Portfolio Management Scheme (PMS): A unique investment opportunity? How does it fare against mutual funds?
How do Portfolio Management Schemes work compared to investing in mutual funds
As people earn more, it's natural for them to wish for above-average returns from their savings. To this end, some opt for portfolio management services, or PMS.
Portfolio management scheme popularly known as PMS are specialised investment vehicles for lump sum investments increasingly seen in India. They are offered by various entities registered with the market regulator.
PMS are specialized investment vehicles for lump sum investments increasingly seen in India.
After that regulators introduced stringent regulations. Among other things, it raised the minimum investment limit and also banned pooling of accounts of different investors.
How PMS works?
The portfolio manager invests the money in shares and other securities and manages the portfolio on behalf of the client.
PMS also offer equity and debt options, but portfolio management schemes are mostly used by high net worth investors to invest in stocks.
Although there are PMS products that also bet on fixed income instruments, there are not many takers for the debt option, as debt mutual funds are more tax-friendly.
The portfolio manager invests the money in shares and other securities and manages the portfolio on behalf of the client.
Earlier, PMS also offer real estate, unlisted shares and structured products options as well, but now these come under a different fund category and are managed according to separate rules by the market regulator.
Accordingly, any income or dividend coming out of the investment made will also be credited in your bank account and the shares will be held in the trading account in your name.
As per the PMS agreement, the authorisation for operating the bank and trading account will be with the portfolio manager. Most portfolio managers give a username and password, which can be used to login into their website and see the portfolio statements.
As per market regulator SEBI’s (Securities and Exchange Board of India) instructions in India, a portfolio manager is required to furnish performance report to their clients every 6 months.
High minimum requirement
Before deciding to invest in a PMS, it is vital to understand that there is a high minimum requirement for opening a PMS account.
In addition to that, base net worth requirement of portfolio managers has been raised to INR 50 million (Dh2.4 million) from INR 20 million (Dh 964,339).
Popular types of PMS
It is service offered by most brokerages and mutual funds. There are two types of PMS: Discretionary and Non-Discretionary.
In discretionary, the fund manager takes investment decisions on behalf of the investor. In non-discretionary, the fund manager suggests investment ideas, while the decision is taken by the client.
One parallel that can be drawn between discretionary PMS and mutual funds is that the manager handles the money on the behalf of the clients.
One parallel that can be drawn between discretionary PMS and mutual funds is that the manager handles the money on the behalf of the clients.
The key difference is, however, that investors in mutual funds get units that represent stocks.
In a PMS, the investor holds the stock in a trading account owned by him, but the fund manager has the authorisation to operate it.
Let's see how the two competitors, equity PMS and equity mutual funds, fare against each other.
PMS versus mutual funds
Structurally, the most basic difference is that in PMS, investors hold stocks, whereas in mutual funds they ( fund managers) hold units.
In PMS, the investor can know which stocks he is holding at any given point in time by logging into his trading account. This is difficult in case of mutual funds.
In India, as per SEBI regulation, mutual funds have some investment restrictions.
There is a maximum limit on the percentage of amount invested in an individual stock. Also there is some maximum cap on the exposure in a particular sector.
Whereas a Portfolio Management Scheme will invest in 15 to 20 stocks. This concentration makes it more attractive and aggressive.
Compared to mutual funds, Portfolio Management Schemes also is considered to relatively have more flexibility to move in and out of cash as and when required depending on the stock market outlook.
Apart from PMS and mutual funds, there is a third alternative—alternate investment funds (AIFs) — but at INR 10 million (Dh 482,169) minimum investment, these are accessible only to a few.
Types of fees for PMS
Like most funds, the fees charged to investors consist of three components – the upfront fee, the management fee and the performance fee.
- Entry Load - PMS schemes may have an entry load of around 2 to 3 per cent. It is charged at the time of buying the PMS only.
- Management Charges - Every Portfolio Management Services scheme charges Fund Management charges. Fund Management Charges may vary from 1 to 3 per cent depending upon the PMS provider. It is charged on a quarterly basis to the PMS account.
- Profit Sharing - Some PMS schemes also have profit sharing arrangements, wherein the provider charges a certain amount of fees/profit over the stipulated return generated in the fund.
- Fixed Fee - Some PMS schemes might have a fixed component in the place of the profit sharing component and charge investors a fixed monthly fee. This is not a percentage based fee and is decided before availing the PMS. It could depend on the size of the portfolio.
But unlike mutual funds, PMS can levy higher charges, though competition keep the charges within a reasonable band.
Investors negotiate for a lower fee if the assets to be managed are big. Mutual fund fees are fixed in percentage terms.
For example, someone investing the minimum INR 5 million (Dh 241,794) in a PMS may have to pay a 2 per cent recurring annual fee, whereas an investor investing let’s say INR 50 million (Dh2.4 million) in the same PMS strategy may pay a lower fee thanks to the bigger lump sum.
Theoretically, this fixed fee in PMS can be agreed at close to zero for very large accounts. In mutual funds, a fixed fee percentage applies to all, and negotiations are not possible at an individual level.
How are the profits shared?
The profits are shared on the basis of a ‘high watermark principle’, which ensures that the manager does not get paid large sums for poor performance.
So if the manager loses money over a period, he or she must get the fund above the high watermark before receiving a performance bonus.
The profits are shared on the basis of a ‘high watermark principle’, which ensures that the manager does not get paid large sums for poor performance.
The manager therefore not only reached the high-water mark but exceeded it INR 150,000 (250,000 – 100,000) (Dh 7,232), which is the amount on which the manager gets paid the bonus.
The performance of the portfolio is also calculated using the high watermark principle. So fund managers usually get paid a fixed per cent of the share of profits above the hurdle rate based on the high watermark principle.
