Should PMS investors switch to special purpose funds following the introduction of tax changes?

Since the shares are held in the investor’s demat account with the PMS, every buy and sell decision made by the PMS manager carries tax implications for the investor, unlike a mutual fund.

Mutual funds have a more tax-efficient structure than PMS because investors are taxed only on the gains on the fund’s NAV. A concentrated fund category was created within the mutual fund category to support high-conviction bets with larger allocations, similar to portfolio management services.

As per the scheme categorisation rules laid down by the Securities and Exchange Board of India (SEBI), targeted funds cannot have more than 30 stocks in their portfolio at any point of time.

Returns the difference

However, in terms of returns, PMS products using flexicap strategies outperformed concentrated funds over one-, three- and five-year periods.

For example, the average return generated by such PMS strategies was 26% annualized over five years (returns as of July 31, 2024), while the average return for targeted funds was 22% (returns as of August 16, 2024).

Check your tax returns after tax

The decision to choose a mutual fund or a PMS product should not be made solely on the basis of tax changes. “Check if your PMS has the potential to beat the mutual fund returns after taxes and fees over a five-year period. If it turns out to be the case, you can continue to stick with your PMS,” says Deepak Shenoy, Founder and CEO, Capitalmind.

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

At the lower end of the spectrum, the minimum returns achieved by a Flexicap PMS fund over a five-year period were 9%, while for a concentrated fund it was 15%.

Impact of fees

In addition to 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, 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 set a total expense ratio limit of 2.25% for all equity mutual funds. However, this can go up to 2.55% if inflows from B30 cities (outside top 30) cross a certain threshold.

How to Choose Targeted Funds

While concentrated funds do not have to adhere to any of the market capitalization restrictions that large-, mid- and small-cap funds do, they still tend to favor large-cap stocks.

According to industry experts, investors should look for concentrated funds that also have a reasonable exposure to mid-cap and small-cap stocks. “Only select concentrated funds have significant exposure to mid-cap and small-cap stocks. On the other hand, PMS flexicap strategies have significant exposure to mid-cap and small-cap stocks, which is also the reason why they have been able to outperform over time,” points out Kirtan Shah, Founder, Credence Wealth Advisors.

According to Anthony Heredia, CEO of Mahindra Manulife Mutual Fund, while mutual fund investors do not incur any tax costs, frequent buying and selling of shares by a fund manager may indicate that he is not making any decisions based on reasoned conviction.

“An investor can estimate the fund’s turnover level based on the portfolio turnover rate,” he said.

Switch or stick?

If your PMS has given you high above average performance after taxes and fees so far, stick with it. However, if you see a dip in performance, expect it to drop further due to the new tax laws. Investors can then consider concentrated funds or even a combination of concentrated funds with other categories of mutual funds as the low minimum ticket size in MFs gives more flexibility to spread investments across different MFs and brokerages.