Portfolio Management Services (PMS) and Alternative Investment Fund (AIF): Meaning, Types and Benefit

Investment portfolios are crucial for wealth creation and financial security. A properly diversified portfolio allows investors to maximise returns while minimising risks. Portfolio management services (PMS) and alternative investment funds (AIFs) are two popular investment avenues that help construct optimised portfolios. This article provides a detailed overview of PMS and AIFs, their types, benefits, taxation, and suitability for investors.

What is a Portfolio Management Service (PMS)?

Portfolio Management Service (PMS) refers to a professional investment management service offered by entities registered and approved by the Securities and Exchange Board of India (SEBI). Under PMS, the portfolio manager handles the investment portfolio on behalf of the client based on predefined investment goals, risk appetite, investment horizon, etc. 

PMS provides customised and flexible solutions to help investors attain their financial objectives. The key benefit of PMS is that investors get access to the expertise of professional fund managers who construct optimised portfolios comprising various asset classes such as equities, debt, gold and real estate. PMS aims to provide higher risk-adjusted returns compared to traditional investment options.

Types of Portfolio Management Services

There are various types of portfolio management services available to investors:

• Discretionary Portfolio Management Service

Discretionary PMS is when the portfolio manager makes all investment decisions in respect of the client’s portfolio. The customer cannot control portfolio composition or which securities are bought/sold. The portfolio manager has full discretion in making changes to comply with the client’s investment mandate.

• Non-Discretionary Portfolio Management Service.

Non-discretionary PMS requires that the portfolio manager should offer investment advice and recommendations only. However, the client controls all investment decisions and has to give the go-ahead for each buy/sell transaction. The portfolio manager is not allowed to trade on his own.

• Advisory Portfolio Management Service

Advisory PMS requires the portfolio manager to advise clients only on the investment. The portfolio manager recommends strategies and investment concepts to help clients attain financial objectives. The client has full control over the portfolio decision-making, and they carry out all of the trades.

Benefits of Portfolio Management Services

1. Professional fund management: PMS makes it possible for beginners to capitalise on the knowledge and skills of market professionals with many years of experience throughout market cycles.
2. Customised Portfolios: The PMS provides customised solutions to each investor depending on their financial position, risk profile and investment objectives. Portfolios are designed to comply with given needs.
3. Diversification: PMS successfully diversifies risk and return due to allocating investments in different asset classes and securities.
4. Liquidity: Portfolio managers achieve appropriate liquidity through careful asset allocation in equity, debt and cash. This meets contingency needs.
5. Regular Monitoring & Rebalancing: All other parameters are continuously tracked, and portfolios are rebalanced to ensure they align with client investment objectives.
6. Performance Reporting: Clients receive comprehensive performance reports that enable analysis of portfolio returns and risk metrics concerning client mandates.
7. Tax Efficiency: Portfolio managers use their wisdom to heighten the tax efficiency of the client portfolios by smart security selection and timely profit booking.

PMS Suitability 

PMS services are suitable for:

• High Net worth Individuals (HNI) who require portfolio sizes exceeding Rs.50 lakhs
• Investors who want professional expertise to manage their corpus
• Investors lacking time and experience to track markets actively
• Investors seeking higher returns over the long run compared to traditional options 
• Investors who want portfolios tailored to their exact requirements of risk, return, etc.

PMS Taxation 

• Long-term capital gains of more than Rs 1 lakh on equity investments held for over 1 year are taxed at 10%.
• Short-term capital gains on equity investments held for less than 1 year are taxed at 15%.
• Long-term capital gains on debt investments held for over 3 years are taxed at 20% after indexation benefit.
• Short-term capital gains on debt investments are added to income and taxed as per slab.
• STT (securities transaction tax) applies to equity purchase/sale. 
• Dividends received are tax-exempt for investors up to Rs 10 lakhs per year.

What are Alternative Investment Funds (AIFs)?

Alternative Investment Funds are investment vehicles that privately pool in capital and invest in alternative asset classes apart from just traditional investments like equities, bonds and real estate. AIFs have been gaining popularity among large investors thanks to benefits like portfolio diversification, higher returns and low volatility.

SEBI regulates AIFs under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. As per SEBI guidelines, AIFs can be set up as trusts, LLPs, companies or body corporates. They have to register with SEBI to operate in India. 

Types of AIFs

AIFs are categorised into 3 broad categories:

Category I AIFs

These funds invest in social welfare projects, SMEs, venture capital undertakings and early-stage startups, etc. They promote entrepreneurship and innovation by channelling capital to deserving sectors.

1. Venture Capital Funds: Funds that invest in startups with exceptional business models and high growth potential at early stages.
2. SME Funds: Funds that invest in small and medium enterprises.
3. Social Venture Funds: Funds that invest in socially beneficial businesses focused on areas like renewable energy, sustainability, healthcare, education, etc.  
4. Infrastructure Funds: Funds that invest in infrastructure projects in transport, energy, water etc.

Category II AIFs 

These AIFs do not fall under Category I or III. They invest across asset classes with a diversified portfolio and aim to generate capital appreciation in the long term.

1. Private Equity Funds: Funds that invest in unlisted companies by acquiring equity stakes.
2. Debt Funds: Funds that invest predominantly in structured or securitised debt of unlisted firms.
3. Fund of Funds:  Funds that invest in other AIFs.

Category III AIFs

Category III AIFs utilise complex trading strategies and leverage to generate returns.

1. Hedge Funds: Funds that aim to deliver positive returns regardless of market conditions using techniques like short selling, arbitrage, derivatives and leverage.
2. PIPE Funds: Funds that invest in listed equities at discounted valuations.

Benefits of Investing in AIFs

1. Higher Returns: AIFs invest in a wide variety of assets that are usually inaccessible to retail investors. The potential to generate higher returns than conventional options is a major draw.
2. Portfolio Diversification: AIFs diversify portfolios by incorporating alternative assets with a low correlation with typical equities or debt.
3. Inflation Hedge: Real estate investments in the AIF are powerful inflation hedges.
4. Lower Volatility: AIFs, including hedge funds, use derivatives and arbitrage to generate positive returns, irrespective of the market conditions, thus leading to lower volatility.
5. Access to sophisticated strategies: By investing via AIFs, even small investors can get exposure to very sophisticated and complicated trading strategies by fund managers.

AIFs Suitability

AIFs may be suitable for:

• HNIs, institutions and family offices looking to diversify portfolios beyond traditional avenues
• Investors with moderate to high-risk appetite targeting higher returns
• Investors seeking inflation hedging
• Investors looking for sophisticated alternative investment strategies to optimise portfolios.

AIFs Taxation

Taxation of AIFs is dependent on their legal structure and class. 

Here are the key points:

• Category I and II AIFs have pass-through status - the investors will pay the capital gains tax directly according to the holding period and applicable rate. The AIFs themselves are tax-exempt.
• Category III AIFs are taxed based on their legal entity type. This is because the AIF distributes the income.
• The TDS rate at the income distribution from AIFs is 10%.
• AIFs do not allow set off of losses against other income.

Conclusion

PMS and AIFs provide tailor-made solutions combining professional competence to assist investors in reaching their diverse investment objectives. PMS seeks customised portfolios, liquidity, and continuous monitoring, whereas AIFs seek to improve the diversification of portfolios and returns by incorporating complex strategies across various asset classes. Investors must consider fees, risks, lock-ins, portfolio size requirements, and returns while choosing the best option that fits their investment needs. A portfolio's mix of PMS and AIFs will lead to efficient risk-adjusted returns for investors.