R Ravimohan: Alternative investments

Provident funds' entry into the stock market, with safeguards, is encouraging

This government is making some nifty moves. Virtually, the unthinkable has happened, with the government now allowing provident funds to invest in equity and mutual funds.

This indeed is a significant development, perhaps one of the most progressive signs that our markets indeed are maturing quite nicely.

The large additional funds from the provident funds will be a welcome supplemental source to the market and diversify substantially the participants' profile.

With their size and long tenure, provident funds will have the ability to lend a stable domestic source for the Indian equity markets, which can nicely balance the dominance of the fleet-footed investors who seem to dominate the markets today.

Hopefully, the fund managers will invest wisely and earn better returns than the dwindling interest income that the members of the provident funds are currently getting.

While the move to include provident funds' participation is welcome and will be positive for the system, it might be prudent to make this transition as robust and as safe as possible.

Undoubtedly, the officials concerned, including the EPFO Board, would be seized of these issues and would be addressing them. There are four possible issues that require attention.

First, there is the issue of the process the provident funds follow for investment in equity or equity-related instruments. Mutual funds, for instance, have adopted a number of process-related parameters that deal with the risk and methodology of conducting equity investments.

Who is authorised to take decisions? What will be the method of selecting stocks? What due diligence process will be adopted before investing in equities?

How will the stock selection process be approved? Will it be subject to some rules, such as stop-loss limits, risk containment measures, exit rules, term of investments, rules regarding churn, and so on and so forth?

How will the funds ensure that ethical and good governance practices are strictly adhered to, so that pension funds are safeguarded against any operational risks arising from process malfeasance or human failings?

It is essential that provident funds too adopt good practices from the very beginning, as they have several models to go by and select those methods that are asfail-safe and tamper-proof as possible.

The second concern that the provident funds will have is to ensure that proper accountability is fashioned from day one. This is especially a tricky issue.

Equity investors the world over have faced this issue and have not come up with any good fail-safe answer to this question. Equity by definition is investment in risk capital.

This means a risk element is inherent in the very nature of this activity. Habitual investors in equity try and incorporate this factor in defining appropriate levels of accountability of fund managers.

They would have some pre-set method of looking at successes and failures and have an agreed method to judge the good and bad behaviour of fund managers.

The trick is not to unduly punish fund managers in respect of honest decisions that go wrong for reasons completely unpredictable by the fund manager, and at the same time, ensure that enough safeguard exists to catch any intended misdemeanour and malfeasance.

There are some strong systems that depend more on the punishment being so drastic that it seriously deters wilful wrongdoing.

The objective of these should be to ensure that the accountability is not so tough as to deter the entry of serious provident funds into the equity market, yet ensure that good practices prevail right from the beginning.

Arising out of this concern is the third element, which is to understand what prudential norms could be adopted by the provident funds when making equity investments.

It is important that they adopt good practices such as mark-to-market valuations, making provisions for diminution in the value of non-performing stocks, measuring and avoiding concentration risk, looking closely at value-at-risk concepts, and using fair and transparent means of calculating net asset values and returns to unitholders.

In other words, the provident funds should set up the most rigorous prudence, governance, and disclosures standards from the very beginning, so that no laxity creeps into the working of the equity investment processes.

The last element is the strategy that the provident funds would use to enter the equity investment space. The first task is to construct the universe of options within which the provident funds would operate.

For instance, they could define that they will operate with the whole universe of listed stocks; some may venture to include all listed stocks and IPOs that will come in future.

The conservatives will choose to define a smaller universe of the listed stocks and set high bars on quality of companies, liquidity considerations, valuation considerations, stock-picking philosophy, etc., thereby seeking to decrease the risk elements enumerated above.

But the most prudent I think will decide to go through the index investing route.

Investment in index funds avoids the perils associated with stock picking. None of concerns expressed above, whether they be genuine issues relating to investment processes or human issues, arises when provident funds operate through index funds.

Yet index funds offer a reasonable scope to increase returns to the members of the provident funds, while eliminating a fair portion of the risks associated with the process of investing.

The upside that may accompany stock picking is all that is given up by those provident funds that invest through index funds as compared to those that are actively managing their portfolio.

The US markets have a phenomenal amount (well over $1 trillion) of provident funds and pensions invested in index funds, as their fund managers have found that for a long term, it is difficult to beat indices and that it eliminates all the hazards that are involved in active equity fund management.

Given that the funds that are under management are under contractual savings obligations, usually the fund managers will also be subject to serious pecuniary liabilities for any mishandling.

Given the combination of good returns and elimination of all process-oriented risks, most funds have consistently opted to invest a majority of their funds through index fund options.

This is something that is certainly worth a serious consideration by the provident funds.

The system that supervises provident funds' foray into the equity space has an obligation to ensure that this important initiative is pursued rightly and on sound footing, lest any mishap in this experiment should set back this extremely powerful and progressive initiative for a long long time to come.

ravimohan@crisil.com