Stopping the PMS Abuse

Portfolio management services (PMS) have been told to change the way they operate. (From DNA)

Sebi asked PMS houses not to pool assets of investors the way mutual funds do and also increased the minimum networth requirement for floating a PMS house.

The networth required to float a PMS scheme has been increased to Rs 2 crore from Rs 50 lakh earlier, purportedly to weed out the smaller players.

The number of PMS players has shot up to 205 as on March 31, 2008, from just 18 in 1999. These include several small and mid-size brokerage firms. This is unlike in the markets abroad, where PMS is run primarily by asset management companies.

The second part - of having a higher net worth - is just to weed out the smaller players.

The first part is important. But before I say why, a little history is worth looking at.

PMS schemes were badly abused in the 80s and early 90s, and were at the time only for institutions (who would give money to banks to invest in bonds/shares). Banks used traders and brokers to freely move money around, but the abuse was in how the banks actually made it take all their losses. Banks had their proprietary trading going as well, and they would take on huge trades. Some of these trades in their prop accounts made losses, and sometimes, large losses.

Banks routinely transferred the losses to their PMS client accounts, essentially saying that these trades happened from the client's money, not their own. With no system to check them, this happened for years and years, even with RBI's knowledge. Why did the clients stand for it? For two reasons - a) some of them were public sector companies where palms were greased. For instance, Sucheta Dalal and Debashis Basu found that Power Finance Corporation had taken a loss of 90 lakh in 1991, and the beneficiary were Aditya Birla's daughter and daughter-in-law. Citibank was the PMS account manager, and presumably this deal was done to please the Birlas and the intermediary brokers. Why PFC stood for it is anyone's guess, and that guess might include some money moved hither to thither.

Another reason was unsaid guarantees. Banks weren't allowed to guarantee PMS returns, but they did, unofficially. Some even to the extent of 25% a year. Then, any profits made above the guaranteed rate, could be offset by any losses, the client wouldn't care.

This kind of abuse went on for years and years until the 1992 scam was unearthed, and many banks simply stopped their PMS services.

Now PMS is back for the individuals, and banks and brokers have lined up for your money. Except, we've heard millions of stories where despite a strong market, PMS products have returned negligible profits. A person I know got exactly 25 lakhs back, on a 25 lakh investment, after two years of investment. Only the Sensex had gone up 2.5 times in the same period. Hundreds of others have written in blogs, comments and sites about pathetic PMS performance.

I can surmise now that the way PMS has operated, with brokerage houses at least, is that they take all this money and put it into a single account. They put their own "prop" money in the same pool. Then they go and trade. Now they must allocate trades to individual accounts, because that's how PMS is supposed to work. So they take all the profitable trades and put it in their account. If any good trades are left, they assign it to the highest valued PMS accounts. The remaining simply take the losses. Abuse, you say? But what can you do to stop it?

With SEBI's new rule, some of this MIGHT be plugged, you think. Since no "pooling" is allowed, each trade has to reflect the owned account, and therefore this abuse is lesser. That may be true - and this will reflect in brokerage results. The recent results have been good, but that could have been because of this kind of abuse - with no allowance to do PMS gotchas, there is likely to be a slide next Q and onwards. But the guys in there are smart enough to figure out other ways to con clients - like assigning day trades to PMS clients (client accounts can be tacked on later), not disclosing client account trades for three months, and such.

So what can you do?

• If your PMS account shows day trades, and the profits generated are not beating the index, then get out of the account. Potentially some kind of shady stuff is going on.
• If your brokerage tells you they won't show you your account transactions for even five days, and the average holding period of a stock is less than five days then exit. You should be able to see transactions literally on an end-of-day basis, or at least while they are open (i.e. bought but not yet sold etc.)
• Don't believe your brokerage if they tell you they don't do prop trading. Prop trading can be a special client account.
• Track your PMS account regularly. They have been sources of fraud for ages, and you don't want to leave it unguarded.

What you want is good disclosure and top quality returns. SEBI's rules are well intentioned but they must audit the PMS accounts and ensure this is being followed - and make a 10 crore fine per incident of fraud. And do this to particularly to the big brokerage houses.

Does SEBI have it in them?