“Do I invest via PMS?” is a question that pops up every now and then. I haven’t tried Portfolio Management Services (PMS), and have no intention of doing so. This post details my reasons.

Downsides of Active Investing

PMSs, by design, are actively managed, and therefore suffer from the same issues that mar active investing:

High Fees: One of the primary selling points of PMS are access to financial expertise, cutting-edge research, etc. However, all mutual funds benefit from the same resources and yet a vast majority fail to outperform their own chosen benchmarks. With a much higher fee structure than mutual funds (2%+ for PMS vs 0.2-1.5% for mutual funds), it’s unlikely for an average PMS to beat low-cost index funds over the long term.

Questionable Alpha: Every PMS claims to have “alpha” (a measure of exceptional skill), but more often than not, it’s just exposure to some unclear risk factor (i.e. disguised beta), which can bite back in unexpected ways. For instance, given the outstanding performance of small and mid-caps over the last five years, it’s hard to determine whether recent outperformance was due to real investing skill or simply buying loads of risky stocks that were all going up (momentum factor).

Yes, some PMSs have certainly outperformed benchmarks, like the Nifty 50, over the years. There will always be a few star performers over any lookback period. But as the regulators regularly warn us, past performance cannot predict future results. One can never be certain that a outperforming PMS selected today will beat the benchmarks for decades ahead.

Behavioural Challenges: If your chosen PMS hits a bad phase and runs into years of underperformance, will you stick with it, or will you switch to another one with better recent performance? If the investor behaviour observed with mutual funds is any indicator, odds are that you’ll switch. In practice, this translates to constant performance monitoring and switching out at the worst possible time.

One could diversify the manager-specific risk by investing across 3-4 PMSs, but that is impractical given the hassle (initial, as well as ongoing). The high minimum investment per PMS (₹50L) doesn’t help either.

Conflict of Interest

Besides the concerns related to active management, my main reasons to avoid PMS is a structural issue: the built-in conflict of interest.

PMSs typically have three common fee structures:

  1. Fixed percentage, of Assets Under Management (AUM)

  2. Performance Fee: Charged as a percentage of the returns above a specified minimum level (called the “hurdle rate”). For example, say the performance fee is 20% above 12% annual returns. If the returns for that year is 15%, the performance fee would be 20% of 3% the difference (15%−12%=3%). If the PMS earns 10%, which is below the 12% hurdle rate, no performance fee would be applicable.

  3. Some combination of the two

#1 means that the primary goal of the PMS manager is to accumulate as large an asset base as possible—that’s how they make more money. The PMS businesses that become large are more likely to be led by managers who are charismatic salespersons than necessarily exceptional investors.

There aren’t many Warren Buffets in the world, and I have strong reservations about handing over my life’s savings to someone just because they talk smoothly.

#2, however, is far more concerning. Superficially, the performance fee setup aligns the incentives of the investors and the portfolio managers (PMS collects more fees only if you also make higher returns). But if you look closely, the manager is incentivized, by design, to take on high risk, often unnecessarily, to increase the chances of achieving abnormal returns and pocketing more money.

Such risk-seeking behaviour is optimal from the manager’s perspective (potential for significant upside with limited downside), but it increases the chances of significant losses for the investors. Economists call this conflict of interest the Principal-Agent problem.

Sophisticated institutional investors use similar fee setups with their hedge fund partners, but they have checks in place to control such behaviour. For instance, they often have well-defined volatility ranges that the managers must abide by—violating that risks getting kicked out. We, retail investors, don’t have the leverage to define such terms.

My Setup

As you can guess, I’m a firm believer in passive investing. My wife and I use a combination of low-cost passive funds (Nifty 50 and GILTS with Constant Maturity of 10-years) to get exposure to equity and long-term debt.

The asset allocation is tailored to our investment goals and risk preferences, and it’s a portfolio that we understand and have complete control over; there are no constraints on when and how much we can withdraw, and costs are below 0.5% of AUM.

Admittedly, our portfolio performance is guaranteed to be average and will never be anything to boast about. But on the upside, I’m confident we can stick with it no matter the market conditions. Since there’s no risk of manager underperformance, it doesn’t need constant monitoring either. I spend no more than an hour a month reviewing and rebalancing the asset allocation, if at all.

Our approach isn’t novel or exciting enough to discuss with friends or colleagues, but I am optimistic that it will help us meet our financial goals while letting us focus on other aspects of life and sleep peacefully at night.

When PMS might be the right choice?

While the above setup works for us, it may not for everyone. PMS may be a suitable choice if you:

  • Don’t want to spend any time understanding different asset classes, making the one-time effort to arrive at an asset allocation that works for you
  • Are willing to take high risks for the possibility of market-beating returns
  • Have significant conviction about specific funds/managers and are confident that you will stick with them through the inevitable tough times