Why the Rs 7,00,000 crore EPFO needs to look beyond just public sector stocks

EPFOLogoVivek Kaul

A news report in The Times of India today (i.e. October 17,2014) points out that the Employee Provident Funds Organization (EPFO) wants to invest a portion of its corpus in stocks. As the report points out “At an informal meeting with labour minister Narendra Singh Tomar on Monday, representatives from Congress-backed INTUC and Bharatiya Mazdoor Sangh, which is affiliated to the ruling BJP, offered their support to a diversification of the EPFO’s investment mix into public sector stocks. At the same time both recommended that such investment should only be undertaken on expert advice.”
The Rs 7,00,000 crore EPFO currently invests only in government securities. Hence, from the point of view of diversification of investment, this proposal, if it goes through, makes immense sense. Nevertheless, there are several problems with the proposal in its current form.
First and foremost the EPFO wants to currently invest money only in
‘navratna’ public sector stocks. There are a couple of problems with this. If the idea is to give investors in EPFO a certain exposure to equity, then why limit it to only the best public sector companies?
The second problem is that the free float of the public sector companies is a lot lower in comparison to the overall market. Free float is essentially the number of shares that are deemed to be freely available in the market. In case of public sector companies the shares held by the government are not considered to be available for sale.
The free float of the companies that constitute the BSE Sensex works out to 53.3% currently. In comparison the free float of the public sector companies that constitute the BSE PSU Index, it works out to 29.2%.
Even if only 5% of the employees provident fund (EPF) corpus were to be invested in the stock market, this would mean Rs 35,000 crore of new money suddenly finding its way into public sector stocks. With a low free float, so much new money is likely going to drive up the value of public sector stocks. Hence, EPFO will end up buying stocks at a higher price. And this in turn will impact the return that the EPFO investor earns.
This is why it is important that the EPF invests in the best companies and not the best public sector companies. A simple way to do this would be to run an index fund which simply invests in stocks that constitute the BSE Sensex or the NSE Nifty. An index fund simply invests in stocks that constitute a market index.
Further, the EPFO wants experts to manage their equity investment. Experts repeatedly get the direction of the stock market wrong and this is something that EPFO can ill-afford at the beginning of what is basically an experiment. A better bet is to simply run an index fund and keep experts out of the equation totally. It is important that investors in the EPF, at least earn the market rate of return, first.
As far as experts are concerned, it is worth remembering what Nassim Nicholas Taleb writes in
The Black Swan, The Impact of the Highly Improbable, “Simply, things that move, and therefore require knowledge, do not usually have experts, while things that don’t move seem to have some experts. In other words, professionals that deal with the future and base their studies on the non repeatable past have an expert problem. I am not saying that no one who deals with the future provides any valuable information, but rather that those who provide no tangible added value are dealing with the future.”
Stock market experts have to deal with future and base their decisions on a non repeatable past. The EPFO needs to remember this while deciding how to manage its investments into stocks.

This article originally appeared on www.FirstBiz.com on Oct 17, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)