Taxmann's Analysis | PMS vs AIF vs MF – How to Choose an Investment Vehicle?
Introduction
If you do not know how to discover a multi-bagger stock or are afraid of picking the wrong stocks, the Mutual Fund, PMS1 or AIF2 can help you invest in the stock market. The risk of losing money by investing in these vehicles is less than that of a retail investor who invests directly with little guidance and research.
PS: Before you read further, here is one disclaimer: You can begin the investment journey with mutual funds by investing just Rs. 100, but you need Rs. 50 lakhs for PMS and Rs. 1 crore with AIF.
All these investment vehicles are managed by professionals, and you have the flexibility to choose according to your risk appetite. Mutual Funds pool resources from retail investors but offer less flexibility within the same scheme. PMS provides high-net-worth individuals with personalised portfolio management and customised investment strategies. AIFs cater to sophisticated investors seeking investments beyond traditional markets, such as infrastructure funds, private equity, and hedge funds.
By understanding the differences and benefits of each option, investors can make well-informed decisions that align with their financial goals and risk tolerance.
1. About the Investment Vehicles
1.1 PMS
In PMS, experienced portfolio managers make investment decisions on your behalf. They aim to maximise the returns and minimise risks. With PMS, you can minimise the risk of making uninformed decisions and maximise the return by investing in various assets, including equities, bonds, mutual funds, ETFs, and alternative investments like commodities. The allocation depends on the client’s objectives and the portfolio manager’s strategy. SEBI specified the minimum investment of Rs. 50 lakhs for an individual to take the Portfolio Management Services. There is no lock-in period to withdraw the investment from the PMS, but an exit load may apply. An investor can choose an active or a passive portfolio management service. In the former, the portfolio manager actively seeks to maximise the returns but may take higher risks. In the latter, the fund manager aligns portfolios with current market trends by investing in index funds.
1.2 AIF
An AIF is established in India as a privately pooled investment vehicle to collect funds from investors, Indian or foreign, for investing as per the defined investment policy. AIF can be set up as a trust, company, LLP or any other body corporate, and it is mandatory to obtain registration from SEBI.
Each scheme of an AIF may have at most 1,000 investors, except for angel funds, which have a limit of 200 investors. It requires a minimum investment of Rs. 1 crore from investors, except from employees or directors of the Fund, who must invest a minimum of Rs. 25 lakhs. In the case of a social impact fund that invests in securities of not-for-profit organisations registered or listed on a social stock exchange, the minimum value of investment by an individual investor must be Rs. 2 lakhs.
An AIF offers three categories of investment.
Category-I AIFs invest in start-up or early-stage ventures, social ventures, infrastructure or other sectors that are considered socially or economically desirable. It includes Venture Capital Funds, SME Funds, Social Venture Funds, Infrastructure Funds, etc. These are close-ended funds with a minimum lock-in period of 3 years.
Category-II AIFs invest in areas where Cat-I and Cat-III do not invest. This includes private equity funds or debt funds for which no specific incentives or concessions are given by the Government or any other regulator. These funds are also closed-ended with a minimum lock-in period of 3 years.
Category-III AIFs are the most aggressive category of AIFs. They are allowed to use advanced or complex trading strategies and may employ leverage, including through investment in listed or unlisted derivatives. They include hedge funds or funds that trade to make short-term returns. Category III AIFs are usually closed-ended within a lock-in period of 1-3 years. For taxation purposes, Category-III AIFs are further classified into Specified Category-III AIFs, which meet the conditions prescribed under Section 10(4D) of the Income Tax Act, and Other Category-III AIFs.
1.3 Mutual Fund
A mutual fund needs no introduction. It pools money from investors to purchase a diversified portfolio of securities such as stocks, bonds, money market instruments, and other assets. SEBI has specified the mutual fund schemes an AMC3 can launch: equity, debt, hybrid, solution-oriented, index funds, and Fundof-Funds. The equity schemes are classified into multi-cap, large-cap, mid-cap, focused fund, flexi-cap, etc. Fund managers cannot explore the unregulated market and only invest in regulated securities. They have the flexibility to invest in securities that fulfil the criteria of the scheme. They cannot invest in securities not belonging to the scheme, even if they are available at dirt-cheap prices. Many mutual funds have a minimum initial investment requirement of around Rs. 100, while some may have higher minimums. This allows investors with varying budgets to participate in mutual fund investments. The lock-in period in mutual funds varies for different schemes. Solution-oriented schemes have a lock-in period of 5 years, while ELSS (Equity Linked Savings Scheme) requires a 3-year lock-in period. For all other schemes, there is no lock-in period; however, an exit load may apply.
