Promise of higher returns in PMS schemes comes with higher risks

Do a careful evaluation of the fund manager, and have limited exposure to these higher-risk strategies in your portfolio

By now you would have read media reports that a few portfolio management service (PMS) schemes have suffered sharp erosions in the value of their portfolios, owing to the ongoing correction in mid- and small-cap stocks. PMS managers like Porinju Veliyath and S P Tulsian have written to their investors admitting to the problem. These events call for an assessment of PMS schemes. High net worth individuals (HNI) who wish to invest in these schemes that come with an entry barrier of Rs 2.5 million should be fully cognizant of their risks.
 
Higher-risk strategies: When HNIs invest in PMS schemes, the premise is that they will offer higher returns than mutual funds. But there are no free lunches in finance. Higher returns entail taking higher risks in the portfolio. There are two kinds of risks that PMS fund managers mostly take to be able to earn higher returns. "Mutual fund managers have very diversified portfolios. PMS schemes, on the other hand, can have very concentrated portfolios of 5-10 stocks," says Ankur Kapur, founder, Ankur Kapur Advisory. Such a concentrated portfolio tends to be more volatile (though, to be fair, a small bouquet of well-chosen stocks also stands a better chance of beating the index over the long term).

 
Another route that PMS fund managers take to earn superior returns is to have high exposure to mid- and small-cap stocks. These stocks, by their very nature, tend to be more volatile. When the markets are running up, as they have been for the  past four years, they tend to be frontrunners of the rally. But when markets are under pressure, as they are now, these stocks also tend to fall harder. The only way HNI investors can deal with such high volatility is by having a long investment horizon of at least seven years. They should not panic and exit during phases of volatility.

 

Greater information asymmetry: In case of mutual funds, investors have easy access to information. Rating agencies provide ratings of funds based on detailed quantitative and qualitative analysis, which makes choosing a good fund a cinch. Aggregated information on all funds is available so that investors can check the performance of their fund against that of its peers. That kind of aggregated information is not available for PMS schemes.
 
The strategies that PMS schemes apply can also be more complex and differentiated. For instance, one PMS scheme could run a concentrated portfolio of five-seven stocks, while another could have 35 stocks. There could be a scheme running a portfolio of 30 stocks whose stock selection is based on artificial intelligence. There could be one PMS scheme that invests in distressed bonds, while another may invest in secondary market bonds.

 
Owing to lack of data and the more sophisticated nature of these schemes, investors are forced to depend on advisors to select the right PMS scheme. "Your advisor should be someone who is capable of understanding what the PMS fund manager's strategy is. One risk of depending on an advisor is that he may have tied up with only a couple of PMS providers. In that case, he will inevitably push those schemes instead of giving you wider choice," says Kapur.
 
Liquidity risk: In many PMS schemes, only a handful of investors may have contributed a major portion of the corpus. If these investors exit, it could force the fund manager to sell some of the higher quality stocks in his portfolio-a development that can have a negative impact on the scheme's future performance.

 
Sometimes, if the fund manager has invested in illiquid, small-cap counters, he could encounter liquidity issues when faced with large redemptions. "Investing in PMS schemes that bet on small-cap stocks, and also have a small corpus size, can be risky," says Vivek Banka, founder, Alitore Capital.
 
Higher incentives for distributors: HNIs wanting to invest in PMS schemes should also be aware that if distributors and wealth management firms are pushing them, it is because they earn higher incentives from them. "In mutual funds, HNIs and large family offices have taken the direct route where there are no commissions for distributors and wealth managers. So the latter are keener to sell PMS, where the incentives are better," says Banka. In most PMS schemes, the wealth manager or distributor's commission is 1 per cent or more.

 
A few tips: HNI investors should invest in PMS schemes fully aware that they pursue higher-risk strategies in the quest for higher returns. Only those who have a portfolio of Rs 20 million and above should invest a portion of it in PMS schemes. Investors should limit their exposure to these strategies to a limited portion of the portfolio. One suggestion would be to limit exposure to PMS schemes to the mid- and small-cap portion of your portfolio, where the scope to earn alpha is higher, and not let this exposure exceed 20-40 per cent of your equity portfolio, depending on your risk appetite.   

 
Many PMS providers have mushroomed in recent years. Kapur says that he is very impressed by the pedigree of some of the younger fund managers who have set up PMS schemes (they hold degrees from IITs, IIMs, MBA from Stanford or University of Michigan, CFAs, and so on). Only the established PMS houses like Motilal Oswal, Alchemy, etc, or renowned fund managers like Kenneth Andrade and Sunil Singhania (who have given up successful careers as mutual fund managers to set up their own PMS houses) have the experience of multiple market cycles. While you may go with a younger fund manager who you think has it in him to do well, a safer bet would be to go with an experienced hand. "If a fund manager does not have a publicly available track record of performance, you don't know how well he will be able to navigate bear markets," says Banka.

 
Investors in PMS schemes can't go purely by the size of the research team backing the fund manager. Some PMS houses have research teams of 60-70 people, while others are single-person outfits and yet have a stellar track record. "You can't apply standard rules to choosing PMS schemes. Meet the fund manager and try to understand what his strategy is," suggests Kapur.
 
Finally, just because costs and entry barriers are higher, there are no guarantees of performance. "Based on the analysis we have done, we have found that many PMS schemes fare worse than high-quality mutual funds," says Banka. So be as diligent in reviewing the performance of your PMS fund manager as you would be with mutual funds.