CIRCUIT BREAKER. EPFO’s equity strategy needs a reboot

Exactly two years ago, the Employees’ Provident Fund Organisation (EPFO), the default retirement vehicle for many Indians, overcame bitter opposition from its trade unions and critics, to take baby steps into the stock market. This was without doubt a great move. An equity allocation can help this ultra-conservative vehicle deliver a healthier retirement corpus to its subscribers. And the EPFO can also prove to be a sustainable source of sticky money for the domestic stock market.

In the short time since taking the plunge, the EPFO has also enjoyed double-digit returns on its equity bets. But taking stock of its current equity strategy, this appears to be more due to good fortune than deliberate design. In order to deliver healthy long-term returns to its subscribers and convince naysayers of the wisdom of equity investing, the fund needs to urgently rethink the following aspects of its investment strategy.

For equity investments to make a significant difference to portfolio returns, they need to be material and well-timed. Despite the large absolute sums the EPFO has been plonking on equities, its overall allocation to the asset remains minuscule. Even with regard to the investment of ₹22,500 crore planned this year, only 2.6 per cent of the EPFO’s aggregate corpus of ₹8.53 lakh crore (as of March 31 2017) would be invested in stocks. This is because the fund pegs its annual allocation to equities (now 15 per cent) to the new money it receives every year rather than its full corpus. With its legacy portfolio parked in government bonds, to move the needle on returns the EPFO needs to allocate at least 10 per cent of its corpus to equities. That will mean a ₹85,000-crore investment, nearly four times the current allocation.

Unlike bond investments, stock market investments need smart timing. Stock market gurus advice buying stocks when they’re down and out, and selling them when they’re soaring high. But the EPFO has in fact taken the opposite road in the last two years, steadily increasing its equity allocations in a rising market.

In 2015-16, when the BSE Sensex hovered between 22,000 and 29,000 levels, it ploughed ₹6,577 crore into equities. In 2016-17, the Sensex range moved up to 24,000-29,000 and the EPFO doubled its equity bets to ₹14,982 crore. Today, when the Sensex is poised at a life high of 32,000, it is set to invest ₹22,500 crore. This can undermine long-term performance, as higher the entry point, lower the returns.

Instead it would be good if the EPFO used a valuation-based approach to decide on its equity allocation. Professional allocation models used by the fund industry today recommend adding stocks when the market PE multiple is at or below 16 times, and cutting back sharply when it is upwards of 22 times.

As a newbie investor, the EPFO is right in taking the mutual fund route to deploy its sizeable corpus, rather than dabble directly in stocks. It is also wise to avoid the confusing menu of actively managed funds and plumb for index ETFs (Exchange Traded Funds). ETFs entail ultra-low costs and also save it the trouble of deciding which active manager to bet on each year.

But having decided to take the ETF route, where the EPFO has faltered is in its choice of funds. Disclosures made this July reveal that, after dividing its money between SBI Nifty50 ETF and SBI Sensex ETF in 2015-16, the EPFO has invested in three more ETFs in 2016-17: the UTI Nifty50 ETF, UTI Sensex ETF and the CPSE ETF. The choice of these five funds is quite hard to explain. Given that all index ETFs exactly mirror their benchmark, owning two Nifty50 ETFs or two Sensex30 ETFs in a single portfolio begets needless duplication. As both the Nifty50 and Sensex30 baskets feature the most liquid stocks in the listed universe, even these two baskets have sizeable overlaps.

The addition of the fairly risky CPSE ETF to this medley is quite inexplicable too. With over 70 per cent of its portfolio made up of just four energy PSUs, the CPSE ETF primarily serves as a disinvestment vehicle for the Centre. Its quiet inclusion in the EPFO in fact raises the question of whether the EPFO, like the LIC, has begun extending a helping hand to the public sector disinvestment programme.

The net result of these strange fund choices is that the EPFO has ended up owning fairly concentrated exposures to the top index stocks through duplication. A far better idea, for true diversification, would be to invest in a single ETF tracking a broad market index like the BSE200, or owning a combination of a Nifty50 ETF and a NiftyNext ETF.

A final aspect of the EPFO’s equity foray that needs clarity is how it plans to measure and account for its stock market gains. For subscribers to gain confidence in the fund’s equity foray, it is important that they be kept regularly informed of the performance of these investments.

Presently, this happens on an ad hoc basic, with the labour ministry disclosing the EPFO’s equity returns in response to periodic queries from Parliament. A disclosure made early this year revealed that the EPFO’s cumulative return on its equity investments amounted to 13.7 per cent on that date. However, this return seems to be based on a simple comparison of the current market value of the equity investments with cost. For investors to get a true picture of the investment performance of the equity portfolio, they need access to the annualised return which factors in the holding period. Given the fluid nature of market gains, it is essential that the EPFO provides its subscribers with, say, quarterly disclosures of the mark-to-market value and compounded annual returns of its equity bets.

The accounting of EPFO’s equity gains also remains a grey area. So far, the EPFO has simply declared an annual ‘interest’ to its investors based on surplus earned by deducting its expenses from income (mainly interest).

In the absence of mark-to-market accounting, the EPFO’s annual accounts reflect only the income component of its humongous portfolio, while ignoring the capital gains/losses component. While this system of accounting may work for a passive investment strategy where bonds are simply bought and held till maturity, it is highly unsuitable for a strategy that includes market-linked instruments. In market investments, the capital gains or losses on stock (or bond) prices can easily offset the interest and dividend income.

To address this issue, the EPFO has already mooted ideas such as an income equalisation fund for equities, or a direct credit of ETF units to subscriber accounts. But the best solution, really, is for the EPFO to transition to unit-based NAV accounting for its entire portfolio like its peer, the National Pension System. It is only with these changes, that the fund’s subscribers can reap the full rewards of its bold equity foray.

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