Should the NPS invest actively in stocks?

The Bajpai Committee has suggested that fund managers be allowed to invest in a bigger universe of stocks as well as other assets.

Jun 29, 2015, 08.00 AM IST

Should the NPS invest actively in stocks?

One big advantage of the NPS is the equity exposure it offers. But this exposure has limits—up to 15% for government employees and a maximum 50% for others. Also, these are passive investments in the 50 stocks in the Nifty. The Bajpai Committee has suggested that fund managers be allowed to invest in a bigger universe of stocks as well as other assets. It also wants fund managers to actively manage the investments for better returns. Will this be beneficial for investors? Here is what experts say:

Sumit Shukla

CEO, HDFC Pension Management Company

YES

The Bajpai Committee has advised a phased move from replicating an index to a prudent investment regime where the fund managers are free to manage portfolios using their own investment philosophies and expertise. The debate between active and passive fund management is old. We need to consider the customer’s perspective and assess which style would generate higher returns over the long term.

Globally, passive funds have yielded higher returns than active funds. But India is a growing economy and in the coming years, active fund managers will get enough opportunities to invest in growth stories and beat the benchmark. This is reflected in the five-year compounded returns of almost all major equity mutual funds. The top bluechip funds have outperformed the benchmark indices by over 200 bps on an average.

The outperformance was substantially higher in case of mid-cap and small-cap funds. This clearly shows that in emerging markets like India and China, active fund management can generate significant alpha over the benchmark.
The close regulatory monitoring mechanism in place will make sure that there are no indiscretions by fund managers.
The committee has outlined a transition roadmap which will happen in phases over the next six years. In each phase, the pension fund managers will be given more freedom and new alternative investments options will be added. This will build fund manager expertise for a flawless transition.

One key issue addressed in the report is about the fund management charges. At present, pension fund managers are charging 0.01% per annum, which is unviable considering the basic cost of running the business.

A reasonable fee for pension fund managers would mean higher cash flows, which will be deployed in bringing quality fund and risk management processes, which in turn would mean better returns.

The committee also looked at providing greater flexibility to NPS funds for government employees. It has suggested raising the 15% ceiling on equity exposure to 50%. It recommended the inclusion of private sector pension fund managers to manage the funds. This will give more choice to investors.

If the recommendations of the Bajpai Committee are addressed expeditiously, NPS can become a “best in class” retirement solution.

Manoj Nagpal

CEO, Outlook Asia Capital

NO

The Bajpai Committee has suggested fundamental changes in the NPS structure without putting forward cogent arguments on how these steps will benefit customers. It has relied on the general principle that a more liberal investment regime will be able to generate higher returns.

It recommends doing away with passive indexing and shifting to active fund management for the private sector NPS. The argument is that active fund management can generate alpha (excess returns) and also control the downside in case of an economic downturn. The NPS funds for government employees have always followed active fund management of the equity portfolio. Logically, their equity component should have outperformed the Nifty. But this equity component in the government NPS has underperformed the index in three of past five years. Even in the two years where it outperformed, the alpha was limited.

The active versus passive debate is a function of how institutionalised the markets are and the intensity of research coverage. Initially, active funds outperform passive funds. But as both these factors mature, it becomes more difficult to outperform the indices.

This is already evident: large cap funds are finding it difficult to consistently beat the index returns. Given that pension assets have a tenure of 25-30 years, NPS should not give up on passive indexing. At best, an additional option of active fund management can be provided to investors.

There are other problems too. The committee has suggested four levels of cost structures, which hits the lowcost model of the NPS. Low costs are imperative in multi-decadal wealth accumulation. Such flip-flop on investment guidelines without data justification is bound to create mistrust.

Arvind Usretay

Independent pension consultant

CAN’T SAY

Across pension funds, 80% of the individual’s retirement income is generated from investment. This means that the asset allocation of pension plans is probably one of the most important decisions to be made with the objective of providing adequate retirement incomes.

The Bajpai Committee’s recommendations seem to suggest that a highly debt-oriented approach may not be the best. However, is high equity exposure the answer? By expanding the exposure to NSE/BSE 100 stocks from the Nifty or Sensex, will we be able to boost income? Maybe yes or no.

The reccommends including asset classes such as PE, REITs, mortgage-backed securities, CBLOs, alternative investment funds, IDRs, commodities and more. It is obvious that when the investment options are plenty and diverse, a passive approach to investment may not work and hence the recommendation for active management. But let us not forget that active management requires the right expertise which comes at a cost, leading to higher fund management fees. Simply put, there seems no single correct answer that would apply in all circumstances.

While making any asset allocation, some of the factors that may be considered include demography and age of the population, income levels across segments of population, state of the economy, structure and maturity of capital markets, benefits provided by social security and legislative and taxation framework.

It is highly recommended that asset diversification across several investment categories (beyond equities and bonds) should also represent a fundamental feature of all pension plans. These plans should be long-term investors across a range of asset classes with strong risk management practices and disclosure norms in place. These are likely to provide improved investment outcomes as well as provide capital for ongoing economic development.

Whatever the current situation, the goal should be to broaden the asset allocation over coming years. The most important and critical outcome of whatever recommendations we make and decisions we take must definitely be a more favorable outcome for the individual investor in accumulating a corpus which generates a reasonable stream of income.

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