This article explores model portfolios, their benefits, and the regulatory uncertainty surrounding them.
In our wealth-tech series, we analyze different wealth-tech products and their legal status. You can read all the posts here.
The COVID-19 pandemic was a turning point in the history of Indian capital markets. Many Indians stuck at home were drawn to the stock-market as it touched new all-time highs. Digital discount brokers also made investing easier and cheaper than ever. But picking the right investment products is complicated, especially for fledgling investors. Over the years, some broad rules have emerged. Like the ‘100 minus age’ rule which involves deciding the equity-debt split in a person’s portfolio by subtracting her age from 100. These rules aren’t based on the investor’s specific risk-tolerance or financial capacity. They only provide general guidance that may be suitable for some but not all investors. But investors also need specific guidance. There are over 5000 companies listed on Indian stock exchanges. How can an investor pick stocks for her portfolio when there are so many options? Enter: model portfolios.
A model portfolio is a list of stocks which the curator of the portfolio considers to be good investments. The list typically contains weighted allocations for different stocks. So, it provides information about (a) which stocks to buy, and (b) how many units of each stock to buy. Model portfolios can be of different types. They can be based on a particular theme (like green energy), industry (like banking), or strategy (like dividend earning). Model portfolios can be a useful starting point for investors who are searching for stocks which match their interests and needs. But the legality of offering model portfolios is mired in uncertainty. To understand why, let us analyze SEBI regulations governing investment advisors and research analysts.
To act as an investment advisor (IA) or research analyst (RA), a person must register with SEBI. And non-compliance can attract penalties. But when does someone act as an IA or RA?
IA Regulations: An IA is someone who provides investment advice for consideration or holds herself out as an IA. Investment advice means advice about investment products, investment portfolio or financial planning. But if a person shares investment advice with the public at large, she won’t be acting as an IA. IAs must comply with onerous obligations under SEBI regulations. These include executing a physical agreement with clients, conducting thorough risk-profiling of clients, and maintaining detailed records.
RA Regulations: An RA is someone who provides an opinion or recommendation about securities which may form the basis for investment decisions (including buy/sell/hold recommendations and price targets) or holds herself out as an RA. RAs must comply with several obligations under SEBI regulations. These include limitations on trading (in securities) and compensation, and disclosure of conflict of interest.
Differences between IAs and RAs: There are three main parameters along which the roles of IAs and RAs can be distinguished. The first is payment of consideration. A person must typically receive consideration for her advice to be considered an IA. But receipt of consideration is immaterial to determine if a person acts as an RA. The second is if advice or information is shared publicly or privately. A person won’t be considered an IA if she shares investment advice with the public at large. However, to be categorized as an RA, this fact is immaterial. The third is client-specificity. An IA is expected to provide bespoke investment advice to clients. In contrast, RAs don’t provide any client-specific advice.
Now, where do model portfolios fit in this regulatory maze? A settlement order between SEBI and a registered RA from May 2022 provides some clues. In this case, Stallion Asset, a registered RA, was alleged to have violated RA regulations by selling model portfolios to its clients. In its show-cause notice to Stallion Asset, SEBI stated that RAs can’t provide model portfolios. Because model portfolios don’t give the RA’s clients the option to invest in specific stocks. And the recommendations are portfolio-based and not stock-specific. This show-cause notice and the subsequent settlement order has raised doubts about who can legally offer model portfolios. SEBI is also reportedly planning to release a discussion paper on the legality of model portfolios. In particular, the paper seeks to explore through public consultation if RAs should be prohibited from offering model portfolios entirely. Or if they should be allowed to offer model portfolios with restrictions on offering weightage for different stocks, customizing portfolios for specific clients, and allowing clients to copy changes made to model portfolios.
We hope that SEBI brings in a more relaxed regime. Why? Because a model portfolio is to our financial health what a diet plan is to our physical health. Our diet must have the right mix of carbs, fats, proteins, vitamins and minerals. But with thousands of dishes having varying nutrient levels, it can be hard to pick the right food. Different types of diet plans – keto, intermittent fasting, paleo, vegan, macro-based – serve different types of eaters. And even these diet plans can be modified according to our preferences. Don’t like that kale salad? Replace it with a sprouts chaat. Similarly, model portfolios provide templatized guidance which can be customized according to our preferences. Without them, investing in the stock market may be too daunting for many retail investors.
In a recent speech, the SEBI Chairwoman listed 5 principles which should guide fintech innovation. Two of these principles – transparency and financial inclusion – indicate the path forward for regulation of model portfolios. Transparency means that the performance of a model portfolio should be clearly and verifiably disclosed. Financial inclusion means enabling regulation of model portfolios because they make it easier for retail investors to participate in the stock market. Hopefully, SEBI follows these principles and adopts a balanced approach towards regulating model portfolios.
(This post has been authored by the fintech team at Ikigai Law.)
If you have more questions on model portfolios, write to firstname.lastname@example.org