A replacement for PMSs?

SEBI's new product proposal is quite interesting and can offer a real alternative to high-value investors, provided the fund industry does the right things

As most people interested in mutual funds would have heard by now, market regulator SEBI has published a proposal to launch a new investment product. The SEBI document is a consultation paper that invites public comments and pitches this product as something that's a halfway house between Portfolio Management Services (PMS) and mutual funds. SEBI's exact language is that an "...opportunity of a New Asset Class has emerged between Mutual Funds and PMS in terms of flexibility in portfolio construction." The paper doesn't have a name for this new product and, in fact, asks the public to suggest a name.

I suggest that this should be called PMS, and the product that now purports to be a PMS should be shut down. That sounds like a joke but I'm sort of serious. Since this new product is supposed to be between mutual funds and PMSs, one should try to understand it by contrasting it with those two. If you compare it to existing mutual funds, they are essentially the same, with some adjustments to various limits. However, if you compare it to PMSs, it's a vast improvement. The new product eliminates the two huge negative points of PMSs: tax inefficiency and lack of transparency.

First, let's look at the tax matter. In PMSs, stocks are traded in the investors' books. Every trade is treated as a separate capital gain or loss event for the investor, leading to complex calculations and high taxes. Over time, the constant tax outgo makes for a large reduction in investors' profits. This new product, structured pretty much like a mutual fund, offers the same tax efficiency as mutual funds, where gains and losses are consolidated within the fund and only realised when the investor redeems their units.

As for transparency, PMSs have long been criticised for their opaque nature, with limited disclosure requirements. As per SEBI's proposal, this new product would require monthly portfolio disclosures and publicly available foundational documents, much like mutual funds. Not just that, since this is a pooled fund, standard NAVs would also be available, enabling returns to be calculated and normalised comparisons and benchmarking to be calculated. None of this is possible with PMSs. This level of transparency would significantly improve over traditional PMSs, allowing investors to make more informed decisions.

Moreover, the proposed minimum investment of Rs 10 lakh, while higher than most mutual funds, is significantly lower than the Rs 50 lakh required for PMSs. This could potentially open up newer investment strategies and a different point on the risk-return scale to a broader range of investors. Of course, that's what the hope is.

The proposed asset class offers several relaxations in portfolio construction. These include a higher single issuer limit for debt securities (20 per cent of assets, up from 10 per cent), increased credit risk-based single issuer limits for various credit ratings, and a higher limit for ownership of paid-up capital carrying voting rights (15 per cent, up from 10 per cent). The new class also allows for greater investment in the equity of any company (15 per cent, up from 10 per cent) and doubles the limits for investments in REITs and InvITs. Sector-level limits for debt securities are increased to 25 per cent from 20 per cent. Most notably, while mutual funds are only allowed to use derivatives for hedging and portfolio rebalancing, this new product is permitted to use derivatives for taking market exposure as well. All these relaxations aim to provide more flexibility in portfolio construction and supposedly higher returns with increased risk.

Will this work? Would these products actually deliver higher returns? It will take years to get a definitive answer, but that should be fine with investors. Transparency of returns and performance should be the cornerstone of any investment product.

However, there is a grave danger in these proposals. If you look at social media posts and conversations about the proposals, you will observe that close to 100 per cent of the excitement is about derivative-based funds and exotica like 'inverse ETFs'. It's entirely likely that the investment industry will see the changes as a licence to just create these financial 'weapons of mass destruction' for an audience that so far was exposed only to simple mutual funds. This is something that the regulator has to be cautious of.

Interestingly, the paper is silent on fees and expenses. The industry would expect these to be higher than normal funds. However, since the structure of the proposals is basically in the form of variations from normal mutual funds, I would say that no mention implies no proposed variation but that remains to be seen.

Of course, the PMS pack will howl with a protest that their service is better, but as the saying goes, 'Jungle mey mor nacha, kisne dekha?' I can confidently say that if PMSs were genuinely better than other asset classes, then these people would have found a way to present provable data. The fact that they do not do so can be taken as evidence that their service is inferior.

All things considered, this is a good proposal if it's seen primarily as a move to take away investors from PMSs and guide them to a better product. Or at least, it can be a good proposal if it does not just become a vehicle for launching derivative-based funds. I'm keeping my fingers crossed.

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