Will This Be Robo Advisory Firms’ Achilles' Heel?

Robo advice has become a buzzword in the financial services domain, and robo advisory firms are mushrooming at a furious pace in India. A combination of factors—growing financial literacy among investors (especially in urban areas), internet penetration, and enhanced awareness about mutual funds, among others—has contributed to this phenomenon. It can be safely stated that robo advice is an idea whose time has come.

As the name suggests, robo advice eliminates human intervention. Instead of an adviser, the investor is guided by algorithms run on a website. Typically, the investor feeds in information about his age, risk-taking ability, income and expenses, current assets and liabilities, financial goals, expected inflation et al. The robo adviser uses the data to produce a suggested asset-allocation and a list of mutual funds that can aid the investor achieve his financial goals while adhering to his risk appetite. Furthermore, robo advisory firms also enable investors to make online mutual fund investments thereby acting as distributors too.

To my mind, several of the robo advisory firms do a decent enough job when it comes to risk-profiling and arithmetic calculations. Likewise, it is evident that some have paid due attention to areas such as user interface. It is the last mile—recommending mutual funds—where most err.

It is commonplace to see funds being recommended based solely on performance. Typically, the three-year period is considered, and top-performing funds make it to the robo adviser's list. Recommendations are also offered in the form of a portfolio of mutual funds. Yet again, the three-year showing is the primary factor for picking funds from various categories. Given the strong showing posted by small/mid-caps in the recent past, it comes as no surprise that at present several recommended portfolios have a strong small/mid-cap bias.

A rule of thumb approach is perceptible in the recommendations. For instance, investors with a moderate risk appetite are offered large-cap funds. However, no thought is applied to the nature of the fund. For instance, a large-cap fund wherein the manager aggressively churns the portfolio, and draws on factors such as news flow, market sentiment and momentum while investing might not be suited for a moderate risk-taker. Yet such funds make the cut thanks to their performance and large-cap classification.

Not only is making recommendations based solely on performance a fundamentally flawed approach, it also reveals a poor understanding of the basics of investing. When the present top-performers are replaced by others (as it can and does happen in the case of market-linked investments) will investors be expected to churn their portfolios? Robo advisory firms can’t take refuge under the premise that their advice is bound to be ‘formulaic’. There is a difference between formulaic advice and flawed advice.

Don’t get me wrong. I’m not questioning the utility of robo advice. For first-time investors and those with uncomplicated investment needs, robo advice can be the way to go. But robo advisory firms must realise that there is more to investment advice than just running calculations. Indeed, flawed advice can significantly hurt investors' interests.

Robo advisory firms have a huge opportunity at hand. If tapped well, robo advice can prove to be a game-changer for both the mutual fund and distribution industries. However ignoring the ‘advice’ aspect of the business will prove to be a costly miss.

Of exit loads, fund houses and distributors - 2

Yesterday...
All my troubles seemed so far away,
Now it looks as though they're here to stay,
Oh, I believe in yesterday...

(Yesterday – The Beatles)

This iconic song pretty much sums up the mood among several mutual fund distributors. For distributors habituated to attractive compensation structures and easy money, the new-look mutual fund industry has come as a rude shock. In one deft move (scrapping entry loads), the regulator changed the rules of the game. Further, the provision for uniform exit loads plugged the loophole that some would have liked to exploit.

Newspaper reports suggest that fund houses’ pleas to roll back/modify the entry load provision has been rejected by SEBI. Some fund houses have decided to compensate distributors by paying them an upfront commission in any case. Distributors on their part are tweaking their business models. Fee structures are being charted out; new value-add offerings are being introduced. Terms like ‘unbiased’, ‘independent’ and ‘research-driven’ are now liberally used in communication. Clearly, the mutual fund industry is in unchartered territory and ‘wait and watch’ is the new mantra.

Despite the gloomy picture being painted by most, it would be safe to state that the scenario isn’t as bad as it is made out to be. In fact, things could become markedly better for all the participants i.e. investors, fund houses and distributors.

Conventionally, distributors have worked on the ‘assets under management’ model i.e. more investments their investors made, higher was their pay-off. Broadly speaking, the latter came from the entry load, the trail commission and ancillary compensation/benefits provided by fund houses. While entry loads have been done away with, distributors can now demand compensation from investors directly. Also, unlike loads, this compensation is not regulated. It has been left to be mutually determined by the investor and the distributor.

Distributors argue that investors are unlikely to be willing to compensate them. There is some merit in that argument. Investors habituated to filling mutual fund forms and writing cheques for the investment amount, might resist the new arrangement initially. However, once they are convinced of the value that the distributor adds to the investment process, the resistance will subside.

