Customised for HNIs

Mass products such as mutual funds do not work for the very rich. Welcome to the world of portfolio management services and alternative investment funds

Illustration by Raj Verma Illustration by Raj Verma

The mutual fund (MF) space has grown significantly in the past two decades. However, being a mass product, MFs follow the law of averages when it comes to risk and returns. This works for retail investors but fails to meet the risk and return objectives of high net worth individuals (HNIs).

This is where portfolio management services (PMS) and alternative investment funds (AIFs) come into the picture. "MFs are standardised schemes with a lot of investment restrictions. PMS and AIF offer more flexibility," says Rahul Jain, Head, Edelweiss Wealth Management. The recent rigid classification of MFs by Sebi has made it worse.

"PMS managers construct a focused, client-centric portfolio with fewer high-conviction stocks having healthy earnings visibility, quality balance sheets and business leadership," says Rajesh Cheruvu, CIO, Validus Wealth.

PMS Returns

Most PMS plans get their returns from equity markets, they cannot remain completely insulated from significant developments in the market. Concentration of stocks generates superior returns in normal course. However, it can be risky in case of a broader market correction like the one at the beginning of the year which eroded wealth of most equity investors. The good part is that it was followed by an equally impressive recovery in subsequent months. "The recovery has been fast. The deluge of global liquidity created by governments and central banks has found its way into various assets, including equities, gold and bonds. Equity markets are placed as if Covid never happened, erasing the losses suffered in February and March," says Unmesh Kulkarni, Managing Director, Senior Advisor, Julius Baer India.

The BSE Sensex is only around 7 per cent short of its all-time closing peak on January 14. A few top performing funds are giving positive one-year returns while a good number are still in the negative territory. One of the biggest PMS funds with assets of Rs 10,778 crore, ASK - IEP, has returned 5.3 per cent in one year and a CAGR of 16.40 per cent since its inception more than 10 years ago. ACCURACAP - ALPHA10 has delivered a return of 17 per cent in one year and a CAGR of 14.29 per cent since inception around nine years ago.

However, the recovery has changed many things for these funds. "The large-caps were knocked down in the pandemic-driven crash by approximately 40 per cent while mid-caps and small-caps were beaten down 50 per cent or more. The recovery has been phenomenal for both small-caps and mid-caps with some stocks trading at as much as 2.5 times their pre-Covid 2020 highs," says Rajesh Cheruvu, CIO, Validus Wealth.

The market is also betting on new favourites. "The initial recovery was led by quality large-caps. The gains later percolated down to select mid-caps and small-caps. The bulk of the returns have come from sectors that have either been less affected by the pandemic or benefited - pharmaceutical, healthcare, technology, agriculture, rural consumption, etc," says Rajesh Saluja, CEO & MD, ASK Wealth Advisors.

PMS - The Options

The biggest differentiator in PMS is the entry criteria. The minimum investment is Rs 50 lakh. There are two options - discretionary and non-discretionary. In the latter, the fund manager advises clients and executes decisions taken by them. In discretionary PMS, the investments are managed by the fund manager as per the objectives agreed by the client. "Most PMS providers offer discretionary services. Non-discretionary PMS is for big clients such as family offices," says Pallavarajan R., Director, PMS

Service providers either charge a fixed amount, or a performance-based fee, or a combination of both. In performance-based structure, there is a hurdle rate of return, returns above which are shared with the service provider as per the pre-agreed rate. "It is important to note that a win-win fee structure is gaining traction wherein there is profit-sharing and no fixed fee. Rules mandate that no upfront fee will be charged by the portfolio manager directly or indirectly," says Pallavarajan. In the non-discretionary space, investors also pay stock buying/selling charges. There is also a fee if the client exits before three years.

PMS services differ from MFs not only in investment size but the entire philosophy and approach. "Portfolio managers typically enjoy a lot more flexibility in portfolio construction compared to traditional equity funds - in terms of absolute return philosophy (instead of benchmarking portfolio weights to an index), having more concentrated portfolios, holding higher levels of cash when necessary, having more agility in some of the schemes due to smaller size (compared to MFs) and ability to charge performance-linked fee that aligns the manager's earnings with the performance of the scheme," says Kulkarni of Julius Baer India. "Most equity MFs hold a large number of stocks (50-70) whereas equity PMS schemes hold 'concentrated portfolios of 10-25 stocks," says Saluja of ASK.

