Pension Fund Management in India: Active or Passive?
A big question for the regulators of India’s pension fund industry is whether to permit active or passive management. The OASIS (Old Age Social and Income Security) report commissioned by the Ministry of Social Justice recommends passive fund management using index-linked funds. The report suggests three types of fund (‘Safe Income’, ‘Balanced Income’ and ‘Growth’) but is not exactly a whole-hearted decision in favour of private pension fund players as prudential regulation recommendations insist on no ‘active fund management’. But there is pressure from the private pension providers for partial liberty on this matter to the beneficiary. Since the policy implication is prudence is process, it is important to develop a justifiable view on a number of issues and document them in support of the active versus passive decision.
Who are the stakeholders affected by the results of this decision? How much risk can they tolerate? How efficient (or otherwise) are the various markets or segments? Are we seeking to improve our RANVA (Risk adjusted net value added) by getting a high return or by reducing costs?Before further discussion let us discus pros and cons of active and passive management.
The job of an active manager is not easy. Active managers add value when fund managers are able to take adequate advantage from inefficiencies in the market and pay for the costs of transaction costs and management fees. For example, if transaction costs total 1.5 percent of the portfolio’s asset return, the portfolio has to earn a return 1.5 percent point above the passive benchmark just to keep pace with it. If the manager’s strategy involves over-weighting a specific market sector in anticipation of price increase, the risk of the active portfolio will exceed that of the passive benchmark. Thus, active portfolio returns will have to exceed that of the passive benchmark by an even wider margin to compensate for its higher risk. Active management also involves greater complexities than passive management since regulators have to deal with a variety of trading strategies used by managers.
There are two basic arguments in favour of active portfolio management, despite the typically higher risk over the passive benchmark. First, active management would almost certainly require actions that would be contrary to the principles of security and neutrality. The rationale for active management, to maximize the potential gain to the trust funds from investment, is a violation of the principle of neutrality. It could also entail the acceptance of some risk (e.g., through the purchase of marketable securities). Managing special obligations so as to maximize the return on trust fund investment – an objective that could be easily accomplished, for example, by redeeming low interest-rate special obligations at par and reinvesting at higher rates – would automatically disadvantage the general fund.
The second reason for active management is also rooted in the principle of neutrality. For the individual fund manager to actively manage the investment of trust fund assets to the detriment of the general fund or, for that matter, to do the opposite, would involve a clear and unacceptable conflict of interest. Active management, employing policies designed to produce neutrality, avoids this dilemma.
In contrast passive fund management harnesses the equity premium reliably by investing in index-linked funds. These are less vulnerable to volatility and are easier to regulate. An index fund passively replicates the returns of an index. The most useful kind of index is where the weight attached to the capital stock is proportional to its market capitalisation. The simplest method of implementing an index fund is through ‘full replication’ where the portfolio held by the index fund is same as the index. The most basic foundation of indexation is the stock market index.
A passively managed fund investing both in domestic and international indices shows greater gains than the actively managed domestic fund. While international diversification sharply reduces risk, it also reduces rates of return accessible to unleveraged investments since equity premium internationally is lower than that of India. The lower volatility of the world stock market index as compared to the much less diversified NSE-50 index will ensure higher rates of return.
The OASIS report recommends passive fund management using index. In my view, this seems a half-hearted approach to the whole pension privatisation question. Undeniably, index funds have the following advantages:
Although indexing has many advantages over active management of portfolio, it has some disadvantages also. One of the main disadvantages of indexing is the loss of incremental returns, which could have been generated by investing in sectors with the highest performance. By not investing in better performing sectors and securities, the opportunity cost can be substantial. Different sectors and different types of securities like treasuries, corporate bonds, mortgage-backed securities, etc. can generate incremental returns for the portfolio.
Another limitation of index funds is the rigid requirements associated with these funds. There may be attractive investment opportunities outside the benchmark universe. If the fund manager is not allowed to invest in securities outside the benchmark index, then some attractive investment opportunities may be foregone. Market inefficiencies in India, such as the current quality of information access, human capital and disclosure laws, present further problems for index fund management.
But this does not mean that the individuals should not be given a choice to try their hand at active fund management. Even though the argument of increased transaction costs may be valid, active fund management should be available to individuals that wish to use market inefficiencies and earn a higher rate of return on their deposits.
Moreover, individuals themselves should be given a choice of whether they would like to adopt passive or active fund management along with the freedom to choose their fund managers. However there could be an argument that the ‘moral hazard’ problem enters into the picture. That is, where individuals are backed by too many government guarantees they could be prompted to take more risks than they would ordinarily have taken and hence would opt for the riskier strategy of active fund Management. But this problem can easily be avoided. The individuals who are ready to take the chance with active fund management should be allowed to do so – at their own risk. Hence in the three-fold scheme recommended by the OASIS report an additional active fund management scheme should also be introduced and pension fund managers should be given the option of choosing from a range of investment styles.
Each investment strategy – active fund management, passive fund management, investment in indexed equities abroad – has its pros and cons in terms of risks and return. Ultimately it is the individual who should be given the opportunities to translate his preferences to reality. On the other hand, as far as pension fund managers are concerned, efforts should be made to give up the closed approach and allow them freedom to function within a broad regulatory framework.