SEBI shines a harsh new light on PMS

SEBI has just floated an iceberg towards India's Portfolio Management Scheme (PMS) operators. Above the surface, the regulator has introduced new guidelines for benchmark comparisons and performance statements. Nothing remarkable on the face of it - these rules are just milder variations of what mutual funds have been following for years. In reality, 90 per cent of the impact of these rules is hidden under the surface and will sink the way PMSs do business and get new clients.

These new measures have been the most meaningful reforms in the conduct of PMSs for a long time. The regulator has said that from April 1, 2023 onwards, PMSs will have a benchmark for performance and will have to be transparent concerning the actual performance their investment schemes have generated for customers. Given the nature of PMSs, these benchmark comparisons will not be as straightforward as mutual fund returns, but it's still a significant step forward.

Let's take a look at these changes, and to enable everyone to understand their significance, let's recap what PMSs are. A PMS, as the name indicates, manages your investment portfolio. This is distinct from mutual funds, even though many of the same outfits that run mutual funds also run PMSs. The fund has a portfolio in mutual funds, and all the investor's money is pooled into that. PMS services are sold on the premise of managing investors' portfolios individually, customised to each customer's needs. They can either charge a flat fee or a performance-linked one, although the latter is more common. Generally, the fee is likely to be a fixed 2 per cent of the asset value, plus about 20 per cent of profits above a pre-decided benchmark.

No doubt, the fees are high. However, that's not the only problem with these schemes. One big problem is the utter lack of transparency, which SEBI has tackled with the new rules. Customers and potential customers have simply no way to get authentic information about what exactly PMSs deliver to their customers. Each customer has (supposedly) a different portfolio, and each has different returns. Moreover, the returns would also depend on the timing of the inflows and outflows from each account.

This means that it's difficult to have a representative number for what returns a PMS manager generates. Difficult, but not impossible, because this is exactly what SEBI has done now. Here's how the regulator has tackled the problem. It has asked PMSs to adopt a broadly defined investment strategy while managing each client's funds. These broad strategies are equity, debt, hybrid and multi-asset. The Association of Portfolio Managers in India (APMI) will specify up to three benchmarks for each strategy, taking into account the core philosophy of the strategy.

As for returns, each PMS will publish a time-weighted rate of returns (TWRR) of their performance, revealing the relative performance in all the marketing material where performance is being presented. The new guidelines also specify that the data would be presented understandably and regularly disseminated.

I expect these changes to create a huge ripple in how PMSs are sold and run. Perhaps you are puzzled by this expectation of mine. After all, you might think, it just amounts to revealing information about what the PMSs are already doing. Why is this a big deal?

It's a big deal because the real returns will come as a shock and a disappointment to customers and potential customers. Currently, PMS operators can cherry-pick what they can reveal. In finance, when you can hide the reality and only selectively reveal parts of it then the reality will always be far worse than you reveal. Practically speaking, this is an inviolable rule.

PMS operators talk big. Still, when I talk to actual customers, it always turns out that after charging expenses, PMS never manage sustained returns that are meaningfully above market performance or above average mutual funds. There is a large amount of anecdotal evidence that PMSs generally do far worse. Therefore, what is likely to happen from April 1 onwards is not just some routine revelation of data but a reckoning with the harsh light of reality for PMSs.

In any case, there are many other reasons why PMSs make no sense compared to mutual funds. For one, they always have higher tax outgo since all equity transactions in a PMS are taxable in the customer's account. In sharp contrast, in mutual funds, investors pay tax only when they invest in the fund or redeem, while equity transactions in the fund itself are not taxable. Add this to the high expenses, and the situation becomes very clear.

Any investment has to be evaluated on basic characteristics like returns, risk, liquidity, and tax efficiency. They say sunshine is the best disinfectant, and PMSs are heading for thorough sanitisation.

Suggested read:
The PMS non-service
PMS providers hide more than they reveal