1.4
Comparative Analysis
Lock-in There is a lock-in period No lock-in period, but exit loads may apply No lock-in period, except in ELSS and Solution-Oriented Schemes. But exit loads may apply.
SEBI (Portfolio Managers) Regulations, 2020
SEBI (Mutual Funds) Regulations, 1996
2. Taxation
2.1 AIF
Taxation of Category-I and Category-II AIF is governed by Section 115UB of the Incometax Act, which provides pass-through status to the funds. The income (other than the income chargeable under the head business or profession) arising to such funds is exempted from tax in their hands under Section 10(23FBA). The unitholders are liable to pay tax on such income as if they earned the income directly. Thus, the income paid or credited or deemed to be credited by such funds to their unitholders shall be deemed to be of the same nature and in the same proportion in the hands of the unitholder. The AIFs shall deduct tax from the payment of other income to the unitholders under Section 194LBB.
There is no pass-through status for Category-III AIF. Thus, the income of Category-III AIF is taxable. However, certain income of Specified Category-III AIF is exempt from tax under Section 10(4D) and Section 10(23FF). These AIFs are located in IFSC, and all their units must be held by non-residents except those held by the sponsor or manager. The non-resident unitholders of the specified Cat-III AIFs are exempt from tax for the income received from the AIF and the Income arising from the transfer of units.
The income of other Category-III AIF shall be taxable in its hands. Further, any income earned by unit holders from Category-III AIF shall also be taxable as per the applicable tax rate.
(a) Taxable as per applicable tax rate if AIF is a Company or a Firm
(b) Taxable at a maximum marginal rate of 42.744% if AIF is registered as any other body corporate [Section 115UB]
Specified Category III AIF
Category III AIF
than business income
[Section 10(23FBA)] Taxable as per applicable tax rate [Section 115UB]
Income from securities Taxable, unless exempt under Section 10(4D), as per the following tax rates under Section 115AD:
(a) Interest or Dividend: 10%;
(b) Short-term capital gain: 15% or 30%;
(c) Long-term capital gain: 10%
[Section 10(23FBC)]
than income from securities
as per applicable tax rate
as per applicable
[Section 10(23FBC)]
as per applicable tax rate
PMS is a way to invest in securities, just like mutual funds. However, unlike mutual funds, there is no explicit provision to tax the income earned through PMS. Thus, such income shall be taxable per the general provisions. The tax rates in some cases have been mentioned in the table below.
Funds investing between 35% to 65% in equity shares
Mutual Funds investing up to 35% in equity shares
2.3 Mutual Funds
The income of a mutual fund is fully exempt from tax. It means the capital gains, dividends, and interest income earned by the mutual fund shall be exempt from tax. However, when the mutual fund distributes such income to the investors or when the investors redeem the units of the mutual fund, the income arising therefrom shall be taxable in the hands of the investors. It should be noted that the income of the sponsor (AMC) shall be taxable.
Investors in mutual funds can choose between two options for receiving returns: Growth or IDCW (Income Distribution Cum Capital Withdrawal).
The growth option focuses on capital appreciation, where the fund’s profits are reinvested back into the fund. This compounding effect can lead to higher overall returns in the long term.
The IDCW option provides investors with regular income streams in the form of dividends, which are paid out of the fund’s profits. IDCW payouts can reduce the potential for capital appreciation over time, as less money is being reinvested within the fund. The dividend income the unitholders receive shall be taxable at the applicable rate.
4 The tax shall be charged on the long-term capital exceeding Rs. 1 lakh.
5 The tax shall be charged on the long-term capital exceeding Rs. 1
6
The capital gains arising from the transfer of units of the mutual funds shall be taxable at the rate specified in the below table.
Equity Oriented Mutual Funds (if STT is paid)
Mutual Funds investing between 35% to 65% in equity shares Applicable tax rate
Mutual Funds investing up to 35% in equity shares
3. Returns
7
Applicable tax rate
In the tables below, we compare the annualised returns8 generated from mutual funds and PMS in various risk categories (large-cap9, mid-cap10, small-cap11 and multi-cap12) against the benchmark returns of that category. Based on the annualised returns, we have identified the winners. Where the winner is a mutual fund or PMS, we specified the alpha generated over the index returns.
