Mutual funds vs portfolio management services: What is the right path for your financial journey?

Piyush Bansal, a Delhi-based IT professional working for a multinational firm, has been investing in mutual funds (MFs) since his first job. As his portfolio has grown substantially over the years, Bansal, now 35, is contemplating a shift towards portfolio management services (PMS) to further customise his portfolio for greater returns. “I’ve been investing in MFs since a young age. Now that my assets have grown and my income has increased, I am exploring alternative options to boost the return from my portfolio. However, I am unsure if PMS is the right choice for me,” Bansal remarks.

Like Bansal, many are keen to put their money in PMS schemes in the hope of generating higher returns on their investments; but why PMS? This is because PMS has the edge in creating higher alpha over MFs in the long term due to its customised and concentrated structure. However, PMS carries a higher risk as well. So, it is crucial for investors to choose the right PMS.

A study by PMS Bazaar of 335 PMS investment strategies and 388 MFs (regular) across one-, three-, five-, and 10-year periods reveals that PMS strategies outperformed their benchmarks by 70% on average, while MFs managed a respectable 48%. But before you hop on the PMS bandwagon, it is important to grasp the distinction between the two, though comparing them directly may not be entirely fair, as they cater to different financial needs and risk appetites.

PMS vs MF

PMS predominantly provides higher customisation and flexibility compared to MFs; each investor has the freedom to set their investment objectives and risk tolerance and to organise their portfolio in a way that best suits them. MFs, on the other hand, have a one-size-fits-all approach and are managed by a fund manager according to the fund’s objectives, predetermined by the fund house, not factoring in individual preferences or risk tolerance. MFs usually provide investors with standardised investment plans that have already been designed with certain investment goals and asset allocation strategies. Investors can choose from various MF schemes based on their investment preferences. PMS, however, offers more differentiated products.

PMS is tailored for high net-worth individuals (HNIs) and ultra-HNIs and requires a minimum investment of `50 lakh, while in MFs, which cater to a wider audience, you can put in as little as `100. Another big difference is the number of stocks held under MFs and PMS. “PMS are concentrated portfolios as compared to an equity MF. They usually have 20-25 stocks in the portfolio as compared to 50-75 stocks in the case of an MF,” says Rohit Sarin, Co-founder of Client Associates, a multi-family office wealth management firm.

As PMS operates on a smaller scale, managers can be more active. This also influences stock selection. With fewer assets under management, PMS managers can allocate more to mid- and small-cap stocks, potentially increasing returns. On the other hand, MFs are constrained to larger-cap stocks, hindering their potential to outperform the market benchmark.

“We offer PMS schemes to provide exposure to more differentiated strategies compared to MFs and for the possibility of higher returns through more concentrated exposure, which is usually more actively managed in response to changing market conditions or investment opportunities,” says Rajul Kothari, Partner at Capital League, an all-women boutique wealth management firm. She adds that MFs are more straitjacketed as they have to adhere to Sebi’s guidelines, and hence, are less innovative.

The PMS manager may take a relatively higher active risk vis-à-vis the benchmark, but most MFs follow an index-hugging strategy, which means that the weights of stocks or sectors in their portfolio won’t have too much of a divergence from the underlying market index. “By virtue of a concentrated portfolio that may also have a higher divergence from the underlying market benchmark, a PMS could have a higher beta or more volatile performance as compared to an MF. This means that in a bullish market, a PMS could outperform the MF, while it could be the reverse in a bearish market scenario,” explains Sarin.

Another key distinction is that in PMS, you own stocks directly, but in MFs, the asset management company handles buying and selling on your behalf. For a PMS account, you need to open a separate demat account and bank account, while you can invest in MFs without opening a demat account or new bank account.

“MFs pool money from multiple investors and invest in a diversified portfolio of securities, such as stocks, bonds, and other assets. Investors buy units or shares of the MF, and a professional fund manager manages the fund. PMS involves the management of individual portfolios on behalf of clients. The holdings are held in each client’s individual demat account,” says Kothari.

Most importantly, tax treatment differs. MFs are tax-free if you don’t redeem units, but in PMS, any transaction by the fund manager in the name of the client is subject to short-term- or long-term capital gains tax, or dividends and interest payments are also taxed as per the investor’s individual tax bracket. “This makes MFs more attractive than PMS schemes, as the tax liability is deferred, resulting in no leakage as long as the investor remains invested in the fund,” says Kothari.

Cost Burden

PMS investing can be lucrative, but it involves multiple costs and fees, which vary depending on the PMS provider, portfolio size, and investment strategy. Kothari says, that to start with, you have management fees—which PMS providers charge for managing your investment portfolio. These are generally billed monthly or quarterly as a fraction of the average assets under management. The percentage varies from 1% to 2.5% of AUM. Investors need to negotiate and fully comprehend these fees before entering into an agreement.

You may also pay performance fees if the PMS provider earns profits above a specified benchmark or hurdle rate. These fees are usually a share of profits and are charged annually or at the end of the investment period. “Usually, most PMS offer two fee variants to investors—fixed fee only or fixed plus performance fee. While the fixed fee currently ranges from 2-2.5% of the AUM per annum, the hybrid fee model comes with a fixed fee of 1-1.5%, plus a performance fee charged beyond a certain hurdle rate,” says Sarin. “In a good year where markets have given upwards of 15% returns, the cost in the hybrid fee model could go up to 3% and beyond. Besides this, administrative costs like custody fee and trading fee are charged as per actuals. Some PMS could have exit loads as well,” he adds.

It’s important for investors to carefully review the fee structure and cost implications before investing in PMS. Additionally, investors should consider the impact of fees on their overall returns and evaluate whether the potential benefits of PMS justify the costs involved. Consulting with a financial advisor or wealth manager can help investors understand the fee structure and make informed decisions based on their investment objectives and preferences. “We follow a core and satellite approach for our clients. In the core part of the portfolio, we take exposure to asset classes like debt and equity, primarily through the MF route. As a policy, we do not take exposure of more than 10-15% of equity to a single scheme, be it MF or PMS,” says Kothari.

@teena_kaushal