Complex products earn higher upfront commissions for Wealth Managers. Hence, there is frequent mis-selling of such complex financial products to investors.
We were recently asked our opinion on one such product which a “Large wealth management company” had pitched to a well-wisher. The product was a Nifty-linked debenture with the following characteristics:
- If 3 year Nifty returns are >26.8% in absolute terms, investor gets ‘Principal + 100% of Nifty return’
- If 3 year Nifty returns are <26.8% in absolute terms, investor gets ‘Principal + 26.8% absolute return’
Assuming an initial Nifty value of 7400, the pay-off to the investor by was illustrated by the Wealth Manager via the graph below
An accompanying email described the product return as Minimum Absolute Return of 26.8% – “even if the Nifty gives a negative return, the product will still give returns @ 7% IRR”. There was a footnote on this calculation being pre-tax and pre-fees.
We believe the Wealth Management firm was being economical with facts and being smart on representation
- Comparative Returns vs a Nifty ETF were not shown post taxes and post fees. Do taxes and fees not matter? Note, the upfront fees were 3% of Principal invested
- This product benchmarked its performance to the Nifty at the end of 3 years but the lock-in period was 3.5 years. Thus, Nifty return was considered for only 3 years even when the lock-in for the product was 3.5 years. Simply put, it was assumed after 3 years the sum invested in Nifty would not earn any return, clearly a false assumption. At minimum, this sum could earn the rate offered by a tax-free GOI bond understating comparative Nifty CAGR to that extent.
We replotted the returns post-tax, post-fees on a wider range of NIFTY scenarios represented in the chart below:
- We assumed tax free 7.5% p.a. returns for a period of last 6 months in calculating total returns for Nifty (since the product is benchmarked to Nifty at end of 3 years and lock-in for the product is 3.5 years)
- Product returns were calculated after adjusting for 3% upfront fee and capital gain tax of 10% on this product on maturity
Contrary to the chart mapped by the Wealth Manager which showed no loss of upside, our results show meaningful upside is given up when the NIFTY CAGR crosses 5.5% from starting value… and this upside increases as Nifty returns increase. All considered, it seemed the wealth manager used tactics of “Fear” and “Greed”- promising principal protection with full upside participation, but was economical with the truth in showing that adjusted for fees and taxes, the Investor would be worse off by investing in the Product vs buying a Nifty ETF under certain NIFTY outcomes.
This insight is critical as a true depiction may result in a client making different choices. With the broader markets being almost flat over the last 24 months, what is the probability an investor will lose Capital by investing in the Nifty over 3 years from today? That would imply negative returns over 5 years, surely a low probability event and one that does not merit allocation to a Principal protected product.
Wealth managers have significant power to influence client decisions. This power should be exercised responsibly. Wealth Managers should have a moral obligation to make clients aware of risk return trade-offs, so clients can make better informed choices. Unfortunately, a commission driven model with annual revenue targets makes it difficult for most to serve client interests with absolute integrity. Solidarity has consciously avoided conflict of interest by choosing the path of being a “client pays fee” firm. Our independence, all in lower investment fees, and refusal to take commissions should offer comfort that our interests are aligned with clients.
Investors can protect their interests by following a few simple rules
- Always compare product options post-tax and post-fees, under a wide range of plausible scenarios
- Demand transparency from Wealth Managers on commissions. High upfront commissions are always a danger sign. Avoid products where fees are to be paid upfront and not linked to the performance of the product
- Avoid complex products which are difficult to understand even after putting in a reasonable time and effort. A combination of equity and debt can closely replicate most outcomes promised by structured products.
Always remember there is no free lunch – if something seems too good to be true, it perhaps is not good, or not true.