Should you invest in PMS Schemes

One of the great surprises of the 2008 financial crisis was that investing in Hedge Funds did not really hedge you when markets turned down. You lost as much if not more of what a simple Index fund investor would have. 

While India has had a few Hedge Funds, one strong growth area has been Mutual Funds and Portfolio Management Schemes. This is not surprising given that most countries at one point or the other have seen a financialization of savings. 

While both Mutual Funds and PMS are sold directly, a greater proportion has been sold by co-opting advisors by paying them a fee that is related to the amount of investment and the tenure of such investment. 

This is not a new model and one that has been there for ages. In fact, in one post of mine here earlier I had highlighted how I started in business by canvassing for fixed deposits. The reason for such canvassing was the percentage cut I used to get. It’s amazing when I look in hindsight how for a small cut, we the advisor are willing to put our name at risk with friends and family.

Portfolio Management Schemes are seen as strategies for the sophisticated investor and the way we define sophisticated is that they are able to invest a minimum of 50 Lakhs to get an entry. 

Why the high minimums? The idea is that if you have 50 Lakhs, you should be able to take a much higher risk (and hence afford to lose much more). No one wants to lose money, but without risk, there is no reward either.

I am sure most readers are familiar with what a PMS is, so I won’t expand on them but on why I don’t think PMS should be part of your investing basket. Yep, you read it right. My view is that other than the very rare instance, PMS doesn’t really add value to your investment 

First, let’s see how PMS are different from a Mutual Fund. The biggest difference is that unlike in Mutual Funds where the funds are pooled and stocks bought for the whole pool with investors allocated units, in a PMS, all the stocks bought stay in your own Demat Account. 

Does this really add value? Aashish Somiah explained in a tweet a while back on why this was advantageous to the investor.

PMS has chance to beat due to 1) concentration & no 10% cap 2) no pressure of fund flows 3) ability to charge as low as one wishes

— Aashish P Sommaiyaa (@AashishPS) August 15, 2016

Concentration is the key differentiator between a Mutual Fund and PMS for most part. Take for example HDFC Top 100 fund. It has 53 Stocks in the Portfolio. Most PMS on the other hand have portfolios of size that are 20 or lower. This along with good stock selection makes it possible to out-perform in bull markets though in bear market and sudden bear attacks like the one we saw in March, they are as caught as any other fund, personalized or not. 

‘Will fund flows have an impact on your returns? It depends on multiple factors including the fund size. A small fund for instance may be forced to exit good stocks to pay off existing investors who want an exit leaving the rest holding illiquid and maybe bad stuff. This is especially true in Debt funds where funds saw their bad assets grow in size because of exits by other unit holders who were paid off by selling good assets.

But if the fund is of significant size, the impact from others behavior is lower though I don’t think there is an easy way to calculate it.

So, why don’t I think it’s worthwhile to invest in a PMS and instead a Mutual Fund or a Index Fund is a much better option.

The first reason is fees. Mutual Fund fees, especially direct are falling and now available at a much lower rate compared a few years back. Index funds for instance charge just around 0.10% (Large Cap) which is really rounding off error in the long term. You cannot go anycheaper than that for a market that is not the size of the United States.

PMS on the other hand have 2 types of fees. A fixed fee that is anywhere between 1% to 2% and a performance fee that incredibly is not linked to the market but a fixed return. This means that if the market moves up 50% and I generate 50%, I take a cut (above 5% or 10% or 0% hurdle rate). The only silver lining is that many firms do have a high water mark cut off which means that once you have paid a certain performance fee, the next fee calculation will start only above it. 

Fees are a hindrance to Compounding. Longer the holding period, more the impact of fees. In 2018, Vikas Bardia wrote a post showcasing the difference in returns if Berkshire Hathway was a 2 and 20 Hedge Fund Manager. The clincher?

However, if instead of running Berkshire Hathaway as a company in which Buffett co-invests with you, had he set it up as a hedge fund and charged the usual hedge fund fee structure of 2/20 (i.e. 2% management fee + 20% of any gains), then the ₹10,000 investment would’ve only become ₹89 lakhs — the balance ₹10 crores would’ve been pocketed by Buffett as fees!

Vikas Bardia

The second impediment is tax. Till 2018, Long Term gains were tax free and till 2020, Dividend tax was paid by the companies. Both have changed and are negative to PMS investors versus Mutual Funds for PMS investing is treated to be the same as Individual Investing with taxes being paid every year. 

Mutual Funds, Index Funds, PMS, AIF have all one thing in common – churn. Some are high, some are low and churn has costs that are common to all of them. Whereas the churn of your mutual fund will not mean anything for you, churn in the PMS needs action from your end in either having to pay the required taxes or claiming the losses for future set offs. 

Launching a Mutual Fund requires 50+ Crores in Capital and 5 Crores (was 2 Crores until recently) in Capital for PMS. It’s not surprising to see the huge number of funds. I myself was until recently involved in a Portfolio Management company but unlike others we offered differentiation in terms of being able to have your own asset allocation mix and a price momentum portfolio that for now has no competition.

With more funds chasing the very same stocks, it’s not easy to really differentiate one from another. Finally, when investing for the long term, fees really add over time. As a saying goes, The only two certainties in life are death and taxes – we cannot avoid death, but we can to an extent save on Taxes.