Case 011Products and fund selectionCore

A couple can put Rs 75 lakh into a PMS charging 2.5% with tax on every trade, or a mutual fund charging 1% with tax only on redemption. For the same 14% gross over ten years, which leaves more, and by how much?

The situation

Nitin and Rashmi Prabhune have Rs 75 lakh to invest in Indian equities for ten years. A portfolio management service has pitched them a concentrated strategy at a 2.5% annual fee. In a PMS the shares sit in the couple's own name, so every sale the manager makes is a taxable event for them that year. The alternative is an equity mutual fund with a similar style at a 1% expense ratio; trades inside the fund are not taxed in their hands, and they pay capital gains tax only when they redeem.

Assume both earn the same 14% a year before costs. Assume the PMS turns over enough that the year's gains are realised every year, taxed at a blended illustrative 15%, and that the fund is redeemed after ten years with gains taxed at an illustrative 12.5%. Confirm current rates before relying on any of these.

Your task

What does each leave after ten years and after tax, how much of the gap is fee and how much is tax timing, and what would the PMS need to earn to break even?

Quick check

Roughly how much more does the mutual fund leave after ten years and after tax?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The mutual fund leaves about Rs 232 lakh after tax against about Rs 191 lakh for the PMS, a gap of about Rs 42 lakh. About Rs 28 lakh of that is the 1.5 point fee difference; about Rs 14 lakh is tax paid every year instead of at the end. The PMS must earn about 16.6% gross, 2.6 points more, just to match.

Step 1Why is the structure a cost, not just the fee?

Compare two ways of saving the same salary. In one, a slice is taxed every month before it reaches your account; in the other, the tax is settled once, years later, and the whole amount compounds meanwhile. Tax you pay later keeps earning for you until you pay it, so the same tax rate costs less when it is deferred. In a PMS the securities are in the couple's name, so the manager's sales create gains in their hands each year. In a mutual fund, the fund's own trading is not taxed to them; they are taxed only on redeeming units. That structural difference compounds exactly like a fee.

Step 2What does each path grow to?

The fund compounds at 14% less 1%, 13% a year: Rs 75 lakh becomes Rs 254.6 lakh, and 12.5% tax on the Rs 179.6 lakh gain leaves Rs 232.1 lakh. The PMS earns 14% less 2.5%, 11.5%, and pays 15% of that every year, so it compounds at 9.775%: Rs 75 lakh becomes Rs 190.6 lakh with no tax left to pay. The gap is Rs 41.6 lakh, and it grows every year the money stays invested.

Same 14% gross: the fee and the tax timing both compound100150200250Year 0Year 2Year 4Year 6Year 8Year 10Rs lakhMF before exit tax 255MF after tax 232PMS after tax 191If taxed at the end 204Fee gap 28Tax paid early 14Mutual fund: 13% a year, taxed once at the endPMS: 11.5% a year, gains taxed every year
From the same Rs 75 lakh and the same 14% gross, the mutual fund ends at Rs 232 lakh after tax and the PMS at Rs 191 lakh; Rs 28 lakh of the gap is the higher fee and Rs 14 lakh is tax paid every year instead of once.
Step 3How do you split the gap between fee and tax?

Add one imaginary step: a PMS with the same 2.5% fee but taxed only once, at the end. It would reach Rs 222.7 lakh and keep Rs 204.3 lakh after tax. The fund against that imaginary PMS isolates the fee, Rs 27.9 lakh; the imaginary PMS against the real one isolates tax timing, Rs 13.7 lakh. Splitting it this way tells the couple what they are paying for: most of the gap is the manager's price, and a real part of it is simply the wrapper.

After 10 years, Rs lakhBefore taxAfter tax
Mutual fund, 1% fee, tax at the end254.6232.1
PMS fee, but taxed only at the end (imaginary)222.7204.3
PMS, 2.5% fee, gains taxed every year190.6190.6
Gap: fund less PMS41.6
The Rs 41.6 lakh gap between the fund and the PMS splits into Rs 27.9 lakh from the fee difference and Rs 13.7 lakh from paying tax every year instead of at redemption.
Step 4When could the PMS still be the right choice?

Only if it earns enough more to cover both costs. Solving for the gross return that makes the PMS match the fund gives about 16.6%, 2.6 points a year above the fund, every year for ten years. That is the hurdle the PMS manager's pitch has to clear, and it is higher than the fee difference alone suggests. A PMS can offer things a fund cannot: a portfolio built around existing holdings, direct ownership, or harvesting losses against gains elsewhere. Those have value for some clients. But they have to be worth about Rs 42 lakh here, and the couple should hear that number before they sign.

Say the limits. The 15% blended rate assumes full annual turnover; a low-turnover PMS pays less tax early and narrows the tax gap. Performance fees, where charged, widen the fee gap. And both products can fall short of 14%; the comparison is about the drag, not a forecast.

Where candidates lose it

Candidates compare the fees, 2.5% against 1%, multiply the 1.5 point difference by ten years, and stop. That misses compounding and misses the tax wrapper entirely, understating the gap by more than half.

The second miss is assuming a mutual fund investor pays tax when the fund manager trades. Inside the fund, the investor is taxed only on redemption, which is the whole reason the wrappers differ.

What the interviewer asks next

  • The PMS turns over only 30% of the portfolio a year. How does the tax gap change?
  • The PMS charges 1.5% fixed plus 15% of gains above 10%. Redo the comparison.
  • When would a PMS's direct ownership of shares be worth paying for?

Company names and figures are illustrative.