EPFO equity push: Stock returns more than 2x those of bonds, shows data

Retirement fund also invests in CPSE index, which has been a laggard among ETFs

The Employees’ Provident Fund Organisation (EPFO), the government’s premier retirement fund, is said to be considering an increase in its equity allocation to 25 per cent. It first began to invest five per cent of incremental inflows in equities starting 2015; that has since risen to 15 per cent. 

This comes amid government bond yields staying well below the returns that EPFO pays its members. Equity returns have been more than twice as much as those on bonds over the last few years. The average equity returns for key market indices over the last five years were 18 per cent. The average March-end 10-year government bond yield was less than 7 per cent over the same period.

The latest available data shows limited equity exposure. The EPFO had invested around Rs 1.23 trillion in exchange-traded funds (ETF) as of FY21. Its debt investments were worth Rs 14.46 trillion.

The bulk of the EPFO’s investments are in government securities. This makes the 10-year yield a close proxy of the approximate returns it has got over the years. The EPFO announced that it would provide returns of 8.1 per cent for the financial year 2021-22 (FY22), reportedly the lowest in around 40 years. The 10-year government yield is currently around 7.5 per cent.

Debt market yields have been low, especially since the pandemic’s outbreak. Central banks have reduced borrowing costs by cutting interest rates to support the economy. This has reduced the returns available to investors such as the EPFO. Equity returns have been significantly higher as markets rallied after governments across the world provided stimulus to limit the adverse effects of the pandemic.
 

Equity investments deliverhigher returns relative to debt investments even without the situation that Covid-19 created. Academic studies have suggested that equity returns tend to be higher because of the additional risk involved in investing in the share market.

Investors can usually expect a return premium of 4-6 per cent on equity investments compared with bonds, according to a 2003 study entitled, ‘Long-run stock returns: participating in the real economy’ by Roger G Ibbotson of Yale University and Peng Chen of Dimensional Fund Advisors.

“For long-term investors, such as pension funds and individuals saving for retirement, stocks should continue to be a favoured asset class in a diversified portfolio,” it said.

Not all equity investments are equal, however. The EPFO invests in ETFs that seek to match the returns of key equity indices. This includes the S&P BSE Sensex and the Nifty50 index. Both have delivered high returns. It has also invested in a basket of public sector companies. The Nifty CPSE index has generated even lower returns than the bond market over the last five years.

In fact, the CPSE index returns have been lower than either the Nifty 50 or the S&P BSE Sensex in 14 out of the last 18 years, according to available data (see chart 2).

The EPFO also takes limited exposure to non-government paper. An analysis of data from Bloomberg shows that the highest rated (‘AAA’) corporate debt has consistently generated higher returns than government bonds. There is an average difference of 93 basis points over the last five years, based on March-end yields. A hundred basis points is one percentage point.

Equity returns are more than 11 per cent higher on average.The EPFO may eventually have to step outside the two main indices, according to a 2021 World Bank report, titled Asian Provident Funds: Meeting Tomorrow’s Challenges by Richard Jackson and Evan Inglis. “…limiting equity investment to ETFs that track the two major domestic market indices may not be optimal in the long run. Over time, the EPFO will need to take a more sophisticated approach to investing in domestic equities. It will also need to consider global diversification of the EPF investment portfolio,” it said.