How to read PMS disclosures on returns and performance

Portfolio management services (PMS) have grown sharply over the years. Today, PMS providers manage assets worth Rs 17.6 lakh crore across 1.3 lakh clients, up from Rs 5.09 lakh crore and 70,000 clients in 2012.

Unlike the Rs 37 lakh crore mutual fund industry, PMS providers have not been as tightly regulated by the Securities and Exchange Board of India (SEBI), which led to some concerns for investors.

However, SEBI overhauled PMS regulations in 2020 so that more disclosures are made to clients and performance reporting is standardised. SEBI also doubled the minimum investment for PMS to Rs 50 lakh to ensure that only high net worth individuals (HNIs) with a higher risk appetite can access the service.

What disclosures are PMS providers now required to make and how will they help investors? Here is a look.

Performance disclosures for each strategy

SEBI in the past had not laid down a detailed set of guidelines on how performances by PMS providers should be calculated and disclosed. There was no uniformity in performance disclosures. Some PMS providers just selectively used their better-performing strategies and disclosed this as PMS firms' overall returns.

These issues were pointed out in the report of the working group on SEBI’s PMS regulations, which was released in 2019. The SEBI regulations of 2020 require all PMS providers to disclose the performance of each strategy and compare them with appropriate benchmarks so that prospective investors are better-informed.

A strategy is just like a mutual fund scheme. It is called a strategy and not a scheme because a PMS only issues model portfolios. One investor’s portfolio might be slightly different from another investor’s portfolio even if both are invested in the same strategy.

One reason is because investors can give either cash to the PMS manager or their own basket of stocks which is then churned and brought in line with the model portfolio. In the interim, this investor’s portfolio returns might vary.

However, unlike in mutual funds, there is no requirement for a comparison with the total returns index of the benchmark, which captures gains from stock price movements and dividend.

Some PMS providers are said to be still not using appropriate benchmarks for strategies. Future regulations are likely to focus on this aspect to clearly define ‘appropriate’ benchmarks and possibly introduce the use of total returns index of the benchmark.

Time-weighted rate of return (TWRR)

Earlier, PMS providers used multiple methods to calculate returns of their strategies.

“This created a lot of confusion,” said R Pallavarajan, founder at PMS Bazaar.

SEBI’s working group report cited a survey by CFA Institute, which pointed out that 31 percent of portfolio managers didn’t use asset-weighted average returns of all client accounts and 46 percent of portfolio managers didn’t use time-weighted returns of all client accounts.

In the 2020 PMS regulations, SEBI mandated PMS providers to use the time-weighted rate of return (TWRR) method to calculate and disclose performances for each strategy.

Why TWRR? The simple way of finding out the returns of a portfolio is to calculate the difference between the current and original value and then compute its growth from the original value. However, this simple calculation does not factor in fresh investments or withdrawals by an investor.

This is where TWRR comes in. It eliminates the effect of client-led cashflows on the portfolio. To put it simply, it adds redemptions to the equation and subtracts subscriptions. The actual calculation is more complex as the performance periods need to be broken up into several sub-periods, starting from the original investment till a fresh investment or redemption is made and so on.

Once the returns are calculated at the portfolio level, they are aggregated at the strategy level. The returns of each portfolio are calculated on the basis of their size (or weight) within the investment strategy. The returns are disclosed net of fees and expenses.

Fees and commissions

PMS providers are not only required to disclose the performance fee to investors, but also the distributor commissions that are charged to investors' accounts. PMS providers can charge a fixed performance fee or a return-based fee or a combination of both.

Return-based fee essentially means the PMS provider can charge a performance fee after crossing a certain return threshold. This threshold rate is known as hurdle rate.

For example, a PMS provider sets the hurdle rate at 10 percent and a profit-sharing fee of 20 percent. The portfolio value at the end of the year rises to Rs 1.2 crore from Rs 1 crore, a gain of Rs 20 lakh. No fee is charged on the first Rs 10 lakh (10 percent returns), but the PMS provider will charge a 20 percent fee, i.e. Rs 2 lakh, on the remaining Rs10 lakh.

After fees, the net value of the portfolio is Rs 1.18 crore, which becomes the base for calculating next year’s return and so on.