Above a regulatory minimum ticket, Indian investors are offered two structures that mutual funds are not: a portfolio management service, where the securities are held in the investor's own name, and an alternative investment fund, where they are pooled. Both charge differently from a mutual fund, and both tax differently. Neither difference is disclosed as clearly as a mutual fund's expense ratio.
How are PMS and AIF fees calculated?
The fee arithmetic is where the money is. A typical structure charges a fixed fee on assets plus a share of returns above a hurdle, subject to a high-water mark. You have to compute all three terms together and in the right order. Apply the gross return, deduct the fixed fee, compare the result against the high-water mark grown by the hurdle, and charge the performance share only on the excess.
Run one account through three years. ₹1,00,00,000 opening, a 1.00% fixed fee on average assets, a 20% performance fee above a 10% hurdle, an annual high-water mark, and gross returns of +24%, −8% and +21%.
Advertisement
| Year | Gross | After the fixed fee | High-water mark | Hurdle level | Performance fee | Closing |
|---|---|---|---|---|---|---|
| 1 | ₹1,24,00,000 | ₹1,22,88,000 | ₹1,00,00,000 | ₹1,10,00,000 | ₹2,57,600 | ₹1,20,30,400 |
| 2 | ₹1,10,67,968 | ₹1,09,52,476 | ₹1,20,30,400 | ₹1,32,33,440 | nil | ₹1,09,52,476 |
| 3 | ₹1,32,52,496 | ₹1,31,31,471 | ₹1,20,30,400 | ₹1,32,33,440 | nil | ₹1,31,31,471 |
Year three is the one to stare at. The account rose 21% gross and the manager earned no performance fee at all, because the high-water mark set in year one, grown by the 10% hurdle, stands at ₹1,32,33,440 and the account after its fixed fee reached ₹1,31,31,471. It missed by ₹1,01,969. Strip the high-water mark out and reset the hurdle to each year's opening value instead, and the same three years generate ₹4,74,350 of performance fees, against ₹2,57,600 with the mark in place. The high-water mark is worth ₹2,16,750 to this investor, which is 2.17% of the original account, earned entirely by a clause. That's a lot of money to hang on one sentence of an agreement.
Over the three years the account compounds at 11.34% gross and 9.51% net, a drag of 1.84 percentage points a year, and the fees of ₹6,06,117 take 15.9% of the gross gain. Put that beside the mutual fund arithmetic. There, a 1.10-point commission wedge took 15.7% of a regular plan's gain. Here, a full performance-fee structure takes 15.9%. The structures look completely different and cost almost the same. That's no coincidence, since it's what a competitive market for distribution does.
What makes a performance fee fair?
Three terms decide whether a performance fee is fair, and they're what you read in the agreement. The headline rate tells you less.
A hard hurdle charges the performance share only on the excess over the hurdle. A soft hurdle with catch-up charges the share on the entire return once the hurdle is cleared, so clearing 10% by one rupee moves the fee from nil to 20% of everything. The headline "20% over 10%" describes both, and they're nowhere near the same product.
A high-water mark means the manager must recover a previous loss before charging again, as you saw in year three. Without it, an investor pays twice for the same rupee of recovery.
The fee base matters too. Average daily assets, opening assets and closing assets give different answers, and a fee on closing assets in a rising year is materially larger than a fee on opening assets. The example above uses the average of opening and closing, which is a fair approximation of average daily assets and is stated so you can reproduce it.
How are PMS and AIF returns taxed?
The tax difference is structural and is the part most investors never see. In a portfolio management service the securities sit in the investor's own name, so every sale the manager makes is the investor's capital gain, taxed lot by lot in the investor's hands, in the year the manager chose to sell. A high-turnover manager therefore hands the client a tax bill the client did not decide to trigger, and the client's after-tax return can be far below the reported pre-tax one. Whether the performance fee itself is deductible against those gains has been contested and never settled. A fee that isn't deductible is a cost paid out of after-tax money [verify: this position turns on case law and on the current wording of the deduction for expenditure in connection with a transfer. Take current professional advice, and don't rely on any summary].
Alternative investment funds split by category, and the split is a tax split. Categories I and II have pass-through status, so income other than business income is taxed in the investor's hands as though the investor had earned it directly. Category III does not have the same pass-through treatment and is generally taxed at the fund level, which changes both the rate and who reports it [verify: the pass-through provisions of the income-tax statute governing investment funds, incometaxindia.gov.in. This area has been amended repeatedly]. For you as a buyer, that means two funds quoting the same gross return can deliver very different after-tax returns to the same person purely on structure. The offering document is where that's stated.