Trying to understand financial products can get tricky, even for seasoned investors. And the overwhelming barrage of new products/strategies/ideas can be confusing to navigate through. Since financial products are often associated with complexity, many times clients inadvertently neglect to ask relevant questions; some are afraid to appear inferior in intellect and others because it simply doesn’t strike them. The result? Either they completely submit to their advisor or shun the idea of investing in financial products (“this just isn’t for me”).

The purpose of this piece is to give you ammunition to analyze and understand ANY available financial product in the world so you can make an informed decision. More importantly, it’ll help you align your expectations with reality so that you’re never in for nasty surprises.

We’re giving you a checklist consisting of six parameters and 20 questions that need to be discussed EVERYTIME an investment product is recommended to you. One read through this and you are sure to surprise the next wealth manager who walks through your door carrying the ‘perfect product’, whether it’s a basket of shares, mutual funds, an insurance policy, an FD, a PE fund, a structured product, or anything else.

1. Expected Return – Please remember returns are a function of probability and the only parameter from our list that is unknown today. No investment return is “guaranteed”, not even a fixed deposit. Yet as investors we are fixated on returns only, as if we control it. However asking the following questions will give us a deeper understanding of the suggested product’s potential performance.

a. How does this product fit into my portfolio’s objective?

b. What is the annual expected return from the product? Please explain your rationale with relevant data.

c. What is the expected holding period for the product to deliver its expected return and how will it change if I reduce/increase the holding period?

d. Since its inception, can you show me the past performance of the product in different several scenarios and time frames? – We call this the ‘rolling returns’.

2. Risk – Return and risk are two peas of the same pod. Discussing one without the other is useless, even dangerous. Take for example the two products below:

· Product A – Expected return of 15% with a standard deviation (risk) of 4%.

· Product B – Expected return is 20% with a standard deviation (risk) of 15%.

Product A is by far the more superior product because it has a better what we call ‘risk adjusted return’. It has delivered more return per unit of risk taken. So please ask the following

a. Can you list down and explain to me in layman terms, ALL the types of risks associated with investing in this product?

b. Can you quantify the risk to me? – Remember, the term ‘high risk’, ‘low risk’ has no meaning. Risk too can be quantified in a number just like return can. Ask for that number and an explanation of what it means.

c. What is the worst case scenario if I invest in this product for the recommended period?

 

3. Cost – In most meetings we do, clients either have no idea or have completely misunderstood how much they are paying for the products in their portfolio. Not that we’re blaming them; after all the industry has come up with pretty creative ways to elude the client from what they need to know. The thumb rule here is – cost/fee should be aligned with the increase/decrease in value of your investment.

a. Is there an upfront charge deducted from my investment amount? If so, why? – Remember these can also be hidden. You’ll only know if you ask!

b. What is the annual expense ratio / management fee / profit sharing being charged and how frequently is it deducted? Please give me an example of the calculation

c. How frequently will you trade and what are costs associated with each transaction? – Remember, generally speaking an increase in trading frequency usually increases costs (think brokerages, STT, taxes, etc.)

d. Please explain to me how the fee being charged is in alignment with my interest.

e. Again, are there any other charges that I should be aware of? – may seem petty but ASK! Did you know that in unit linked insurance plans (ULIPs) the investment units are deducted as ‘policy administration charges’? Imagine purchasing 10 shares of company to realize that tomorrow you have only 9 and one has been taken away on account of ‘fees’. How would you feel? Exactly!

Please understand that tiny differences in cost compounded over years can destroy or build huge amounts of wealth. BUT (and this is a very big but) being overtly cost sensitive can often be extremely dangerous. Cost MUST be viewed in tandem with return. You wouldn’t want to end up with a mediocre basket of products only because they are cheap, would you?

4. Liquidity – Perhaps the most underrated parameter but extremely crucial. Liquidity is the time taken to convert your investment to cash at a negligible/reasonable cost, the latter part of the statement being very important. And what is a ‘reasonable cost’ depends on the asset class, the product, and its strategy. Your RM should be able to justify the cost/exit load/penalty (whatever it’s called) to you. As a thumb rule – any illiquid investment better give at least a 3%-4% annual return greater than the liquid counterpart. For example, a property better be giving 3%-4% more than equity. Remember, liquidity is opportunity. Liquidity is king!

a. What is the lock in period of my investment and what is the justification for that lock in period?

b. Is it possible that the lock in period is extended, has it happened before in similar products?

c. Is it possible to liquidate under the lock in period? If so, what is the penalty to liquidate my investment? Please show me an example of the calculation.

5. Taxation – Remember, we are concerned with the post-tax return after all. Tax can eat away a major chunk of your returns and often you’ll find out after years of investing. Remember to ask:

a. What type of incomes will be generated from the product?

b. Under what heads will the incomes be taxed and what would be the applicable rate? Please show me an example of the calculation.

c. What is the difference between the pretax and post-tax return assuming we make the intended return?

 

6. Transparency – Perhaps the most over-used word in the industry? If you ask me, transparency of a product can be covered in two questions.

d. Is the current price/value of the product and its performance available in public domain? How can I check?

e. How well regulated is the product? How do the regulations protect me as an investor? Please give me some examples.

Clients often ask us “how should we select a financial advisor?”, “how do we know that the products being recommended are in fact right for us and not just right for the advisor?” Although we will do a separate (more detailed) piece on this, I would say start by keeping the above parameters and questions in mind. Keep them handy before every meeting, even if you’ve been working with someone for years. If there’s lack of time maybe email the list of questions to your advisor and ask him/her to keep the answers ready before the new product pitch. Clarity will follow.

Remember, financial products aren’t as complex as they are perceived to be. They’re just like buying something from the store. The only difference instead is that a buffet of products comes to you in a neat file presented by confident men/women in suits and ties. I hope this has been helpful and as always please do not hesitate to reach out in case of any questions.

Happy Investing!

Siddhanth Jain | Partner

BlueFort Financial