The taxation is similar to MFs. "Investors are taxed as per tax slabs. Capital gains are taxed as long-term or short-term on the basis of the holding period. From FY21, the dividend will be taxed at the tax slab rate," says Rajmohan Krishnan, Principal Founder & MD, Entrust Family Office.

AIF Returns

AIF is a new category and so few funds are more than five years old. However, five out of eight funds under the 'long-short' strategy in the PMS Bazaar universe had delivered a one-year return of more than 11 per cent till July-end. In 'long-only' strategy, the top four funds delivered a return of more than 11 per cent in one year till July-end. However, a large number of funds are in the negative territory.

AIFs are for sophisticated HNIs who want to employ complex investment strategies and even take leveraged positions. Investments start from Rs 1 crore. "AIFs offer highest flexibility - long-short, multi-asset, leverage, hedging, etc, without restrictions," says Jain of Edelweiss Wealth Management.

"AIFs are geared towards sophisticated investors with higher appetite for risk as their investment strategies are more complex. However, compared to a basic MF, AIFs can be less risky due to hedging. The main criterion is higher tolerance for risk and significant investable surplus of Rs 1 crore," says Nikhil Kamath, Co-founder and CIO, True Beacon and Zerodha.

AIFs come in three forms - Cat I, Cat II and Cat III. Cat I AIFs invest in start-ups or early stage ventures or social ventures or SMEs or infrastructure and other areas which government or regulators consider as socially or economically desirable and include venture capital funds, SME funds, social venture funds and infrastructure funds. Category II AIFs include funds such as real estate funds, private equity funds, funds for distressed assets, and so on. These do not leverage or borrow other than to meet day-to-day operational requirements. Cat I and Cat 2 AIFs are customised investments designed to meet the need of each individual client. Hence, having a standard product structure is difficult. But Cat III AIFs come in the form of structured products. They employ diverse/complex strategies and may use leverage, including through listed or unlisted derivatives.

The two broad strategies adopted by Cat III AIFs are 'long only' and 'long short'. "Long only' involves investing only in equities while 'long-short' strategies, in addition to equities, include derivatives too. While derivatives are riskier due to the leverage, they can also hedge equity portfolios," says Kamath.

AIFs also charge setting up and recurring fees. "The higher the investment, the lower the management fee (in percentage). There can also be a set-up/placement fee (one-time, as per cent of capital commitment)," says Pallavarajan. A few performance-driven companies do not charge a management fee but a share of profits above the hurdle rate.

AIF Taxation

Just like the product, the taxation, too, is complex. "AIF Cat III is not a pass-through entity for taxation. Typically, the nature of income under AIF Cat II would be capital gains or business income. Income which is not under a special rate like capital gain, i.e., business income, interest, dividend, etc, would be taxed at the maximum marginal rate in AIF Cat III. For FY21, the rate would be 42.74 per cent. If business income is earned by AIF Cat III, the AIF will automatically pay a tax of 42.74 per cent (tax bracket for individuals with over Rs 5 crore taxable income). This may lead to the investor paying more tax than his tax bracket requires him to," says Rajmohan Krishnan of Entrust Family Office.

Word of Caution

So, what should you go for - AIF or PMS? The first thing to look at is the ticket size, which is Rs 50 lakh for PMS and Rs 1 crore for AIF Cat III. The next could be your comfort with strategies adopted by the two. "If you are looking for multi-asset, more flexible or differentiated strategies, go for AIF Cat III, but if it is a simple buy & hold trade, PMS is better," says Jain of Edelweiss Wealth Management.

Whether PMS or AIF, these are high-stake investments and suited for investors who understand the risk-return dynamics in depth. "Besides, while investing in thematic strategies, you should be aware if such thematic portfolios invest in a single sector (or only a handful of sectors) or access the theme through multiple sectors. If it is the former, then once again, the investor runs concentration risk," says Kulkarni.