Should PMS investors switch to focused funds after new tax changes?

Portfolio management services (PMS) are navigating new challenges after the Union Budget for 2024-25 increased tax on long-term capital gains (LTCG) and short-term capital gains (STCG).

As stocks are held in the investor's demat account in PMS, every buy and sell decision of the PMS manager has a tax impact for the investor, unlike a mutual fund.

Mutual funds have a more tax-efficient structure than PMS, as investors are only taxed on the gains made on the fund's net asset value (NAV). The focused fund category has been created within the mutual fund categories to back high-conviction bets with bigger allocations, just like portfolio management services.

According to the scheme categorization rules by the Securities and Exchange Board of India (Sebi), focused funds cannot have more than 30 stocks in their portfolio at any given time.

Returns differential

However, when it comes to returns, PMS products running flexicap strategies have done better than focused funds in one-, three- and five-year periods.

For example, the average returns delivered by such PMS strategies was 26% annualized in a five-year period (returns as of 31 July, 2024), while it was 22% for focused funds (returns as of 16 August, 2024).

Check post-tax returns

The decision between choosing a mutual fund or PMS product should not be driven by tax changes only. "Check whether your PMS has the potential to beat the mutual fund returns on post-tax and post-fee basis over a five-year period. If you find that to be case, then you can continue to stick with your PMS," said Deepak Shenoy, founder and chief executive officer of Capitalmind.

There is a much wider range of returns when it comes to flexicap PMS products. Over a five-year period, the maximum return a flexicap PMS strategy delivered was 69.97%, while it is 37.1% in the case of focused funds.

At the lower end, the minimum returns delivered by a flexicap PMS over a five-year period was 9%, while it was 15% by a focused fund.

Impact of fees

Apart from taxes, you also need to consider the fee structure of your PMS. Different portfolio management services have different structures. There are flat fee structures and profit-sharing options. In the latter, the profits are shared with the PMS manager after a certain threshold.

In the case of mutual funds, Sebi (Securities and Exchange Board of India) has capped the total expense ratio for all equity mutual funds at 2.25%. However, this can go up to 2.55% if inflows from B30 (beyond the top 30) cities exceed a certain threshold.

How to pick focused funds

While focused funds don’t need to adhere to any market cap limits, like large-cap funds or mid- and small-cap funds, they still tend to favour large-cap stocks.

According to industry experts, investors should look for focused funds that have a reasonable exposure to mid- and small-cap stocks as well. "Only select focused funds take sizeable exposure to mid- and small-cap stocks. On the other hand, PMS flexicap strategies take significant exposure to mid- and small-caps, which is also the reason they have been able to show outperformance at different points in time," pointed out Kirtan Shah, founder of Credence Wealth Advisors.

While there is no tax impact for a mutual fund investor, when a fund manager buys and sells stocks, a frequent buying and selling would show that the fund manager is not taking any high-conviction calls, according to Anthony Heredia, chief executive officer of Mahindra Manulife Mutual Fund.

“An investor can figure out the churning level of the fund from its portfolio turnover ratio,” he said.

Switch or stick?

If your PMS has so far managed to deliver strong outperformance on a post-tax and post-fee basis, stick to it. However, if you see a dip in performance, expect a further hit due to the new tax rules. Investors can then look at focused funds or even a combination of focused funds with other mutual fund categories, as the low minimum ticket size in MFs gives more flexibility to stagger investments across different MFs and fund houses.

Also read: This distributor puts 99% of his clients' assets in PMS. Here's why.