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Aarati Krishnan

AFTER sputtering and stalling for over two years, the new pension system may finally be up and running in a few months. This week, the Cabinet gave the go-ahead to a move to draft a new set of rules which the new pension fund, and fund managers, will be expected to play by.

The government is hoping that the new system will encourage salary-earners to build their own retirement fund from market-linked instruments.

At present, they lean quite heavily on the comfort of government-run or government-backed schemes, which promise a fixed return.

Where to invest is the crucial question

A host of niggling administrative matters will no doubt have to be resolved before the pension system is flagged off. But the most important question for salary-earners like you and me will be where your monies will actually be invested. On this score, only sketchy details are available so far.

Yes, you do know that the pension funds offer three basic types of schemes — a "safe" option packed only with debt, a "balanced" option with both equity and debt, and a "growth" option, which will feature a higher exposure to equity than debt.

But where exactly will the "debt" portion be invested? And which stocks or funds, will the "equity" portion be parked in?

These will obviously determine whether investors will place faith in the new system, or continue to cling to government-backed schemes.

The case against indexing

Initial murmurs from the government that the new pension funds may be allowed to dabble in equities only through index funds, may severely handicap the "balanced" and "growth" options even before they start out.

Often hailed for its low risks and costs, index investing may have delivered the goods to investors in far-off America or Europe, but it has been an unmitigated failure in the Indian context.

Loss of opportunity

A simple comparison of the returns from an actively managed equity fund to that from the stock market index over the past ten years, tells the story. If you invested Rs 100 in the Franklin India Bluechip Fund — an equity fund with a good track record — in October 1994 and held on for the next ten years, your investment would have grown five-fold to Rs 570 at the end of the 10-year period. A similar investment in the S&P CNX Nifty would leave you with a mere Rs 133.

A comparison of the performance of actively managed equity funds with that of index funds over various time-frames, invariably leads to just one conclusion — active investing scores over index investing, hands down.

Seven of the ten active equity funds have beaten the Nifty and the Sensex over the past five years.

And the good ones have trounced the index by enormous margins, generating large gains when the indices fell, or multiplying value while the indices stayed put.

Big scope for value-add

There are several reasons for this. One is the imperfect construction of the market indices such as the Nifty or the Sensex, which feature concentrated exposures to too few sectors or stocks. Fund managers have always found it quite easy to outperform the indices, by the simple expedient of staying away from stocks (or sectors) which take up really big weights in the index, but do not see much action because the stock (or sector) is out of the limelight.

Second, many of the big moneymaking opportunities in the stock markets, especially over the past couple of years, have come from the universe of medium or small-sized companies, which often do not find place in the index.

Third, the low cost associated with the strategy is one of the strong arguments advanced for index investing. But even this may not hold good in the Indian context.

Most passive funds tracking the index here have found it difficult to minimise their tracking error in the face of frequent rejigs in the composition of the indices and other distortions in price discovery.

The fee that you shell out to the fund manager may seem important when active funds scrape past the indices by just one or two percentage points.

But it is difficult to advocate such penny-pinching in the Indian context, where active funds beat the indices by tens of percentage points, more than justifying an additional 1-2 per cent in fees.

All this is not to say that the retirement monies of salary-earners should be blindly channelled into actively managed funds, without devoting any attention to the considerable risks associated with an active strategy.

But quite a few fund houses have done a reasonable job of containing the downside risks associated with equity investing through controls on portfolio concentration. The government can take a leaf out of their books and work on guidelines that could help contain the risks from equity investing, without actually asking fund managers to stick to the basket of index stocks.

This may persuade Indian investors to get over their traditional distaste for equities when it comes to funding their retirement.

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