The hurdle rate is the minimum rate of return the fund must achieve before the fund manager gets paid his share of the profits.
For example if the hurdle rate is 10 per cent then the fund manager will only get paid performance fees in excess of the minimum 10 per cent hurdle rate
TIP: Experts say that since the PMS manager has his skin in the game in the profit-sharing model, it helps generate alpha. (Excess return of an investment relative to the return of a benchmark index is the investment's alpha.)
Exit load?
Like mutual funds, there is also an exit load if you withdraw early. (Fund schemes levy an exit load of 1 per cent if stocks are sold within one year of buying. it is a mechanism to deter investors from premature withdrawals.)
Like mutual funds, there is also an exit load if you withdraw early.
Mutual funds fees are regulated, and the structure and limits are defined by the regulator. On the other hand, PMS fees are more market driven for structure and limits.
TIP: Essentially the conservative portion of your equity investment can go into mutual funds. The aggressive portion can go into Portfolio Management Scheme.
Tailor-fit portfolios
While many PMS providers offer standardized portfolios, some offer investments tailored to clients' goals.
For instance, a client may want to invest a large amount in a single stock. This is not possible in mutual funds, as they cannot hold more than 10 per cent net asset value in a single stock.
While many PMS providers offer standardized portfolios, some offer investments tailored to clients' goals.
While this spreads risk, a big disadvantage is that mutual funds cannot hold a big stake in a company even if it is a very good investment. PMS do not have this limitation.
Risks to investing in PMS
Since we have skimmed through what are the widely known risks to investing in PMS schemes, let’s explore in detail what are the downsides, before making a decision to whether or not to invest.
PMSs have low portfolio turnover ratio
As touched upon earlier, because PMS do not have the limitation of holding more than 10 per cent net asset value in a single stock, most of these schemes practice buy-and-hold strategy.
Portfolio turnover is calculated by taking either the total amount of new securities purchased or the number of securities sold (whichever is less) over a particular period, divided by the total net asset value (NAV) of the fund.
The measurement is usually reported for a 12-month time period.
And so therefore, there are restrictions on trading turnover when trading in a time horizon. Meaning, since the fund follows a buy-and-hold strategy, the portfolio has a low portfolio turnover ratio.
Portfolio turnover ratio represents the churn of the fund portfolio or the percentage of the portfolio holdings that have changed over a time period
So, we have so far explored risks like high minimum requirement, way too many charges in certain instances and low portfolio turnover ratio, here is yet another – albeit rare – risk.
Fund goes bust?
The risk of your fund going bust. But right off the bat, one should know that SEBI rules on big losses – if the PMS you have opted for goes bust.
Let’s say an investor does happen to face such a situation. Can he make a claim against the portfolio managers’ net worth or assets in the event of a capital loss? Also what should he or she do in such a situation?
JP Morgan had frozen debt mutual funds from redemption as Amtek auto had defaulted its payment and within a week its outlook has become negative.
Many investors who wanted to redeem their money were not allowed and since then SEBI has made stricter rules to make sure that fund houses doesn't invest blindly and have an eye on their investments.
Although you – as an investor - are not, however, protected from general investment risk – for example, if the underlying stocks in your fund go bust or perform poorly.
Asset Protection
If you hold a fund and the fund manager goes bust, then the underlying assets are protected.
The stocks owned by that fund are held separately by a trustee or a depositary, so if the fund manager goes under, the investments in the fund remain.
If you hold a fund and the fund manager goes bust, then the underlying assets are protected.
Also in certain other instances worldwide like in the case of Britain’s fund manager Woodford abruptly shutting its fund, money was returned to investors – albeit in chunks.
Instances are rare, but in the likelihood it does – while investors will not be charged direct fees, they will still be incurring high costs for the winding up of the fund.
Role of SEBI in PMS schemes
When it especially comes to portfolio management schemes, the markets watchdog periodically issues strict guidelines under which they can operate.
Apart from regulations, SEBI also updates on fees and charges that can be charged - which can be found here.
When it especially comes to portfolio management schemes, the markets watchdog periodically issues strict guidelines under which they can operate.
SEBI intervention
Still SEBI has laid out a set of rules and regulations to ensure the investor protection from time to time. It has published various directives, driven many investor awareness programs, set up investor protection Fund (IPF) to compensate the investors.
In India, the investor can ask for the compensation if a member (broker) of the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE) or any other stock exchange fails to pay the due money for the investments made.
The limit allows that the money to paid as a compensation for a single claim shall not be less than INR 100,000 (Dh4,835) - for the case major Stock Exchanges like BSE and NSE - and it should not be less INR 50,000 (Dh2,417) in case of other Stock Exchanges.
But to answer the question, can investors make a claim, the answer is yes.
In case of winding up of a scheme, the funds pay a sum based on prevailing NAV after adjustment of expenses. Unit holders are entitled to receive a report on winding up from the mutual funds which gives all necessary details.
So should you invest in a PMS or in mutual funds?
Some PMS schemes have given terrific returns. But small investors are better off investing in mutual funds. Despite the terrific returns, experts feel that small investors should stay away from PMS.
Firstly, the large minimum investment requisite is a deterrent. Secondly, not all PMS schemes have done so well. Most have matched the performance of the best performing equity diversified funds.
Some PMS schemes have given terrific returns. But small investors are better off investing in mutual funds.
Here is what SEBI had to say, when weighing the two.
“Portfolio management services, unlike mutual funds, are more complicated and riskier products and are meant for investors with higher risk-taking capacity. Increasing the limit is thought prudent, so that retail investors with limited understanding of volatility and risk, don’t enter this product. ”