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EPFO Hikes Equity Allocation Ceiling

The investment limit in exchange-traded funds (ETF) has been recommended to be raised from 10 per cent to 15 per cent by the Central Board of Trustees

Photo Credit : PTI

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Buoyed by the 13.3 per cent return it earned on its equity investments last year, the Employees' Provident Fund Organisation (EPFO) has decided to hike its equity investment limit from 10 per cent to 15 per cent this year.

“The investment limit in exchange-traded funds (ETF) has been recommended to be raised from 10 per cent to 15 per cent by the Central Board of Trustees, Employees Provident Fund, in its 218th meeting held in May. Accordingly, the estimated investment in investment in ETF for current financial year is approximately Rs 22,500 crore,” said labour minister Bandaru Dattatreya in a written statement, earlier this week.

With an investment portfolio estimated to be in the range of Rs 10 lakh crore (10 trillion), the EPFO is one of the single largest fund managers today. Its AUM is roughly 4 times larger than that of India’s largest mutual fund. The recent move is expected to draw close to Rs 22,500 crore of fresh inflows into ETF’s. UTI Mutual Fund’s recently launched NFO in this space (NIFTY Next 50 ETF) appears to have been fortuitously timed! UTI Mutual Fund is expected to go IPO soon, and this move could mean a shot in the arm for the leading AMC.

The EPFO is likely to announce its rates for this fiscal following its trustee meeting slated for later this month. It is widely anticipated that the rates for FY18 will be further lowered this year, from 8.65 per cent, by another 20-25 bps.

With the yield on the 10-year G-Sec falling to as low as 6.4 per cent in recent times, and another fall of 25-40 bps on the cards in light of the persistently low inflation numbers, the EPFO has been perforce constrained to look for alternative sources of yield and returns.

Earlier this month, the EPFO’s apex decision making body decided that 2 per cent of the investible surplus, or approximately Rs 3,000 crore, could be allocated to AA+ rated bonds. These bonds are one notch lower in their credit rating that AAA’s, and therefore have a slightly higher default risk associated with them.

The house has always been divided on the question of the EPFO taking on incremental risks in its portfolio. Some have widely criticized the move to include ETF’s, while others have lauded it as forward thinking. Ironically, it is the same individuals who criticize the EPFO’s more to allocate a portfolio of its investments to higher risk/ higher return assets who are also most vocal about reduced returns. This is nothing but a poor understanding of how risks and returns flow in tandem with each other. With FD rates hovering around the 6.5 per cent mark, EPF investors shouldn’t complain even if returns were to fall to the range of 8.4-8.5 per cent per annum!

The question is, is this the right time to take on incremental risk? With the P/E ratio of the bellwether index NIFTY hovering around 25 times current earnings, stocks – especially the front running growth stocks that comprise indices – aren’t exactly cheap. The EPFO’s mandate to stick to ETF’s will, by and large, restrict it from taking the coveted value bets that mutual fund managers would be able to take in the pursuit of alpha.

The NIFTY has risen close to 15 per cent in the past year, but what if slow earnings, coupled with the short term disruptive effects of GST, were to spark off a short term negative trend that lasts for 12-15 months? That could mean a hit of anything from 1.5-2 per cent on the EPFO’s investment portfolio for the fiscal. It’ll be interesting to see how such a situation will be managed, as we’ve not really witnessed a heavily bearish phase since the EPFO decided to enter the equity markets for the first time in August 2015.

With the EPFO’s decision to go more aggressive, investors need to prepare for a slightly higher degree of volatility in their annual returns. This is not a bad thing at all, when you consider that EPF is intended to be a retirement planning product with a very long-term investment horizon. Volatility of rates notwithstanding, the move to look beyond G-Sec yields will surely benefit investors in the long run.