SEBI recently directed Portfolio Management Services (PMS) firms not to operate pooled accounts. These firms can henceforth offer only separately-managed accounts to their clients. The capital market regulator has also increased the minimum networth required for PMS firms, from Rs 50 lakh to Rs 2 crore.
Both these directives could compel PMS firms to increase the minimum investment size for clients to economise their operations. Importantly, SEBI’s directives could lead to gradual closure of boutique investment firms. These are small-sized PMS firms that have the potential to offer custom-tailored products to small investors. So, where does this leave this class of investors?
This article suggests that portfolio advisors and mutual funds can work together to replicate PMS-style products for small investors. Specifically, portfolio advisors can add value with their manager selection skills — selecting mutual funds in each style universe to construct a portfolio of mutual funds. These advisors can also employ their security selection skills for investors who prefer self-managed custom-tailored portfolios.
Custom-tailored portfolios
PMS firms typically offer custom-tailored portfolios to HNIs. The process starts by risk-profiling the investor. A risk-profile process would probe into areas ranging from whether an investor likes bungee jumping to whether she prefers to invest in term deposits! This process is expected to help the portfolio manager arrive at the client’s risk appetite.
The portfolio manager and the investor then draft the investment policy statement. This statement includes the investment objectives, the expected return, the time horizon, frequency for rebalancing the portfolio and other constraints that the investor may impose. One such constraint may be not taking exposure to companies manufacturing products that harm the environment.
The portfolio manager would custom-tailor a portfolio based on the client’s risk-return preferences. A PMS firm operating pooled-account cannot offer a custom-tailored portfolio as a firm that operates separately-managed account. In some ways then, a PMS operating pooled-account is similar to mutual funds. It is, perhaps, for this reason that SEBI has directed PMS firms not to operate such accounts.
Market for structured products
Mutual funds do not offer custom-tailored portfolios to investors. An asset management firm floats a fund and collects moneys from investors. Often, mutual funds do not clearly disclose the investment style in the offer document. An investor could be, therefore, unintentionally overexposed to an investment style. An investor may, for instance, have exposure to four funds ranging from Opportunity Fund to Equity Growth Fund but with same investment styles.The mutual fund industry has to shed the habit of offering same-genre funds with different names and instead focus on offering newer-generation products.PMS firms’ offer structured products to their clients. Capital guarantee with upside participation in the stock market through exposure in large caps is one such product. Mutual funds should increasingly offer such products so that small investors can construct a style-diversified portfolio that meet their long-term investment needs.Some asset management firms are gradually venturing towards hedge-fund replication products and other structured products. Lotus India Long Short Equity, for instance, is a market-neutral fund that proposes to generate returns on the long and short side of the equity market.The SEBI directive on pooled accounts provides an incentive for mutual funds to offer more such structured products to cater to the broader needs of small investors.
Replicating PMS
Portfolio management is a two-step process in a PMS firm that operates separately-managed accounts. The first step is drafting the investment policy statement. The second step is the portfolio construction process. In a PMS-style replication process, the investment policy statement will be drafted by a portfolio advisor. The portfolio construction process will be facilitated by the advisor and executed by the investor.Specifically, the portfolio advisor would help the investor choose mutual funds that will optimally suit her risk-return preferences. This process involves first choosing various investment styles and then selecting funds in each style universe. The portfolio advisor performs a similar role as a fund-of-funds manager in that she employs her manager-selection skill. The advisor would also recommend individual stocks for those clients who prefer to take direct exposure in equity. These are clients who want custom-tailored portfolios.
The portfolio will be rebalanced at periodic intervals depending on the investor’s needs. The portfolio advisor will receive a fee for providing the advisory services - this will typically be a percentage of the total assets advised.
The primary difference in case of advisory services is that the client maintains her own trading P&L account. In the case of the PMS, the firm provides a monthly performance report to the investor.
The SEBI directive on pooled accounts is a welcome move in that it will increase demand for portfolio advisory services. And if such services take off, the mutual fund industry will be a major beneficiary.
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