CIRCUIT BREAKER. An open letter to the EPFO

Dear EPFO, Congratulations. I am thrilled to know that the Employees Provident Fund Organisation is finally taking its long-awaited plunge into equity investing this week. I know that in so warmly welcoming equity investments, I must be in a minority among your 5 crore subscribers.

I am glad that you haven’t given in to the scare-mongering that equities would sink the EPFO and leave lakhs of employees without a pension. I have been personally investing in the Sensex for the last ten years. I’ve managed a 13 per cent return. That has been much better than the 8.25 to 9.5 per cent interest that you have been declaring every year. At that rate, I had lost all hope of beating inflation.

In fact, I am a tad disappointed that you intend to invest only ₹5,000 crore of the ₹6.5 lakh crore that you manage, in stocks this year. That’s only 0.7 per cent of your portfolio. Even if that money doubles, it’s not going to make a big difference to the returns. But hey, it’s a big move and I guess you want to start off with baby steps.

The reason I am writing to you is that I’d really like your stock market experiment to succeed. While I’m not new to equity investing, you seem to be. So I thought I should give you some tips on how you can make that ₹5,000 crore go a long way.

For the whole of last week, I’ve been reading in the pink papers that the EPFO plans to flag off its investments on August 6. I’ve also read that you are looking to invest in the Sensex, Nifty and PSU stocks.

Hey dude, why did you do that? When an organisation of your size invests in the market, it moves market prices. If I were you, I certainly wouldn’t tip off every member of the public about when I plan to enter the market.

Many of my trader friends have made a killing just by taking positions in PSU stocks last week. This sort of front-running effectively increases the cost of your investment. So in future kindly don’t announce your market moves in advance. In fact, announce your purchases after the fact and your investors will probably make a killing from it.

Don’t believe these experts on television who tell you that timing doesn’t matter. In the stock market, it matters a lot. But because market highs and lows are only evident in hindsight, timing is hard to get right.

I can see that you’re worried about this, from your statement that you will deploy more money when the market corrects. But have you set any quantitative parameters? If you invest after the Sensex corrects 10 per cent, it can still correct some more. In 2008, it ‘corrected’ more than 50 per cent.

To get the timing of your entry right, use market valuations as your indicator. In the past, Indian markets have topped out when the Sensex price earnings has crossed 24-26 times and bottomed out when it fell to 10-12 times. But if that sounds too complicated, just divide your annual allocation into equal parts and invest equal sums in the market every week, which is what retail investors do with mutual funds.

But don’t tip off the market about the date of your SIP!

I see that you have decided to route all your equity investments into two index ETFs (exchange traded funds). I understand your preference for ETFs because they’re low-cost.

But I see that you are planning to invest 75 per cent in the Nifty ETF and 25 per cent in the Sensex ETF. If you are doing this for diversification, you’ve got it all wrong. Have you looked at the extent of overlap between the Sensex and the Nifty stocks? Both indices are likely to give you almost identical returns for identical risks.

Instead, why not invest some money in a broader market index like the CNX 500 or the S&P BSE 500? Or better still, insist on a an ETF which selects stocks based on fundamentals. Take a look at the NSE’s strategic indices like the NV20 or Quality30.

You’ve announced that the equity portfolio will be managed exclusively by SBI. You seem to have chosen them for their ultra-low fund management fee — 5 basis points.

Now, I have nothing against the SBI, but if you wanted the best manager for your money, would you plumb for one with the lowest fee? Most top performing equity funds in India, including those from SBI Mutual Fund, charge their investors 250 to 300 basis points as fees.

True, passive ETFs can manage with lower costs. But even ETFs usually charge 50-100 basis points. Even in an ETF, factors such as efficient execution and tracking error (the extent to which the fund lags the index) matter a lot in generating returns.

To get the most out of your equity investments, it is best that you enlist multiple managers, and monitor their performance strictly against benchmarks.

Also, if you’re handing over all our money to these managers, we need to know where they’re investing and whether they’re doing a good job of it. The EPFO’s current portfolio is a black box.

But if you want us not to lose sleep over your equity investments, you should insist on regular portfolio and return disclosures from the fund managers.

One statement I found quite alarming was that you would take stock of your equity investments in one year and invest more if they delivered an 8.75-per cent return. That’s problematic, dude. For one, unlike bonds, equities seldom fetch you returns like clockwork. So, don’t be surprised if, after one year, your equity portfolio has delivered only single-digit or even negative returns. So give those equity investments five years or more to deliver. But do track returns against the benchmark to evaluate if the fund manager is slipping up.

Two, I wouldn’t be happy with an 8.75-per cent return. Be sure to add a risk premium for equities and demand a return of 13-15 per cent from those equity managers.

This is difficult to say. But now that you have such a large kitty for the markets every year, you are bound to face all kinds of pulls and pressures on what to do with it. If the Centre’s short of its divestment target, it may gently nudge you to invest in PSU stocks. Or if public sector banks fall foul of Basel III, you may be asked to chip in with capital. You may even be called upon to help with nation-building, by investing in the Railways.

But if you want your equity experiment to succeed, you must learn to ignore all such demands and to leave the investing to professional managers. Remember, the money you’re deploying represents compulsory deductions from the monthly pay of lakhs of employees. They haven’t voluntarily opted to invest in equities. You made the choice on their behalf. So, make sure that you manage the money in the subscriber’s best interests. You’re not running a welfare fund.