Risks of Investing in Portfolio Management Services
Anyone familiar with investing in financial markets understands that risk is an inevitable companion to returns. After all, it’s impossible to seek returns without accepting some level of risk. If there were truly risk-free investments with high returns, wouldn’t everyone rush toward them?
Just like there’s light and dark, there’s also risk and return in the world of investing.
In this article, we will explore the various risks associated with investing in Portfolio Management Services (PMS). Let’s dive in!
What are Some of the Risks Associated with Investing in PMS?
Market Risk
If you’re familiar with the stock market, you’re no stranger to market risk. Remember the disclaimer that comes with every investment?
“Investments in securities are subject to market risk. Please read the offer documents carefully before investing.”
Well, market risk is very real, and it is here to stay. As defined by SEBI, market risk includes those factors that affect the overall performance of the financial markets, and the economy on the whole.
Let’s understand this with an example.
Let’s travel back in time to the beginning of 2020. Your fund manager has created a well-diversified portfolio of equities and equity-based mutual funds for you. You’ve got quality stocks, and you’re optimistic about the return potential.
Then, out of the blue, COVID-19 strikes and the entire economy goes into lockdown.
As for the stock market, well, that takes a tumble. Or more accurately, a free fall.
From 12,352 on 17 January 2020, the Nifty50 fell to 8,083 on 3 April 2020. That’s a crash of about 34.56%!
In such a situation, all the sectoral diversification in the world could not have helped you. The only thing that could have was that you had multiple different asset classes in your portfolio, preferably those with negative correlation to each other.
Concentration Risk
Concentration risk arises when a portfolio is overly focused on a few securities or sectors.
Imagine, for instance, that your fund manager believes the green energy sector in India is poised for immense growth in the next few years. They discuss this with you, and then they invest a major chunk of your capital into stocks and mutual fund schemes in this sector.
Now, all is going well. Then, suddenly, the enthusiasm and the momentum buzzing around the sector dies out. There are several issues, and the green energy sector’s future in India suddenly grows dim.
Unfortunately, this also means that your portfolio potential returns will dim along with it.
This approach can lead to substantial potential returns if those investments perform well. But, as your portfolio is concentrated in a specific sector, it also increases the risk of significant losses.
Liquidity Risk
Liquidity risk refers to the difficulty in selling assets quickly without affecting their market price. In PMS, portfolios may include illiquid assets such as small-cap stocks or private equity, which are harder to sell during market downturns.
For example, your portfolio has some allocation to private equity investments in startups within a promising sector. Now, for some reason, the potential of that sector falls, and with it, the demand for shares of those startups.
In such a situation, it can be quite hard to exit from those investments, even though you may wish to. After all, unless your portfolio manager finds a buyer, how will you extract what remains of your original capital allocation?
Before investing in PMS, you should inquire about the liquidity profile of your potential portfolio. Be very cautious of investments that might be challenging to exit in turbulent times.
Managerial Risk
No one is perfect and that means, no matter how experienced, people can make mistakes. Your fund managers are no different.
Managerial risk refers to instances when the fund manager's investment decisions do not achieve the expected outcomes. Therefore, it is crucial for the fund manager to source, select, complete, and realise appropriate investments.
Even seasoned fund managers can make unwise decisions influenced by behavioural biases and personal opinions. For example, a fund manager may overweight a particular sector based on flawed market predictions, which can ultimately result in underperformance.
Performance Risk
When you create a portfolio and design it from scratch, you will obviously do it with the best of intentions. After all, we invest in the stock market with the intention of making potential returns.
Sometimes, however, even the best-laid plans may fall apart.
Performance risk refers to the possibility that the PMS may not achieve its performance objectives. This risk can be influenced by market conditions, the manager’s strategy, unforeseen economic events, and a variety of other factors.
Performance risk is generally unintentional. SEBI requires PMS providers to clearly define performance benchmarks and fee structures. Performance fees are designed to incentivise fund managers to exceed a set hurdle rate or benchmark.
For instance, if the hurdle rate is 10%, then your fund manager can only charge performance fees when your portfolio returns exceed 10%. If your portfolio grows by 20%, then your fund manager will be able to charge a portion of the extra profit, above and beyond 10%, as their performance fee.
To Sum Up
Investing in PMS comes with its own set of inherent risks, just like any other investment. These risks include market volatility, concentration in specific assets, liquidity challenges, managerial errors, and potential underperformance.
However, don’t let these risks discourage you from considering PMS as part of your wealth management strategy. All investments carry some level of risk, and the decision to invest in PMS should be based on your individual financial goals, risk tolerance, and investment horizon.
If PMS aligns with your investment objectives and risk appetite, it can be a valuable tool for customised wealth management.
SEBI requires PMS providers to disclose all risks, investment strategies, and fee structures to help investors make informed decisions.
FAQs
What are the disadvantages of PMS?
The main disadvantages of PMS are the higher minimum investment amounts and the fees involved. As this service involves customised portfolios that are designed exclusively for your requirements, they also involve higher management and performance-based fees.
How is PMS taxed in India?
PMS investments in India are subject to capital gains tax, similar to direct equity investments. Short-term capital gains on equity investments apply at 20%, and long-term capital gains are taxed at 12.5%. Non-equity investments are taxed at the applicable rates based on holding periods.
Is PMS better than MF?
Whether PMS is better than mutual funds depends on the investor's requirements and risk appetite. PMS portfolios can be customised and actively managed. They can create higher potential gains but also have higher fees and greater risks.
Mutual funds, on the other hand, are more accessible and regulated. They’re suitable for a broader range of investors.
Disclaimer:
Investments are subject to market risks; read all investment-related documents carefully. Dezerv Investments Private Limited is a Portfolio Manager with SEBI Registration no. INP000007377 (hereinafter referred to as “Dezerv”)
The information contained in this article is for educational purposes only. This article should not be construed to be an offer to buy/sell any securities or provide any investment advice to any party. Please refer to the disclosure document, client agreement, and other related documents for specific risk factors for securities/ assets/ portfolios.
In the preparation of this article, Dezerv used information developed in-house and publicly available and from other sources believed to be reliable. While reasonable care has been taken to present reliable data in this article, Dezerv does not guarantee the accuracy or completeness of the data. The information/data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment strategy. Actual results may differ from expressed or implied performance due to market uncertainties. The statements made herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions.
This document should not be reproduced or redistributed to any other person without Dezerv's prior permission.
Dezerv and/or its subsidiary/associates/employees are not liable for any risks/losses pertaining to any assets/securities or investment opportunities available from time to time.
External advice: Please consult your legal, tax and financial advisors to determine the implications or consequences of your investments in such financial products or before making any investment decisions.
