Do PMS fees justify their returns vs Mutual Fund fees?

Short answer : if you find the ‘right’ PMS, yes. Many PMS schemes perform no better than the best Mutual funds, and in those cases, one may sign up to give away too much in fees relative to returns. But if you stick with what appear to be the very best PMS offerings, the returns may well justify the fees.

In the ideal world, we would have something similar to the fee structure that Buffett had in place when he ran his partnership (0% fixed, 25% of profits over a hurdle rate of 6%). More on this here. No fixed fees go a long, long way to help you as an investor because the manager is only able to earn a fee when excess returns are realized.

Over the last 5 year period (as of Aug’16), the best-performing MFs (independent of investing approach/style) have averaged an impressive 27-30% CAGR after fees, though their 10 year performance is much lower – within the 15-18% range. The best performing longer term mutual funds have delivered a 25-29% CAGR but their 5 year returns are in the 16-19% range.

On a simplistic basis, MFs charge 2% as fixed fees every year & PMS charge 1-2% fixed + performance fees of 10-20% above certain hurdle rates. To truly compare MF fees vs PMS fees, one would have to put together detailed spreadsheets going over a range of actual fee options under each PMS juxtaposed with several return series possible. I’ve done this, and have tried to not get too lost in the numbers. The first conclusion is that MF fees are ‘stable’ at ~2%, but PMS fees scale up to as high as 5-7% if their returns are over 30% annually. Is that a bad thing? Or is that fair? If a fund manager makes 30% in a year, is keeping 5% (contractually) “bad” ?

I believe a good fund manager ought to eat his pudding. Their having a significant / meaningful stake in the fund is good for investors, and when they make out-sized gains, they ought to be able to take their contractual share. Conversely, if they don’t, they’re not paid a performance fee – this too is contractual. Mutual funds “bleed” a fixed 2% (ball-park) regardless of their outcome.

Fees have a huge impact on long-term returns, so every 0.5% makes a difference. It is worth looking for a low fee option, but only if the return possibilities are comparable. Said another way, no point “saving” on fees in a MF which makes 15-20% a year vs a PMS which makes 20-25%  (both returns being net of fees). Manager quality makes a huge difference.

That said, within PMS offerings, it may be better to stick with fixed-fee options.

If we assume the various PMS options will compound at 15% a year for the next 10 years, then there is no large difference between fixed-fee & performance-based fee options. So if the PMS returns 15%, you as a client would receive on average ~12-13%. The Fixed fee option of 3% (3.3% with service tax) tends to be slightly more expensive than the performance-based options.

If we change the future return expectations from 15% a year to 20% a year, fixed fee options are very attractive to you as the client. 1 Cr compounded at 20% over 10Y is 6.2 Cr. If you factor-in  fixed fees of 3%, your “in hand” value is 4.7 Cr.

Over a 10Y period, the fund earns 1.5 Cr for achieving that high return. You would see, in effect, a ~17% return on your initial investment. [1]

In contrast, a profit-sharing structure would typically be far-worse on your net-returns.
If the portfolio returns 20% a year, the fund would earn 6-7% a year, and you would earn the remaining 13-14%.

So in effect, the higher the future returns, the better off you would be if you stuck to fixed-fee arrangements.

Choose wisely.

There is a better way to look at this arrangement, imo :
You, as a saver, provider of excess capital & investor, earn 16.7% a year on your money;
The fund manager, as a steward & efficient allocator of that capital to productive investments, earns 3.3% a year on that same capital. The sum total of 20% is actually seen by nobody – at best, it goes into a presentation of the fund demonstrating that the “gross” return was 20%, before fees.

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