Investing in the Indian financial market offers a plethora of options, with mutual funds and Portfolio Management Services (PMS) being two popular choices. However, there is often confusion surrounding the taxation of gains and hence post-tax returns in these investment services. This article aims to address the common misconception that Portfolio Management Services (PMS) deliver lower post tax gains as compared to Mutual Funds.
The misconception stems from the timing of capital gains. In case of PMS investments capital gains may be due at the end of each financial year. However, in mutual fund investments, capital gains are to be paid only at the time of redemption when these gains are realised. Due to this difference in timing of tax payments, mutual funds are generally considered a more tax-efficient investment class.
However, if we delve deeper into the calculations of post-tax returns for each of these two options, the delta in net returns arising due to this difference in timing of taxation is lower than what many individuals believe.
Calculation of Returns and Taxes – PMS vs MF
To illustrate the post-tax returns in PMS and mutual funds, let’s consider two scenarios. In scenario one, the investment is made in a mutual fund (direct plan) and in scenario two the same amount is invested in a PMS.
In each scenario
● Duration of the investment is 10 years.
● Amount invested is Rs 50 lakh upfront with no capital addition thereafter.
● Assumed pre-tax return is 15% p.a. in each of the two investments.
Scenario 1: Mutual Fund [MF]
● Value of invested capital (pre-tax) at the end of 10 years (at 15% CAGR): ₹20,227,789
● Long-term capital gains tax (at 10%): ₹1,522,789 (payable at the time of redemption i.e., at the end of the 10th year)
● Value of invested capital (net of tax) at the end of 10 years: ₹18,705,010
● Net CAGR (post tax): 14.10 %
Scenario 2: Portfolio Management Service [PMS]
● Assumptions specific to PMS investment
○ The PMS churns its portfolio completely in twelve months and hence some capital gains are due at the end of every financial year.
○ Of the capital gains, 70% are assumed to be short term (STCG) and the rest 30% long term (LTCG) [this is a conservative assumption, if 70% of the securities are held for only a few quarters but 30% spill over to beyond 365 days]
○ These capital gains taxes are paid by taking out the required amount from the capital invested with the PMS; the funds that remain continue to compound.
○ STCG are taxed at 15% and LTCG at 10%
● Total STCG and LTCG paid: 1,862,738 (sum of all taxes paid at the end of each year for the 10 years of investment)
● Value of invested capital (net of tax) at the end of 10 years: ₹16,935,324
● Net CAGR (post tax): 12.97%
Detailed calculations for PMS investment
| Year | Starting amount | Gain(Assumed 15% p.a.) | STCG(70% of gain assumed to be STCG) | LTCG(30% of gain assumed to be LTCG) | STCG tax@15% | LTCG tax@10% | Tax paid | Gain net of tax | Closing amount |
| 1 | 5,000,000 | 750,000 | 525,000 | 225,000 | 78,750 | 22,500 | 101,250 | 648,750 | 5,648,750 |
| 2 | 5,648,750 | 847,313 | 593,119 | 254,194 | 88,968 | 25,419 | 114,387 | 732,925 | 6,381,675 |
| 3 | 6,381,675 | 957,251 | 670,076 | 287,175 | 100,511 | 28,718 | 129,229 | 828,022 | 7,209,698 |
| 4 | 7,209,698 | 1,081,455 | 757,018 | 324,436 | 113,553 | 32,444 | 145,996 | 935,458 | 8,145,156 |
| 5 | 8,145,156 | 1,221,773 | 855,241 | 366,532 | 128,286 | 36,653 | 164,939 | 1,056,834 | 9,201,990 |
| 6 | 9,201,990 | 1,380,298 | 966,209 | 414,090 | 144,931 | 41,409 | 186,340 | 1,193,958 | 10,395,948 |
| 7 | 10,395,948 | 1,559,392 | 1,091,575 | 467,818 | 163,736 | 46,782 | 210,518 | 1,348,874 | 11,744,822 |
| 8 | 11,744,822 | 1,761,723 | 1,233,206 | 528,517 | 184,981 | 52,852 | 237,833 | 1,523,891 | 13,268,713 |
| 9 | 13,268,713 | 1,990,307 | 1,393,215 | 597,092 | 208,982 | 59,709 | 268,691 | 1,721,616 | 14,990,329 |
| 10 | 14,990,329 | 2,248,549 | 1,573,985 | 674,565 | 236,098 | 67,456 | 303,554 | 1,944,995 | 16,935,324 |
PMS vs. Mutual Funds: The Post-Tax Comparison
In the above scenario, when comparing the net CAGR (post tax) of investment in a PMS (12.98%) vs a mutual fund (14.10%), the difference is 112 bps.
While mutual funds benefit due to delayed timing of taxation, the power of Portfolio Management Services (PMS) lies in their potential to generate superior returns due to higher flexibility. This in turn is due to these reasons:
– Portfolio Management Services typically invest smaller corpus of funds as compared to mutual funds, allowing for agile entry and exits.
– They have the flexibility to invest in relatively less liquid securities i.e. microcaps; also a function of the investment corpus
– Portfolios can be customised as per the risk tolerance of the clients.
Additionally, since most mutual fund investors buy via the indirect route (i.e., through distributors) and hence incur additional costs typically more than 1%, the probability of their return exceeding that of a similar investment in a PMS reduces even further.
Over the past five years, PMS fund houses have consistently provided investors with returns that surpass those of mutual funds. This period has seen mutual funds (direct investment) deliver a median Compound Annual Growth Rate (CAGR) of 12.71% (pre-tax), while the median for PMS investments in the same period has been 15.25% (pre-tax) . The outperformance of 254 bps on an annual basis more than compensates for the tax benefit enjoyed by mutual fund investments (calculated to be 112 bps earlier). This data clearly demonstrates the superior performance potential of PMS investments.
Other Benefits of PMS investments
Apart from the potential for higher post-tax returns, Portfolio Management Services (PMS) offer these other advantages too:
● Customised Portfolios: PMS investments allow investors to tailor their portfolios according to their specific needs and goals. They can choose the sectors, capitalization, allocation, and themes that they want to invest in. Investors can also exclude certain stocks or sectors that they do not want to invest in. This gives them more freedom and ownership over their portfolio.
● Transparency: Portfolio Management Services offer transparency to investors who can access detailed reports of their portfolio holdings, transactions, performance, fees, and charges on a regular basis. They can also communicate directly with their portfolio managers and get regular updates and feedback on their portfolios.
Conclusion
In conclusion, the notion of significantly higher capital gain taxes in PMS investments compared to those in mutual funds is a misconception – the tax difference exists but is not as high as often perceived. More importantly, PMS investments have the potential to offer higher returns due to various structural advantages with this vehicle. Investing in a PMS can thus be a prudent choice for long-term wealth creation. It’s essential for investors to grasp the nuances of investing via various investment options, enabling them to make well-informed investment decisions.
Data Source – Mutual Funds Average Returns : Value Research; PMS Average Returns : PMS Bazaar