The problem with this approach is that both regulators and producers hope the investor will select the right product using the information that is disclosed. This has not been the case for three main reasons. First, producers bring too many products with poorly differentiated variants and are not too bothered as long as they comply with disclosure rules. Second, distributors and advisers push these products to investors for a commission, leading to misselling. Third, disclosures are too technical and complex for investors to make an investment decision based on them.
The focus in financial markets is slowly shifting to 'suitability' of financial products, where investors are helped by advisers and distributors to select the right product based on its appropriateness for their specific situation. This means the selection of the right investment product is done by the adviser based on his understanding of the investor's needs. Several assume that collecting financial data from the investor and running a risk profiling questionnaire would solve this problem. Many investor advisory processes tend to build around these two documents. However, more needs to be done.
Let us consider the case of a retired investor. The first question is about his needs, or what he would expect the investment to do for him. He would like to receive a regular income that adjusts for inflation and protects his capital from erosion. The second question is about the extent to which he depends on this investment for these objectives. Or how critical is the performance of this investment for the given objective, and whether there is a buffer or alternate sources to meet the given objective. The third question is about how willing the investor is to accept any variation in the investment performance, say, the minimum monthly income that he expects at all times. The fourth question is about the willingness and ability to accept any changes to the invested value and the maximum downside that can be accepted without stress.
In the above framework of suitability, the adviser should be able to compare the alternatives that are available. For example, a bank deposit or a government saving scheme may serve the objective of safety of principal and regular income, but may not protect against inflation. An investment in equity may offer long-term protection from inflation, but will offer neither capital protection nor regular income. A suitable solution is a combination of equity and debt, which generates an income within the range that the investor is comfortable with.
How should a mutual fund's monthly income plan (MIP) be positioned in the context of the suitability framework? The investor should know that the product does not offer a guaranteed dividend of a fixed amount every month. Therefore, unless he has an alternate source of income, such as rent, interest from deposits, income from an alternate profession, an MIP would be unsuitable. It is at best an add-on product that can supplement existing income from another source. Recommending that the entire retirement corpus be invested in an MIP would make it unsuitable for an investor seeking a fixed amount of monthly income.
It would, however, be suitable for an investor who is willing to take some downside risks to income and capital, in return for a growth in the value invested over a period of time. This needs investor agreement on risks to capital value and income, to some extent. However, unfortunately, MIPs are typically positioned as a 'yield plus' product, which is only half the story. Advisers tend to tell retired investors that the MIP will offer a return better than that of a bank deposit or saving scheme, since the equity return will top up the interest income earned by the debt portfolio. This is not always true. What the investor needs to know is that the presence of equity incorporates risk into the product in return for appreciation in the value of the investment over the long term.
Assume that the debt component earns a return of 9%, and 80% of the portfolio is invested in debt securities. This translates to a return of 7.2%. The equity component of 20% is risky. It can earn a return of say -15% to +15%. This means that it contributes -3% to +3% to the return. After allowing for costs of, say, 2%, the return to the investor ranges from 2.2% to 8.2%. If suitability is the criterion, the investor who chooses this product should be willing to accept both variation in income and in the value of the amount invested, given the equity component in the portfolio. Only those retired investors who accept this proposition pass the suitability test. Others will reject it.
What happens in this context? The adviser positions the MIP as 'better' without highlighting the risk brought in by equity, and positions the return for one of the many scenarios where it is higher. The fund manager is expected to meet the demands of the sales team that has made the promise, and juggles the equity and debt components to deliver a stable return, or announce a regular dividend. The funds that manage to pay a regular dividend are heavily invested in debt, not meeting the need of equity for the investor; funds that deliver a high return do so in a bullish equity market, unable to replicate it in a falling one.
We have a sad situation where MIPs are offered with various equity levels (5-30%) and their performance swings wildly. In a rare phase of good equity and debt returns, they are stars with double-digit returns. During good equity markets, they are the deposit-plus product advisers love. The rest of the time, they are products whose performance and returns are tough to explain and investors remain unconvinced.
Suitability requires comparison of alternatives. The retired investor may be better off adding equity to his post office deposits or an index fund to his bank deposit. Such solutions require advisers and investors to examine both risks and returns, and agree on what they are willing to give up in terms of security and comfort, in exchange for inflation protection and return. That is the process we need.
(The author is Managing Director, Centre for Investment Education and Learning.)
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