The importance of quality advice and service cannot be overstated. The distributor has a vital role to play in aiding the investor achieve his financial goals. Making an investment plan, successfully managing and tracking an investment portfolio are no mean tasks. And once the distributor effectively communicates how his services can aid the investor, there’s no reason for the investor not to come on board.

Sure, distributors who fail to add value and work in the investor’s best interests might see their business dwindle. But that would only be a fair and natural consequence.

From the fund houses’ perspective, it’s an opportunity to have access to serious, long-term money. It isn’t entirely uncommon to see ill-advised investors invest monies simply to ride the rising markets. With quality advice being made available to investors, we could see the rise of a breed of informed investors who are willing to stay invested for the long-haul. Investors who don’t panic when markets experience downturns; instead they see the same as an opportunity to make investments at attractive prices. Now wouldn’t fund houses love to have such investors investing in their funds? Also, it would be fair to assume that fund houses will handsomely compensate distributors facilitating serious investors and long-term monies, for their efforts.

As for the investor, it's options galore. Some distributors will operate on the ‘transaction’ model i.e. use technology to offer investors a low-cost platform for making investments, others will bank on providing quality advice and then there will be those whose USP will be personalised service. In most cases, there will be an overlap. From the investor’s perspective, the importance of being aligned with the right distributor has never been higher. Investors will have to thoroughly evaluate the proposition offered by each distributor and select the one that best works for them.

For instance, if a distributor boasts of his research set-up, quiz him about the same, the size of his team and their experience. If a distributor claims to be independent, enquire how he ensures that his independence is not compromised with. If ‘low-cost investing’ is the platform on offer, find out how the same compares with other distributors. The onus to conduct a thorough due diligence and make an appropriate choice lies with the investor.

It won’t be surprising if investors choose to be associated with multiple distributors; for instance, the advice could be sourced from one distributor and transactions made with another.

As mentioned earlier, the mutual fund industry and its participants are in unchartered industry. However, despite what the naysayers would want you to believe, it need not be all gloomy. Remember the adage about – it’s not the cards you are dealt, but how you play them. The ‘how you play them’ part could hold the key for the mutual fund industry, going forward.

Here comes the sun,
Here comes the sun,
And I say it's all right,
Little darling, it's been a long cold lonely winter,
Little darling, it feels like years since it's been here,
Here comes the sun, here comes the sun,
And I say it's all right...

(Here comes the sun - The Beatles)

Will small savings schemes be rationalised?

Lately, several business dailies have been carrying reports suggesting that the rates offered by schemes from the small savings segment are up for review. Apparently, banks that have been nudged by the Reserve Bank of India (RBI) to cut lending rates have demanded a rationalisation in small savings schemes; the rationale being that attractive rates on the same prevent banks from lowering deposit rates. This in turn impacts their ability to reduce lending rates. A recently-appointed RBI deputy governor echoed similar views.

What are small savings schemes?
Small savings schemes are colloquially referred to as post office schemes. Broadly speaking, schemes like Public Provident Fund (PPF), National Savings Certificate (NSC), Kisan Vikas Patra (KVP), Post Office Monthly Income Scheme (POMIS) and the Senior Citizens Savings Scheme (SCSS), among others form the small savings segment. These schemes are backed by a sovereign guarantee, making them risk-free investments. Also, certain schemes offer tax benefits under Section 80C of the Income Tax Act.

The rationalisation saga
Reports of a rationalisation in the small savings segment have cropped up on several occasions over the past few years. Several panels and committees mandated by the central bank have recommended a more 'rational' structure. However, barring some cosmetic changes, the small savings segment has remained largely unchanged.

Incidentally, provisional figures (sourced from RBI's website) reveal that in 2008-09, inflows in the small savings segment grew after falling successively in the two previous financial years. It's not difficult to understand the reason for this phenomenon. The aforementioned time-frame coincided with a sharp downturn in equity markets; consequently investors smarting from heavy losses in equity and mutual fund investments chose to opt for 'safe' avenues. And investors' preference for small savings schemes in a time of adversity only bears testimony to their popularity.

Will the FM bite the bullet?
Come July 3, 2009 when the Union Budget is presented, will the FM announce a reduction in rates offered by small savings schemes? Your guess is as good as mine. However doing so would certainly qualify as a bona fide unpopular step. For instance let's consider a segment of investors like senior citizens and retirees who are largely dependent on income generated from investments. For such investors, POMIS and SCSS are 'bread and butter' investment avenues, given their need for safety of capital and assured income. Any reduction in interest rates on these avenues is unlikely to go down well with investors. Also, let's not forget that speculation is rife, that we are in store for a popular budget.

The 'middle of the road' approach
A more likely scenario seems one wherein interest rates on certain schemes will be altered, instead of 'across-the-board' changes. For instance, the PPF which runs over a 15-Yr period offers assured returns, however the interest rate (8% pa at present) is subject to change. Post Office Time Deposits (POTDs) offer an investment proposition similar to the one offered by bank fixed deposits. A reduction in interest rates on such schemes is unlikely to raise many eyebrows.

