The scope of incidental advice in Financial Product Distribution

Distributors are legally bound to determine suitability and accordingly provide incidental advice pertaining to the products they recommend. What does this mean?

Ensuring suitability is a part of SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to securities market) 2003. This amendment to the regulation included mis-selling in units of a mutual fund scheme within the ambit of the mis-selling regulation. The regulation defines mis-selling in units of mutual fund schemes as any of the below:

1. Making a false or misleading statement, or

2. Concealing or omitting material facts of the scheme, or

3. Concealing the associated risk factors of the scheme, or

4. Not taking reasonable care to ensure the suitability of the scheme to the buyer.

The proper matching of the scheme (product) to the buyer (investor) can only happen when we have adequate information from both the sides. So, first and foremost, in-depth product knowledge is important in order to come up with a suitable match for the investor's requirements. This is taken care of by SEBI, NISM and AMFI, as they allow only licensed distributors to operate, who have demonstrated the necessary product knowledge by completing the respective certification requirements.

Now, what information is required from the investor's side to determine suitability for arriving at the right asset allocation and product recommendations?

Investor Profile

Points to ponder:

• Would it be suitable to recommend 100% equity funds allocation to senior citizens?

• At the other extreme, would it be prudent to suggest 100% debt funds allocation to young working professionals?

• Take another case: Would it be suitable to suggest 100% equity allocation to a lower income category person who does not have any contingency funds or adequate insurance coverage?

• And on the other hand, would it be a proper match to recommend 100% debt allocation to an investor with a high tolerance for volatility who is looking for investments with a higher potential return?

So, to determine suitability effectively, relevant factors about the investor profile like age, investing experience, financial situation, risk tolerance etc. need to be considered.

Financial Goal Planning

There are various aspects to goal planning as listed below.

1. Goal Time Horizon: Is a pure equity product a suitable recommendation for a goal that is coming up in just 2 years time? Or would a 100% debt allocation be right for a goal that is coming up after 10 years time? The time horizon is one of the most important considerations to determine a suitable asset allocation for the goal.

2. Goal Priority: Allocating funds to low priority goals while high priority ones remain unfunded may not make sense. So, it is necessary to have the full list of goals and rank them by priority.

3. Goal Amount: The target goal amount and currently available investable surplus that can be allocated towards the goal is an essential input to determine an appropriate asset allocation for the goal. For example, if the investable surplus is high and hence the target goal amount is easily achievable, there may be no reason to invest in higher volatility assets just for achieving higher returns.

In conclusion, a proper understanding of the investor profiles and their goal requirements is important to ensure suitability and determine a proper asset allocation. Arriving at the asset allocation is the basis for deciding which categories of products are to be recommended. All these steps put together logically form the scope of incidental advice to be given, without which determining suitability and recommending the right products would simply not be feasible!