Sidebar: ‘Alpha’ is a metric used in the stock market to measure an investment’s performance relative to a benchmark index. A scheme’s higher alpha shows the excessive return it generated over the index return. An ‘index’ or ‘benchmark’ return refers to the performance of a basket of stocks in that index over a specific period. NSE has more than 70 indices, which are classified into broad market indices, sectoral indices, thematic indices, fixed-income indices, etc.
7 The tax shall be charged on the long-term capital exceeding Rs. 1 lakh.
8 Based on data filed with the SEBI until 30th June 2024 and downloaded from www.moneycontrol.com and www.pmsaifworld.com
9 Large-cap means a fund that invests at least 80% in shares of large-cap companies.
10 Mid-cap means a fund that invests at least 65% in shares of mid-cap companies.
11 Small-cap means a fund that invests at least 65% in shares of small-cap companies.
12 Multi-cap is a fund that invests at least 25% in large-cap companies, 25% in mid-cap companies, and 25% in small-cap companies.
3.1 Median returns of Mutual Funds and PMS against the category benchmark
In the table below, we have identified the median return of the top 10 funds in the given risk category and compared it against the index returns. We have identified the winners based on the annualised returns in the given time frame. Where the winner is a mutual fund or PMS, we specified the alpha generated over the index returns. Where the benchmark has given higher returns over the funds, the alpha has not been computed.
In the higher time frame, the benchmark returns have outshined the returns generated by the funds in all risk categories except in multi-cap.
3.2 Top performing Mutual Funds and PMS based on CAGR return of 5 years.
In the table below, we have identified the top-performing funds in the given risk category based on the annualised return (CAGR) in 5 years.
3.3 Median Return from AIF
In the table below, we have computed the median return of the top 10 AIF CategoryIII funds in the given risk category based on the annualised returns in the given time frame. There are two risk categories in AIF Category-III - Long Fund13 and Long-Short Fund14 .
13 A long-only fund is an investment strategy where the manager buys and holds securities, expecting their value to rise, without engaging in short selling.
14 A long-short fund is an investment strategy in which the manager takes both long positions (buying securities expecting their value to rise) and short positions (selling securities expecting their value to decline and repurchasing them at a lower price).
3.4 Top performing AIF based on CAGR return of 5 years.
In the table below, we have identified the top-performing funds in the given risk category based on their annualised return (CAGR) in 5 years15
4. Conclusion
When deciding between Mutual Funds, Portfolio Management Services (PMS), and Alternative Investment Funds (AIF), investors should consider several critical factors: risk appetite, flexibility, transparency, taxation, expense ratios, duration, and the investible amount.
4.1 Investible Amount and Accessibility
Due to their higher entry thresholds, PMS and AIF may be impractical for investors with limited investible amounts. In such cases, Mutual Funds present a more accessible option.
4.2 Expense Ratios
PMS and AIF charge significant fees, often around 2.5% of the total portfolio value. In contrast, sectoral or thematic Mutual Funds typically have expense ratios below 1%, with index-based Mutual Funds even lower at around 0.5%. Therefore, evaluating the expense ratio is crucial when selecting an investment vehicle.
4.3 Lock-in Periods and Liquidity
PMS and AIF usually impose lock-in periods ranging from 1 to 3 years, with potential exit charges if funds are liquidated early. Mutual Funds, however, do not levy exit charges after one year, and index funds only have a 7-day lock-in period. Mutual funds are preferable for investors seeking flexibility and shorter commitments.
PMS and AIF offer greater transparency, providing detailed and regular updates on the shares bought and sold. Mutual Funds, on the other hand, disclose portfolio details periodically, typically quarterly. Investors valuing frequent updates might find PMS and AIF more attractive.
4.5 Taxation
The taxation impact on PMS and Mutual Funds is generally similar, but AIFs may incur additional taxes. Thus, tax implications should be carefully considered when choosing between these investment options.
4.6 Risk Considerations
Investors with a lower risk tolerance should consider index-based Mutual Funds due to their lower expense ratios and minimal lock-in periods. Such investors are advised to avoid PMS and AIF, which often involve higher risks and costs.
By weighing these factors, investors can make informed decisions that align with their financial goals and risk preferences.
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