Market regulator Sebi's new product: MF's efficiency, PMS' control

New product poses a threat to the PMS industry by combining the advantages of both PMS and MF. Most PMS providers will apply for MF licences to offer new product

In early 2000 my family and I returned to Mumbai by train. The entire train emptied at Borivali station, and a large crowd converged towards the sole bridge. As another train arrived, the crowd on the platform swelled further. 

 

The bridge became jam-packed, and the crush of people created a real risk of a stampede. We chose safety over risk and moved towards a pillar, creating a small safe space for ourselves. We exited safely after some time. The price we paid for safety was the delay in exiting the platform.

 

I shared this experience with our client, Mohan, who was debating whether to invest in small-cap stocks via a mutual fund (MF) or a portfolio management service (PMS). Both are professionally managed, but their structures differ. An MF pools investments, giving all investors equal units, while a PMS manages individual portfolios separately.

 

To illustrate, if a fund manager convinces four investors to invest Rs 1 crore each (total Rs 4 crore) in 50 small-cap stocks, there are two options. In the MF route, the money is pooled to buy the 50 stocks worth Rs 4 crore. Investors own equal shares of the portfolio. In the PMS route, each investor’s Rs 1 crore is invested in 50 stocks, creating four individual portfolios.

 

The stampede analogy comes into play during a market panic. Unsellable stocks pose a challenge in such a situation. In an MF, the manager sells liquid stocks to meet redemption demands. Cool-headed investors are left owning the unsellable stocks. This leads to an adverse outcome for such investors post-recovery.

 

In a PMS, each investor’s portfolio remains intact. The cool-headed investor’s post-recovery portfolio remains unaltered. The market panic has no impact on his post-recovery outcome.

 

Thus, a PMS offers better control. It gives choice to individual investors and does not allow the actions of others to affect their outcome. 

 

However, this comes at a high cost. Investors in an MF pay tax only upon redemption (buy and sell transactions by their fund managers are not taxed). PMS investors must account for each buy and sell transaction, receipt of dividends, and expenses incurred. They need to pay taxes on capital gains and dividends. 

 

In addition, the minimum investment for a PMS is Rs 50 lakh, which may deter even risk-tolerant investors like Mohan from trusting a single fund manager with such a large amount.

 

This is where the new product (NP), approved by the Securities and Exchange Board of India (Sebi), stands out. While the full details are awaited, the NP will enjoy the tax and operational efficiencies of an MF. The minimum ticket size will be Rs 10 lakh. It is also likely to have the flexibility to limit redemptions during high-pressure situations, reducing the risks of a “run” on the fund.

 

NP poses a significant threat to the PMS industry by combining the advantages of both PMS and MF. It is likely that most PMS providers will apply for MF licences to offer NP. 

 

For their core PMS offering, they may target UK and US investors, who face tax disadvantages for investing in MFs and hence prefer PMS.

 

Truth be told, NP is likely to be a game-changer for Indian investors. It will offer an efficient alternative to PMS at a lower ticket size. It will evolve over time. Sophisticated (but risky) investment strategies will emerge for investors comfortable with high risk. Indian investors should thank Sebi for ushering in the new year with this innovation.

 

The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; X (formerly Twitter): @harshroongta