Mutual Funds, Portfolio Management Services (PMS) and Alternative Investment Funds (AIF) are all investment vehicles, where your equity or debt investments are managed by professional fund managers. Each of these investment options has their own pros and cons. The most suitable investment vehicle for your investments, would come down to your unique requirements.
In this post, we identify the key positives and negatives of each of the 3 investment options, to help you understand what would be the best for you.
Mutual Funds – Pros & Cons
Pros
- Very Small Min Investments
- Highly Tax-Efficient
- Ease of Operations
- Systematic Investment / Transfer / Withdrawal Possible
- Typically Low-risk Diversified Portfolios
Cons
- Lack of Institutional Focus on any particular category or investment style
- Lower Risk leads to Lower Returns
- Low Differentiation
- Risk of Fund Manager Changes
- Targeted at Retail Customers
Mutual Funds are clearly the most popular investment vehicle, given their ease of investments and the low initial investment requirements. They are also highly tax-efficient (debt funds having long-term capital gains benefits and equity funds only being taxed on redemption, and not when the portfolio is changed).
The ability to do SIPs / STPs / SWPs, also make them a very convenient vehicle to reduce the risk of market timing. This is very valuable from a financial planning perspective.
These benefits make Mutual Funds a very good option for most investors, including HNI’s.
The main drawback of mutual funds, is that the structure does not make it easy to offer more differentiated and higher risk-return strategies. This does limit the return potential of mutual fund investments, which is where a number of HNI’s also seek to invest in PMS or AIF strategies.
Additionally, Mutual Funds also have the risk of fund manager changes, which is reduced substantially in the case of owner-managed PMS & AIF schemes.
Portfolio Management Services – Pros & Cons
Pros
- Differentiated Strategies
- Larger range of risk-reward options
- Customised Portfolios Possible
- Direct Ownership of Stocks
- FM Stability (owner-managed PMS's)
- Deep specialisation can be created around specific categories/investment styles
Cons
- 50 lakh Min Investment
- Tax Disadvantage
- Large Number of Lower-quality schemes
- Leverage & Shorting Not Allowed
With minimal regulatory and minimum corpus hurdles, the PMS platform is the easiest investment vehicle for fund managers to launch and run differentiated investment strategies. This allows for a large number of differentiated strategies, with varying risk-return ratios, that would appeal to more sophisticated investors. Additionally, the PMS platforms also allows for equity portfolios to be customised to meet the unique requirements of individual investors.
In recent years, a large number of very high-quality fund managers have left their senior investment positions at top AMC’s to set up their own PMS house. This provides investors with confidence on the long-term stability of the core fund management team.
While PMS’s do offer investor’s considerable advantages, there are few important challenges as well. A minimum investment of Rs. 50 lakhs, makes PMS’s out of reach for most retail investors. As PMS investments are tax-pass through vehicles (it is considered that the investor is investing in equity shares themselves), they do not offer the same tax advantages as mutual funds.
While there are a number of very high-quality PMS schemes, there are an equally large number of lower-quality schemes. This makes it very important that the investor & the advisor, have a good understanding of the true risk-reward prior to investing.
Lastly, restrictions around shorting and leverage, restrict PMS houses from launching the more complex strategies that are possible under the AIF structure.
Alternative Investment Funds – Pros & Cons
Pros
- Highly Complex Strategies Possible
- Larger range of risk-reward options
- FM Stability (owner-managed AIF's)
- Deep specialisation can be created around specific categories/investment styles
Cons
- 1 cr Min Investment
- Tax Disadvantage
- May be Difficult to Understand True Risk-Reward
AIF’s are the most flexible of the three investment vehicles, allowing for investments in unlisted shares, along with the use of leverage and shorting. This allows for AIF’s to offer strategies of much higher levels of complexity, as compared to what is possible under PMS or Mutual Fund Structures. This leads to the highest range of risk-reward options that are available to investors.
