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High Risk, High Reward

Although PMS plans perform better than mutual funds in the long run, investors must be aware of the risks involved
Aprajita Sharma  New Delhi     Print Edition: January 12, 2020
High Risk, High Reward
Illustration by Raj Verma

Portfolio management services (PMS), which offer tailor-made portfolios, have been a preferred choice of high net worth individuals (HNIs) and ultra HNIs for quite a few years now. With deep pockets and high risk-taking ability, these investors hunt for index-beating alpha (a measure of return above index). While promise of good returns and personal attention from portfolio managers are a big draw for HNIs, they must be aware about the risks involved in PMS, apart from the new rules that have come out to make these investments safer for investors.

Recent Regulations

According to the working group on SEBI (Portfolio Managers) Regulations, 1993, assets under management of portfolio managers grew from Rs 4.7 lakh crore in February 2012 to Rs 18.07 lakh crore in April 2019 (over 70 per cent is contributed by funds from EPFO/PFs). The number of clients rose from 82,391 in February 2012 to 151,618 by April 2019.

As PMS have grown at a fast clip, SEBI has brought in regulations to protect investors' interests. For example, last month, it introduced a slew of regulatory changes such as increasing the minimum PMS investment from Rs 25 lakh to Rs 50 lakh and minimum net worth required to become a portfolio manager from Rs 2 crore to Rs 5 crore. This is apart from strengthening the eligibility criteria to become the decision-making authority, mandatory appointment of a custodian and defining the nature of securities in which PMS can invest. The investment threshold was revised in 2012 (from Rs 5 lakh to Rs 25 lakh). The aim of these changes was to ensure that only serious investors with capacity to take risk enter these products. "Globally, regulators don't follow the practice of defining minimum investment for such products. Instead, they define the type of investors who can take exposure to such products; these are referred to as accredited or qualified investors with certain minimum net worth and other criteria," says Dhaval Kapadia, Director - Portfolio Specialist, Morningstar Investment Advisors India. However, in India, SEBI is trying to keep retail investors away from this higher risk investment option.

PMS vs MFs

There is a perception that PMS is a "rich man's mutual fund". However, the two products are different and cater to different client sets. While mutual funds pool money from various investors (largely retail) to invest in the market, in PMS, each client's money is handled separately.

Besides, it has become tougher for mutual funds to beat their benchmarks after SEBI imposed stricter asset allocation limits for various MF categories. PMS, being a theme-based investment with exposure to select stocks such as high-beta (a measure of price volatility and risk) ones, are better at alpha generation. "MFs are regulated in terms of the types of strategies they can adopt, minimum holdings, maximum exposure to individual sectors/securities, etc. Equity PMS plans, on the other hand, offer customisation in portfolio construction, customised expenses, possible access to the portfolio manager, and so on," says Unmesh Kulkarni, Managing Director and Senior Advisor, Head - Markets and Advisory Solutions, Julius Baer Wealth Advisors.

Aashish Somaiyaa, MD & CEO, Motilal Oswal AMC, points out that PMS is a better platform to remain detached from market occurrences. "MFs are managed as a pool and the outcome is impacted by total flow behaviour of millions of others. In PMS, the behaviour of one investor doesn't impact the outcome for others."

Also, the MF investors are not updated about churning. "PMS clients get a debit note at the end of the month with actual charges. In an MF, when trades are done, investors get to know only if they compare the portfolio with the one at the end of last month. Some MFs have 50-250 per cent annualised churn. On the other hand, PMS churn less and intimate clients about every buy and sell order." However, for HNIs, compliance could be an issue in PMS. "Unlike PMS, where stocks are purchased in the name of investors, MFs are unitised schemes and, hence, HNIs do not have to worry about any regulatory/compliance restriction pertaining to any particular stock," says Kulkarni.

Discretionary vs Non-discretionary

There are two types of PMS - discretionary and non-discretionary. When a portfolio manager makes all buying and selling decisions with no client participation, it is discretionary. The portfolio manager assumes primary responsibility for management and performance of the portfolio. In non-discretionary, while all research and ideas come from the portfolio manager, he cannot take any buy and sell decision without the client's approval. The client has complete control over the portfolio. Since it involves active participation on the part of the client, the manager's responsibility is reduced.