While reducing interest rates would be the direct approach to rationalisation, there are other ways as well. These would entail reducing the attractiveness of the schemes. For example, Section 80C benefits can be removed from some of the schemes. The investment tenure/lock-in can be enhanced, thereby forcing investors to stay invested for longer. Clearly, there's more than one way to rationalise the small savings segment.

What investors must do
For investors who were planning to invest in small savings schemes, now wouldn't be a bad time to get invested. This is especially true for avenues like NSC or POTDs wherein the rate of interest is locked at the time investment. This will ensure that the investments are immune to any subsequent change.

Without doubt, the small savings segment looks set to undergo an overhaul; as regards the magnitude of the same, only time will tell. However, few would dispute the role that small savings schemes can play, in terms of being the risk-free debt component in the portfolio. As always, investors would do well to judiciously select schemes that suit them the best.

Do you have a contingency reserve in place?

Does your investment advisor/financial planner recommend that you have a contingency reserve (or fund) in place at all times? Also, does he help you evaluate the adequacy of the same at regular time intervals? If not, then there might be a case for re-evaluating your association with the investment advisor/financial planner.

Simply put, maintaining a contingency reserve amounts to saving for a rainy day. Alongside creating portfolios to meet goals like retirement and children's education, having a contingency reserve in place is equally important. As the name suggests, this is a pool of money set aside to provide for unforeseen events. While the concept of maintaining a dedicated reserve for the aforementioned purpose isn't exactly a recent phenomenon, its need has certainly become more pronounced now, thanks to the layoffs, pay cuts and enterprises shutting shop.

A contingency reserve ensures that you can go about with your day-to-day activities even in the event of an unexpected (and unpleasant) situation arising. In effect, it ensures that you don't have to compromise on your lifestyle, even in difficult times.

How much money will I need
Like investing, creating a contingency reserve is also a personalised activity i.e. it has to be tailor-made for you. What you need to do is determine how much money you need to meet all your expenses on say a monthly basis. This will include making an estimate of all expenses i.e. grocery bills, utility bills (electricity, telephone, petrol, rent and EMI), outlay towards children's tuition fees, among others. Activities like dinners in restaurants, weekend getaways, movies and shopping sprees at malls should also be provided for. You might also want to incorporate a certain amount for medical emergencies, given how expensive hospitalisation and medical treatment can be (remember, medical insurance doesn't cover all ailments). While theoretically the list can be endless, you need to arrive at one that is right for you. It should comprehensively cover all the areas that you would need to spend on in the normal course, and thereby ensure that your lifestyle is not dented.

The next step is to determine the period for which you would like to make a provision. Again, this choice needs to be made, based on what works for you. Suppose you arrive at Rs X as the sum that you need to spend every month; furthermore, you believe that 6 months is the period for which you would like to have a 'safety net'. In that case, you should have a contingency reserve of Rs 6X.

How to create a contingency reserve
It's possible that you may not have the requisite sum (Rs 6X) available at your disposal, to begin with. That's fine. Set aside what you have and keep adding to it in a disciplined manner until the target is achieved. It is important that the contingency reserve be invested in appropriate avenues. Safety and liquidity are two factors that must be accorded high priority. Hence, the sum can be stored in a separate (more on this later) savings bank account; a portion of the reserve can even be held in cash. The intention is ensure that the earmarked funds can be accessed at a short notice and also, that they are not exposed to any risk.

The contingency reserve is sacrosanct
It is vital that you respect the sacred nature of the contingency reserve. In some cases, the sum being set aside can be quite substantial. There will be temptations to dip into the reserve and use the monies for purposes, other than the intended ones. For instance, if equity markets are surging, a substantial sum of money lying unutilised in a savings bank account may stick out like a sore thumb; there will be temptation to invest those monies in the markets. When it's the festive season, attractive discounts are commonplace. You might be tempted to use the reserve to capitalise on the same. Don't succumb to such temptations. It would certainly help to hold the contingency funds in a separate bank account. Thus the likelihood of the funds getting used up for extraneous purposes will be reduced.

Finally, at regular time intervals, it is important that you review if the contingency reserve is adequate. An upgrade in your lifestyle could mean that the contingency reserve has become inadequate. In such a scenario, replenishing the same at the earliest should be given priority.

In a time of crisis, not having a contingency reserve could force you to either compromise on your lifestyle or divert monies from other needs. In either case, it would be an undesirable scenario. Several individuals are vulnerable to the "it will never happen to me, so why provide for it" syndrome. While it would be nice to be never faced with a crisis, banking on the same might amount to wishful thinking. Remember, the rationale for a contingency reserve can be traced to the time-tested tenet of - prevention being better than cure.