AIF’s are categorised into 3 categories – Cat 1 (investments in early-stage & start-up ventures), Cat 2 (those that do not fit in Cat 1 or 3) and Cat 3 (funds that employ diverse or complex strategies, including the use of leverage).
In recent years, a large number of very high-quality fund managers have left their senior investment positions at top AMC’s to set up their own AIF’s. This provides investors with confidence on the long-term stability of the core fund management team.
While AIF’s do have the ability to offer investor’s complex and differentiated investment strategies, they do have some disadvantages. A high Rs. 1 cr minimum investment, makes AIF’s clearly out of reach for most retail investors.
Additionally, AIF’s do not offer investors the same tax advantages as mutual funds. Cat 1 & Cat 2 AIF’s are taxed as pass-through vehicles (from a tax perspective, it is considered that the investor has directly made the investment themself). Cat 3 AIF’s are taxed at the fund level, based on the type of income (business income, capital gains and dividend).
Some of the more complex trading strategies adopted by certain AIF’s, may be difficult for advisors or investors to truly understand. This can potentially lead to investors making investments, with a true understanding of it’s risk-return.
PMS vs Cat III AIFs
Investor’s sometimes struggle to decide between Cat III AIF’s and PMS’s, since they are both quite similar in terms of offering investors differentiated investment strategies in listed equities.
Given their similarity, we are clear that the various parameters that are used in accessing the quality of a scheme (the quality of the AMC & investment team, and the investment philosophy of the scheme) are more important than the structure, in deciding what is the best investment option.
That said there are some pros & cons of the PMS & the AIF structure, which are useful to keep in mind while making an investment decision.
- AIF's give fund managements more flexibility: In an AIF, when the fund gets inflows or redemptions, the fund manager can choose what specific company to buy or sell. In a PMS on the other hand, the fund manager is forced to sell the entire model portfolio. The AIF structure can lead to more efficient investment decisions, especially in illiquid market conditions or in situations where specific stocks have moved substantially.
- Close-ended AIF's give FM greatest flexibility in stock selection A major advantage of a close-ended AIF, is the fund manager has visibility of fund flows and accordingly has greater flexibility in investing in more illiquid stocks (which the FM may have stayed away from in an open-ended structure). However there is also an important con - in a close-ended AIF, it is very important that market conditions are favorable for an exit at the time of the fund coming to maturity. Unfavourable market conditions, could lead to forced exits at unattractive prices, adversely impacting investor returns.
- In PMS's you directly own stocks: In a PMS, your stocks are held in your own demat account and are not held as units of a common trust structure. This gives you the option of redeeming via a transfer of securities, instead of in cash.
- Taxation at an AIF Level: Since Cat III AIF's are taxed at the AIF level, investors do not have to deal with the complexity of filing taxes on their own (as is the case in PMS's).
- Close-ended AIF's are highly impacted by market conditions at the time of exit: A major advantage of a close-ended AIF, is the fund manager has visibility of fund flows and accordingly has greater flexibility in investing in more illiquid stocks (which the FM may have stayed away from in an open-ended structure). However there is also an important con - in a close-ended AIF, it is very important that market conditions are favorable for an exit at the time of the fund coming to maturity. Unfavourable market conditions, could lead to forced exits at unattractive prices, adversely impacting investor returns.
- AIF's are taxed as a single entity & not on an individual investor basis: This leads to the tax impact due to the redemption by a single investor (leading to a sale of shares and accordingly capital gains), being spread across all investors in the trust. This typically is not a big issue in the case of an AIF with a large number of investors, but in certain cases this could have some adverse tax implications.
What’s the Right Choice for You?
Ultimately, the choice between Mutual Funds, PMS and AIF schemes comes down to your own unique risk-profile and financial goals. It is quite common to see investor’s invest in a combination of all 3 investment vehicles, based on identifying specific schemes that most suit their requirements. There can also be different vehicles that are suitable for different goal types.
Our investment specialists at IME Capital, have a deep understanding of all the 3 investment vehicles. We would be happy to guide you through your range of options, to help identify what investment product is the most suited for your unique requirements.