The recent move by the Ministry of Labour to allow the Employees Provident Fund Organisation to invest in equities is a bold reform. The Ministry nevertheless seems to have hedged its boldness by limiting such investments to Exchange Traded Funds (ETFs) and index funds in the first phase. Critics feel that the preference for index funds, non-starters in the Indian mutual fund industry, is mainly designed to ensure the success of the ambitious budget target for divestment. For the mutual fund industry, currently mired in a tussle with distributors, not reacting to this would do greater harm than neglecting two earlier decisions did- IRDA’s diktat to insurance companies to set up their own investment department in 2003 and the 2009 SEBI order on banning entry load.

Currently, the Indian mutual fund industry is entirely driven by local retail flows which ebb and surge based on market movements. US was similar to India in the seventies. In 1972, the US markets had been in a bull run for over a decade and the fund industry was growing furiously. The oil crisis and the slowdown led to the industry giving back most of these gains. According to Charles Ellis in his book “The Capital way”, between 1973 and 1979 the number of independent financial advisors halved and the AUM of the industry crashed. Between 1973 and 1979 the number of independent financial advisors halved and the AUM of the industry fell sharply. At this juncture, the management of General Mills called up Capital International to manage their pension corpus. Soon other corporates started using money managers to manage their pension liabilities. This gave an entirely new lease of life to the fund industry and pension funds became a key pillar of the success for the mutual fund industry in the US.

The investment of pension money in funds can be similarly game-changing for Indian funds. Unlike retail money, which ebbs and flows with markets, pension money is like a perennial river constantly flowing in as long as medium and long term track record of a fund remains superior.

The need for equities to become part of the pension fund’s corpus may be accepted. But the mode which pension fund includes equities in their investment menu needs to be discussed. For one, restricting such exposure to ETFs and index funds, may not be the most appropriate route given the superior track record of active funds. Over a 10 year period, at least 75% of the mutual fund schemes in the large cap and Large/Mid Cap categories have outperformed the BSE 100. Moreover, the average outperformance has been between 2.5 to 3.6 per cent on an annual basis over the benchmark. Clearly, investing in mutual funds would have boosted returns over index investing.

Two, even today pension funds of a few corporates invest in Index funds. However, their investment style is more based on tactical timing of the market rather than long term investing. In an upward trending market, such a strategy of tactical timing will work, but whether it provides the best return for the investor (and the millions of subscribers to pension funds) over the long term can be debated. Finally, the aim should not be to just reach x per cent of the corpus. A clear framework for measuring performance, type of funds etc should be formulated.

There are several celebrated examples of endowment funds such as Yale and pension funds like Calpers being successful equity investors. These could be case studies to emulate for Indian EPFO. In India, Army Insurance Group, has over the years, developed a nuanced and long term strategy of investing in equities through equity mutual funds. This institution would have earned higher returns through such a strategy rather than through investing entirely through Nifty index funds. For the Ministry of Labour, a study of such institutional investors could be useful first step before stepping into the equity market.

Hence, while the EPFO invests in equities, the following principles should be adopted:

Tactical timing of the market should be avoided. Index funds should not be used for punting. The statistical probability of making numerous trades in a year and getting them right is low.

Success in investing in equities increases as the duration of stay increases. The probability of generating a positive return over a 1 year period as compared to a 7 year period varies significantly.

Active funds outperform market indices over the long term and not allowing subscribers of EPFO to benefit from this significant outperformance does not make sense.

Using SIPs for long term investing in equities has recorded significantly higher returns than trying to time the market with episodic investment.

Mutual funds should offer a lower cost plan for institutional investors, at lower costs than direct plans. * Rather than artificially creating new segments like pension plans, lower cost plans of existing mutual fund schemes should be allowed to attract investment from pension funds. This will provide the industry an opportunity to use scale and lower costs, while offering pension funds the opportunity to invest with fund managers having a good track record.

To sum up, allowing equities in pension funds is perhaps the boldest reform to be announced by the Modi Government. For the mutual fund industry this is a critical opportunity to nurture and encourage an alternate long term source for funds, reducing its current dependence on erratic (and expensive) retail flows.

The writer is Head of Equities, UTI Mutual Fund

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