to approximate that principle, that is in keeping with these guidelines.

    3. Shyam,

      In the article, in point number 2, I am suggesting a ‘principle’ for fees (of the fees being primarily a function of effort). In the US it is possible to precisely implement that principle but in India one might be able to achieve only an approximation of that principle.

      I completely agree with you about the difficulty in estimating the scope and effort involved at the beginning of the engagement. And this does make it quite difficult for an RIA in India to try to approximate the principle of fees being primarily a function of effort.

      As a result, it is possible that an RIA in India might land up putting in 25% less effort or 25% more effort than the fees that the client paid and that is ok. The principle is that charging 5-10 times more for double the effort is not in keeping with these guidelines.

      Different RIAs in India may prefer different approaches to approximating that principle. As long as they are trying to approximate that principle, that is in keeping with these guidelines.

  2. Excellent Thoughts. RIAs fee should not be linked to any Assets or Income. Paying a AUM fee is like buying a home from a broker and paying brokerage till the time you own the home.

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