Discretionary PMS plans are cheaper as multiple client trades can be executed together, which means cost-effective execution, says Kapadia of MorningStar. Nearly 90 per cent of all PMS are discretionary. As per SEBI data, there were 1.45 lakh clients in discretionary PMS and only 7,500 in non-discretionary PMS, as on June 30. Non-discretionary makes sense for clients such as family offices where ticket size is large and investments are diversified across multiple PMS plans. "The wealth manager of a family office may stay in touch with portfolio managers of different PMS plans to manage the investments of the entire family keeping in view the broader asset allocation of the family," says Pallava Rajan, Director, PMS Bazaar.

Rajan says the first important factor the investor has to keep in mind is that the PMS investments are for the long term. "Any investor with less than three years' time horizon should avoid PMS."

Although the minimum investment is Rs 50 lakh, people with only Rs 50 lakh capital should avoid PMS due to the concentrated nature of the portfolio, which is often theme-based. "Investors should understand the product in detail before investing. The nomenclature of the portfolio is the key to matching the individual's risk profile with the PMS apt for him or her," says Rajan.

"HNIs looking at specialised strategies that are different from mutual funds can evaluate allocation to equity PMS plans. On the other hand, HNIs looking at participation in broader equity markets without too much customisation are better off investing in mutual funds," says Kulkarni of Julius Baer.

Since the Rs 50 lakh investment shouldn't necessarily be in cash and can be securities or combination of both, Rajan of PMS Bazaar says investors with Rs 50 lakh in mutual funds or stocks may consider shifting to PMS. "Retail investors often have bad stocks. The reasons could be two - they don't understand markets well or don't have time. So, an investor with Rs 50 lakh worth of equities should consider PMS."

However, they must know that the regulations are still evolving. In the name of protecting the privacy of clients, not much information is disclosed even to regulators. Although most portfolio managers send performance and debit reports to individual investors on a monthly basis, there is no standard process to calculate returns and fees. The SEBI working group says some portfolio managers are selectively disclosing the portfolio, getting it audited, and showing the returns. Besides, performance is reported for various strategies/products and there is no way for the regulator/investor to identify whether the performance reported is accurate. Benchmarks are also not specified. That said, only investors with high-risk appetite and long-term horizon should plunge into these "high risk, high reward" schemes.

What You Pay

The fee is charged in different ways - fixed, variable and fixed-plus-variable. There are other expenses as well over and above the portfolio management fee such as custodian fee, depository charges, brokerage tax, service tax, security transaction tax and other statutory levies. These work out to around 0.5 per cent, says Rajan of PMS Bazaar.

The distributor may charge a one-time set-up fee of up to 2 per cent that is deducted from the client's capital contribution. For example, if you invest Rs 1 crore, Rs 2 lakh will go to the distributor and Rs 98 lakh will be invested. Investors should know that the set-up fee is a discretionary charge. In theory, it is an agreement between a distributor and a client. However, distributors do not tell the investor that it is optional. "Earlier, nine out of 10 clients used to pay set-up fee. Now, awareness has increased. Out of 20, four-five are paying it."

One should also be aware of exit loads. Although there is no lock-in period, the asset management companies (AMCs) may charge exorbitant exit loads if you liquidate your investment within one to five years. "Exit load ranges from 1-8 per cent for up to five years. Exorbitant exit loads are not in the interest of investors or the industry. There is a need to standardise exit-load structures," observes the working group report.

Among AMCs in PMS Bazaar universe, Ambit Capital, AMSEC, O3 Capital, India Nivesh, Sanctum, Marcellus, Pelican, Unifi Capital and Buoyant Capital have zero exit load.

One major lacunae that makes PMS products prone to mis-selling is upfront commission - the one-time fee paid by AMC to a distributor. SEBI had banned upfront commission for MF distributors last year. Since then, say industry observers, distributors have been pitching PMS products to investors even if MFs suit their needs better. "The scope for mis-selling increases, particularly in products that offer higher upfront incentives to distributors, if the distributors do not have adequate internal checks and controls. In that sense, PMS schemes can be potentially mis-sold (like any other product)," says Kulkarni of Julius Baer.

The SEBI working group's July 2019 report had recommended that the distributor commission "may only be paid on a trail basis and only from the fees charged by the portfolio manager". SEBI is yet to act on it.

Interestingly, a number of PMS schemes offer trail commission to distributors. Investors should ask for such details before committing money to such schemes. Although the upfront commission doesn't affect the cost or return of the investment per se for clients, it leaves scope for dubious distributors to mis-sell products only to earn commission.

@apri_sharma

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