Mark Twain famously asked this question: "What is the difference between a taxidermist and a tax collector?” And then went on to wittily provide the answer: “The taxidermist takes only your skin."
There are plenty of funny tax punchlines, but I found this one apt for the subject at hand. What is the difference between the return from your mutual fund and a PMS? You guessed it right, it is the tax angle.
When Deepak Kapur emphasizes the need to calculate the annual performance of your portfolio on a post-tax basis, he does have a very strong case. Here he explains it in a very simple fashion.
Don’t get carried away with pre-tax returns.
Whether it is PMS or RIA, this rule holds.
With a minimum investment of Rs 50 lakh, Portfolio Management Schemes are out of the reach of most retail investors. But many avail the services of Registered Investment Advisors who offer customised portfolios.
All of them display their benchmarked performance post fees and costs. But what about taxes? The reason most don't talk about post tax performance is because the tax implications differ from individual to individual and hence it’s not possible to present one post tax performance number.
(The same goes for Alternative Investment Funds, or AIF. However, the taxation is much more complex in case of AIF’s and dependent on the category as well as pass-through status.)
Fair enough. It is not as cut-and-dried as we would like it. Having said that, it is up to you to figure out how your portfolio has fared once you take taxes into account. If you are considering associating with a PMS or RIA, you need to ask them for some indication of historic returns on a post-tax basis.
Understand the context.
You can negate the above point by saying that one pays taxes whether it is a mutual fund or a PMS or an index fund. You aren’t wrong. But there is more to it.
Usually, a PMS/RIA uses an index as a benchmark to contextualize performance. In effect, the comparison is between an active strategy and a passive buy-and-hold index strategy.
You can invest in an index fund or ETF if you want to mimic the performance of an index at low cost. Technically, their performance should match the index they are mimicking. But once you take into account fees and other variables, the performance will be slightly lower (about 0.5% to 1%). This passive investment incurs no taxes till the investor sells the units of the fund. For as long as it is held – zero taxes.
In the case of PMS/RIA, investors incur taxes whenever any securities are sold at a profit and the aggregate profits booked in a financial year (net of losses) lead to a tax liability.
Always look at the post-tax returns.
Let’s look at a simple illustration with Anjali to drive home the point.
PMS
- Investment: Rs 1 lakh
- Tenure: 3 years
- On Maturity: Rs 1,50,000
- Annual statements showing the value of the investment, net of fees and costs. They also advise on annual tax obligations which client has to pay as part of income tax filing.
Index Fund / ETF
- Investment: Rs 1 lakh
- Tenure: 3 years
- On Maturity: Rs 1,40,000
- NAV is declared which is post expense ratio.
On the face of it, the PMS shows an out-performance of 10%, an alpha of 3% per annum. However, in most cases, the client’s portfolio will witness a certain amount of buying and selling of securities through the year. Tax liabilities may accrue out of realised profits. Interestingly, those who normally opt for PMS pay any taxes due from such activity from other sources and do not draw down from their PMS to pay the taxes. Anjali did likewise. So the Rs 1,50,000 value did not account for taxes paid over the 36 months as a result of PMS activity.
Let’s say Anjali withdrew from the PMS to pay the taxes that arose out of PMS advisory. Naturally, the post-tax value of the portfolio would be lower. In fact, it would be only Rs 1,41,000 vs. the indexed fund of Rs 1,40,000. Where is the outperformance?
In 2017-18, mid and small cap focused PMS did very well and many asset managers booked profits during course of the year. As part of normal activity, they went on to reinvest the proceeds in other stocks. The client’s portfolio value and gains on March 31, 2018 were extremely impressive on a pre-tax basis. Clients paid reasonably taxes on these realised gains. By March 31, 2019, due to a market-wide correction in small and mid caps, portfolios were down substantially. While the portfolio showed a certain drawdown as per the PMS report (say -35%) the client was down a lot more than that, as she had also paid taxes separately on the realised gains of the earlier year.
Hence the need for current or potential clients to always ask: ‘What’s the post-tax performance’
Here’s what you need to note:
- Futures and Options and intra-day trading in stocks do not get the benefit of the short-term capital gain rate of 15%. These are considered as business income and the normal tax rate of client is applicable.
- Higher the churn of a PMS/AIF/RIA, higher the likelihood of taxes.
- Publicly reported performance data by PMS/AIF/RIA/Smallcase RIAs, do not adjust for this tax drawdown. If you do not capture the effect of taxes, the picture is incomplete.
- Once you adjust for taxes, the alpha shown by some vs. the benchmark, may turn to zero or negative.
- Investors must account for tax to truly gauge the benefit of their association with their respective wealth manager.
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