Published Article Details

Are exclusive portfolio management services worth the cost?

Posted by: Uma Shashikant on Jan 23, 2017, 06.30 AM IST

The lure of the exclusive club is too attractive to give up. This is what my much-travelled and wealthy friend had to say, when I teased him about being an unapologetic snob. He is the kind who loves walking to the empty business class lane, as if the milling crowd at the economy gates did not exist. Or flash a card from the stack in his wallet, at every club of privilege.

But when it comes to investing, my friend’s penchant for exclusivity is his undoing. He thinks that SIPs in mutual funds are for the commoners. His money is managed in a portfolio management scheme (PMS) run by a brokerage, for the exclusive benefit of a few well-heeled investors like him. He told me that they do not accept anyone with less than a crore of rupees at least, as investors. But that what is a crore in today’s world? I asked him what his privileges were. He told me that he received custom attention from the manager and that his portfolio was different from other members. 

But then, would it be worthwhile for a broker to appoint a manager for just a crore of assets? I asked him. He is not from the financial services industry and therefore, whenever our conversation turns technical, he tends to get uncomfortable. He asked me what the scale of operations might be. That is a language he is familiar with. I told him that there would only be one manager who would be running a model portfolio, and that an algorithm would post the buy and sell entries into individual client accounts, based on the cash inflow and outflow into those accounts. He was incredulous. 

It is not difficult to achieve exclusivity in the PMS world using technology. There are enough sophisticated software applications that can deal with several constraints while managing money. A client may have stocks he does not want to sell; or may not want cash holdings to go above a level; or might have a cash flow requirement that is different from others. All these can be factored in, and a portfolio can be generated exclusively for the client, but aggregated at the manager level, to translate into a series of central actions of buy and sell across stocks. All that my wealthy friend holds is a product whose costs are higher and at a tax disadvantage to himself. 

In a mutual fund, the buy and sell actions of the manager will not reflect on the books of the investor. A capital gain tax on a short-term transaction is payable only if the investor sells the units of the fund. Actions of the fund manager are tax-neutral for the mutual fund investor. In a PMS, all transactions are on the books of the investor. They reflect in the demat and bank accounts, and the investor is liable to pay transaction costs and taxes on them. This is apart from the management fee and distributor commissions. 

Some like to belong to a club if the willing ness to pay premium charges is a pre-requisite. He asked me if there is a merit to the PMS product. There are only two that matter to an investor: the portfolio manager’s expertise and track record of performance. A PMS provides the manager the free hand to hold concentrated positions, cash, or even derivative positions if the product includes it. All this flexibility should translate into post-cost returns, and there should be enough evidence to believe that such returns are skill-based and replicable, and not luck-based and transitory.

A good amount of my friend’s wealth was also invested in structured products. He admitted to me that he did not understand much of it, but he bought in as it was offered only to a few exclusive clients. A structured product is an equity-linked bond, where the interest income from the bond is used to buy derivative positions. The pay-off from the derivative positions offers an equity linked return, while the basic bond is redeemed at face value on maturity. 

The latest product he bought was one with a knock-out option at a pre-specified equity index level. I asked him if he had the view that the equity markets would rise, but not cross that level. He told me that he was not sure. Then how did he buy the product? If on any date before maturity the index crosses that knock-out level, all that he would get is the face value of the bond. My friend was quite confused. He told me that there was a guarantee. Yes, that is only on the bond, not the equity derivative.

An equity derivative product does offer leverage. With a small premium, one can take a position on the underlying asset and if the view turns out to be right, make a decent amount of money that is higher than what a conventional bond would offer. But, it is also an all or nothing bargain. If the call is that the index would close above a specific level, and if that level was not reached, an option expires worthless. Therefore, to buy an exclusive and exotic structured product, the investor should have the sophistication to take a view on the underlying asset whose derivative is being bought.

And be willing to settle for no return but the face value of the bond, if the view did not materialise. Apart from this, the structured product is a liability of the issuing broker and there is the credit risk of that balance sheet. Needless to add, the costs of managing and distributing the product is also high. My friend had invested his bonus into a structured product and hoped to access it when he needs it for a business idea he has been toying with. When he was told that a structured product cannot be liquidated before maturity, he was shocked. 

Why do investors fail to ask even the basic questions about investment ideas brought to them? It should not take over five minutes to ask what return to expect under what conditions and to know what the risks are. In their world of exclusive privilege, such investors are so taken in by the deferential treatment they receive from sellers, that they fail to protect their own interests. That many of these privileged investors hold poor quality products in their investment portfolios, is a well-kept secret. This group of victims does not like to talk about its gullibility. 


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