How Sebi's new rules have changed the risk-return profile of PMS schemes

Fewer investors mean you will get more time with the portfolio manager and will be able to understand his investment strategy better; but there are downsides too

The Securities and Exchange Board of India (Sebi) recently hiked the minimum investment limit in portfolio management services (PMS) from Rs 25 lakh to Rs 50 lakh. Fewer clients will now be able to access this investment avenue, which has grown impressively over the past few years in terms of both, asset under management (AUM) and number of clients. Let us try and understand what this move means. Thereafter, we shall examine alternatives that clients who are unable to meet the Rs 50 lakh threshold may consider.

Protecting investors: PMS is a riskier product than mutual funds. In the latter, Sebi has laid down several checks to protect clients. MF portfolios have to be diversified, and there are limits on how much exposure a fund manager can take to a single stock. In the case of PMS, however, no such limits exist on the exposure a portfolio manager can take to a single sector, stock, or even how much cash exposure he chooses to have. “While such freedom makes it possible for the portfolio manager to generate higher alpha, it also raises the risk and volatility of the portfolio,” says Pallavarajan R, founder-director, Pmsbazaar.com, a portal that provides PMS-related information, analytics and advice.   

Mutual fund portfolios tend to be diversified. More than 90 per cent of equity mutual funds generally have portfolios with 50-60 stocks or more. This limits the risk. In PMS, the number of stocks in a portfolio could be as low as seven or eight, or could go up to 25. Most PMS managers build concentrated portfolios with 15-20 stocks on an average. When the number of stocks is so low, both the level of risk and volatility rise.

Experts say that Sebi’s primary motive for hiking the minimum investment threshold is to ensure that only people who understand the risks in this product well, and have the financial wherewithal to handle it, and enter it.

Fewer clients, better understanding: At present, there are 145,000 PMS clients. Pallavarajan says earlier he expected another 150,000 to get added over the next three-four years; now the figure may come down to 75,000-100,000. Sebi has also hiked the net worth requirement of PMS managers from Rs 2 crore to Rs 5 crore. As a result, the number of PMS managers is also expected to dwindle from the current 320 or thereabouts. Here, again, the intent is to ensure that only serious players remain in the field.

One consequence of hiking the limit from Rs 25 lakh to Rs 50 lakh will be that the fewer clients who are left will be able to enjoy greater access to their portfolio manager. Through more frequent interactions, clients will be able to understand better why a portfolio manager has bought certain stocks, exited others, or why the fund is underperforming currently. All this will hopefully allow the investor to stick to his portfolio manager and stay invested for the long haul.

Less diversification: A negative fallout of this measure is that it reduces the scope for diversification. An investor who had Rs 1 crore to invest in PMS could earlier invest in four funds. Now he will be able to invest only in two. Since the number of stocks is low in PMS, diversification becomes all the more important. Diversification across investment styles—value, growth, etc—and portfolio managers are necessary to reduce risk. The scope for doing this will decline.  

Only people with a total portfolio of at least Rs 4-5 crore should consider investing in PMS now. Of this, if their equity allocation is Rs 2-3 crore, they can invest in about three-four PMS strategies. Just investing in one PMS should be avoided.

Alternatives investors may explore

Many investors have considerable investments in mutual funds. They then want to invest in strategies that can give them higher returns. There are also direct equity investors who have considerable stock holdings, but are unable to manage them well due to lack of time or understanding. Both these types of investors would earlier migrate to PMS. Many of them may find it difficult to access PMS now. They may consider two options: readymade stock portfolios like the ones offered by smallcase Technologies, and Sebi-registered investment advisors (RIAs) who offer stock-related advice.

Readymade portfolios: Smallcase refers to a readymade portfolio of stocks or exchange traded funds (ETFs). These portfolios are well diversified, which makes them less risky compared to investing in a single, or very few, stocks. Brokerages can now offer these stock baskets, instead of single stocks (as they have done traditionally), to their customers. Brokerages like HDFC, Kotak, and so on now offer smallcases.

More than 70 smallcases are available today that can cater to a wide variety of customers—from novices to veterans. There are smallcases for varies risk appetites. Some are suited for greenhorns who have just entered the market, while others cater to veterans with the ability to take higher risk in pursuit of higher returns.

Another advantage is cost. Regular mutual funds have an expense ratio of 1.5-2 per cent while here you only pay the brokerage fee for buying and selling the constituent stocks.

Sebi RIAs: Many Sebi RIAs and research analysts operate as independent equity research outfits that publish research reports on listed companies. These reports are different from the sell-side (brokerage) reports, as there is no incentive to churn, and hence the term 'independent equity research' for them.

Typically, such research services are available for a flat annual fee (fixed), irrespective of the portfolio size. The advisor doesn't execute on the client's behalf, so he can’t be sure of portfolio size. So, instead of charging a fee as a percentage of capital, he gives access to his entire research for a lumpsum fee.

These are mostly suitable for do-it-yourself investors who want full control of their capital. “Unlike a mutual fund or PMS where you have to write a cheque or give a power of attorney in favour of the fund manager, here the entire capital stays in your existing broking account, in your name, and under your full discretion. The advisor only recommends which stocks to buy, how much to buy, and when to sell. On the flip side, it does need more time to  understand the advice and execute it, unlike mutual funds or PMS investments, which are passive,” says Jatin Khemani, founder and CEO, Stalwart Advisors, a Sebi-registered independent equity research firm.

Some subscribers (investors) replicate the entire model portfolio based on suggested weights, whereas some selectively the pick stocks they like.

Khemani suggests that one should not, as a thumb rule, pay more than 2 per cent as advisory fee. So, if you are subscribing to a model portfolio that costs Rs 20,000 per annum, then you must be having at least Rs 10 lakh to invest in it. As the account grows and you add more money, research cost as a percentage of the corpus will come down. For smaller portfolios, the mutual fund route is preferable. The time, effort and cost that goes into managing a portfolio oneself pays off only if it is above a certain size. Khemani says the portfolio size should be at least Rs 10 lakh.

One should prefer RIAs who have skin-in-the-game. They should not just be analysts but should also be investors who have put their own capital in the same stocks they have suggested to their subscribers. Check the track record in terms of stock picks, rationale, reasons for exit, and judge the RIA on that basis. Most of the subscription-based research models have the guest account option, wherein a prospect can sign up for free to see the past or exited stocks and select stocks from the current portfolio.

Both number of clients and AUM have risen rapidly in recent past
DISCRETIONORY PMS (JUNE 2015 TO JUNE 2019)
As on June 30,	2019	2018	2017	2016	2015
No of Portfolio Managers	321	271	243	236	208
No of Clients	144,879	120,929	82,753	52,761	43,217
AUM (Rs cr)
Listed Equity

112,744.51 100,583.31 84,392.80 53,427.25 41,492.64 Unlisted Equity 522.00 407.12 585.66 867.55 1,583.09 Plain Debt 1,074,011.81 1,046,685.92 911,524.90 769,389.88 652,669.35 Structured Debt 1,111.74 414.64 358.09 163.04 114.23 Equity Derivative 120.61 570.90 215.72 186.37 176.16 Mutual Fund 12,095.52 11,421.46 10,207.52  8,191.36 5,710.11 Others 127,679.26 15,864.12 16,131.70 16,900.42 22,503.93 TOTAL 1,328,285.45 1,175,947.47 1,023,416.39 849,125.87 724,249.51

EPFO/PF contribution (Rs cr) 

1,186,486.00 1,020,712.50 896,324.254 778,344.07 655,002.09 Source: Pmsbazaar.com