Having tasted success with its maiden equity investments over the last two years, the Employees Provident Fund Organisation (EPFO) is readying to increase its bets this year. The Minister for Labour recently revealed that the Central Board of Trustees had recommended increasing the EPFO’s equity allocation from 10 per cent of its annual deposits to 15 per cent this fiscal. This is likely to funnel nearly ₹22,500 crore of EPFO money into stocks. While these equity allocations are still not large enough to materially impact the fund’s returns (the sum is less than 3 per cent of its accumulated corpus), it is imperative for the EPFO to fine-tune its equity strategy to deliver better returns to its subscribers.

To start with, there’s the timing of its allocation calls. The fund has cited the good returns on its equity portfolio as the reason for raising its exposure from 5 to 15 per cent in the last two years. But seasoned investors know that the best time to raise one’s equity allocation is when past returns are depressed. In fact, sophisticated asset allocation models use valuations, and not past returns, as the guidepost to decide on equity weights. Two, while the fund has been tom-tomming its equity gains of over 13 per cent, that’s not a very impressive return for a nearly two-year holding period, in a market where the bulls have been in charge. Returns could be muted owing to a phased deployment of money; if so, the internal rate of return may offer a better measure of performance. Three, the fund’s strategy of ‘diversifying’ its equity exposure across two Sensex ETFs (Exchange Traded Funds), two Nifty ETFs and the CPSE ETF, is hard to explain, given the substantial overlaps between these baskets. Owning a combination of Nifty50 and NiftyNext50 indices or even the BSE 500 makes a lot more sense, from a portfolio perspective. The fund should also refrain from showcasing short-term equity returns to convince naysayers. Returns in the stock market always come in fits and starts, and extrapolating a recent good spell can lead to future disappointments.

Apart from these strategy changes, the EPFO needs to work out a mechanism to distribute equity capital gains to its subscribers over the long run too. Thus far, fixed income investments have enabled the EPFO to pay out a predictable ‘interest’ each year. But equities add a new ingredient to this mix. Equities as an asset class deliver good returns only if allowed to compound for five years or more, and their returns can swing widely from year to year. The EPFO can probably examine periodic bonus payouts or, better still, an equalisation fund to smooth out the payouts to subscribers.

Related Topics