Even though the EPFO's equity investments seem to be going well, there are some obvious problems in the future
25-Feb-2021 •Dhirendra Kumar
Here's a quote from a news story from October last year: The parliamentary standing committee on labour has asked the Employees Provident Fund Organisation (EPFO) why the retirement fund body continued to invest in the equity market, even when the market was falling in March-April. "Who took the call in this regard? Who was responsible for the decision? Give the details to us in writing," the committee chairman Bhartruhari Mahtab told the EPFO top brass and the labour ministry officials in a meeting.
The investment strategy that the standing committee seems to have leaned towards is clear: stop buying (maybe even sell) when the market is falling, and start buying when it is rising. I wonder how that would work out if it were actually done. Actually, one need not wonder. That's exactly the strategy that many first-time investors follow. They soon lose all their money and then switch back to bank deposits. If there is one investment strategy that is guaranteed to lose money, this is it.
The EPFO's equity investments will always be open to this type of criticism. As is often said, India is a fixed-income country and investments that can decline in value, even temporarily, are a no-no in any context that is connected with the government or with retirement. Of course, at the level of an instinctive response from a bystander, I have no quarrel with this idea. It would be perfect if the equity graph had the slope of the stock market with the smoothness of short-term debt. However, that's not the way the world is built.
The solution that the EPFO equity investment has to this criticism is passive investing through ETFs based on Nifty 50, Sensex, Central Public Sector Enterprises (CPSEs) and the Bharat 22 Indices. Sticking just to ETFs is common to pension plans the world over. If you're just investing in ETFs, then you can get criticised for drops in the market but not for the actual investment calls that active fund managers take.
Or can you? I'd say that the nature of the indices that are on the menu for EPFO to invest in amounts to an investment call, and it's not a great one. It's a choice that appears to be safe from criticism but has some potential problems that will surface in the years down the line. Firstly, none of these indices are designed as investment vehicles. They might be fine for individuals and organisations that are basically equity investors but for a decades-long retirement vehicle in India, they may not be. The Sensex and the Nifty, because of the free-float market cap weighting and the nature of the Indian markets, are extremely top-heavy.
For the time being, this is creating an ever-more powerful self-reinforcing effect in a small number of stocks. The inflows from the EPFO are growing continuously and are quite predictable. More importantly, they are an important fraction of the flows into a fairly small number of stocks. In effect, they form a floor under the prices of these stocks. Going forward, this itself becomes a distortion in the composition of the Nifty 50 and the Sensex.
Over a longer timescale, another problem will come up, which is of the reversal of these flows. At some point, some years from now, a larger and larger number of members from the equity investment era will start hitting retirement age. Since the total equity exposure in the EPFO's assets cannot go above a certain limit, these assets will also have to be sold. At that point, we could enter a phase when instead of putting a floor under some stocks, the EPFO's trades could put a ceiling above their stock performance. At the very least, on a net basis, it will amount to a removal of the floor under them.
The entire financial sector in India as well as the EPFO's operations are heavily regulated. It has taken more than a decade of back and forth for equity investments to be started in the retirement fund. And yet, there doesn't seem to be very clear thinking about the nature of these indices and whether their formulation makes them suitable for the purpose.