PremiumInvestors should check how much skin in the game a fund manager has, the expense ratio and track record of the product they invest in, regardless of whether it is portfolio management services (PMS), alternative investment fund (AIF) or mutual fund (MF), says Saurabh Mukherjea, founder and chief investment officer of Marcellus Investment Managers, in an interview with Mint. Edited Excerpts.
To what do you attribute the growth in the PMS industry in 2021?
What’s happening is that structurally most Indian households are pivoting their savings away from physical assets towards financial assets. As a result, whether it’s a bull market or a bear market, flows into financial products are incredibly robust in India.
The mutual fund is becoming the mass-market product for middle-class investors who can afford to say save ₹5-25 lakh per year.
On the other end is the AIF for ultra-high-net-worth investors (UHNIs) who have several crores of rupees to invest in a year. In between the two is the PMS sector, which is becoming the vehicle of choice for HNIs who can afford to save ₹50 lakh– ₹2 crore a year.
What are the factors that an investor should consider before selecting a PMS manager?
Regardless of whether it is a PMS/AIF/mutual fund, there are three things that investors should look at. First, how much skin in the game does the fund manager have—what percentage of his/her wealth is invested in that mutual fund or in that PMS; Second is the expense ratio of that product; and third, the track record of the PMS or AIF or the mutual fund.
Investors who are new to this industry can go to a high street bank and speak to the wealth management desk which will have this data for PMSes as also for AIFs and mutual funds.
So what do think is the ideal skin in the game percentage, expense ratio and track record?
The ideal situation is that the fund manager’s entire net worth should be invested in the investment product that he or she is managing. With regards to the expense ratio, the ideal situation is that fixed fees should be close to zero. The only fixed expenses investors should have to bear are charges such as custody fees and fund accounting fees, which should be a few basis points of cost.
When it comes to the length of the track record, I would suggest that investors look for at least a three-year track record.
Shouldn’t investors consider performance data at all?
The weight of the three factors I mentioned earlier can be 90% in deciding which PMS an investor should choose. Backward-looking returns (also called the “track record") should only be 10% of the decision-making algorithm.
As we have shown in our 2018 ‘Coffee Can Investing’ book, most equity mutual funds in India which outperform in a three-year block tend to underperform in the next three-year block. So, there exists very little persistency in terms of returns – whether it is a PMS or a mutual fund. Hence, this tendency to look at historical returns and jump up and down has its limitations.
Talking about returns, the Securities Exchange Board of India (Sebi) had in 2020 amended the performance reporting standards for all portfolio managers. How has it significantly changed the way disclosures are made?
As per Sebi, when we report performance, we must pull together the assets of all the clients, and returns are presented net of all fees and expenses in a time-weight manner. What the PMS manager cannot do is be selective. For example, the PMS manager cannot say that I will only take XYZ portfolios and exclude ABC clients’ portfolios.
Standardizing performance reporting in the PMS industry has made the product more investor-friendly. If you look at the PMS industry’s inflows after the January 2020 regulations, they have noticeably gone up.
In the case of an existing investor of a PMS, what kind of discussions can investors have with their portfolio manager?
As per Sebi’s rules, the entire portfolio of the PMS must be disclosed to investors every quarter. If you are an investor, you should look at not just the raw return or relative return but also look at the expenses incurred by the PMS provider. If the expenses appear to be egregious, say anything north of 2%, the investor should call up the PMS provider and seek to understand what is going on.
And remember, expenses are not just fees; they include the other ancillary expenses being borne by the PMS, such as brokerage costs, custody costs, and so on.
Secondly, look at the extent of churn in the portfolio. If the portfolio is being churned by 20-30% every quarter, over a year the entire portfolio gets churned. And again, that’s something to discuss with the portfolio manager.
Lastly, check how many of the stocks held by the fund manager over the last 12 months have performed well and how many haven’t. Typically, a well-managed portfolio will have 30 to 40% of the stocks doing really well. So it’s important to have a portfolio where the returns are relatively well distributed across the stocks rather than skewed towards one or two stocks.
The churn also results in PMS investors paying capital gains tax despite there being no cash flow. Do you think this is hindering the convenience of PMS investors from a compliance perspective?
The only type of fund structure in India where churn doesn’t trigger a tax incidence is mutual funds.
Whether it’s an AIF or a PMS or indeed a mutual fund, low churn investing strategies reduce brokerage costs and reduce tax incidence for investors. And therefore, the more sensible investment managers in India tend to have low churn investment strategies. High churn also creates tax incidence.
From a capital gains tax complexity perspective, you will find it hard to find a simpler construction than the current PMS constructs in India.
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