NPS: Evolution


The National Pension System has evolved over the years. From policy for withdrawals to taxation and choice of fund managers to asset allocation, it has seen multiple iterations. Recently, new investment norms were introduced that give pension fund managers a broader canvas to play with.

The Pension Fund Regulatory and Development Authority recently revised the investment norms for its pension fund managers. Until now, pension fund managers could invest in any stocks that are a part of the future and options basket, with a threshold market capitalisation of at least ₹5,000 crore. This effectively restricted the investment universe to little over 100 stocks—most of which are large-cap names. This basket has now been thrown open for the top 200 stocks by market cap. According to Sebi definition, top 100 stocks by market cap come under large-cap segment. Stocks ranked among 101st and 250th by market cap are classified as mid-cap. Going by this definition, the NPS investment universe will now also comprise of many more midcap names.

Given the current investment restrictions, NPS equity portfolios across fund managers have a heavy large-cap bias. All NPS funds have more than 90% of the equity corpus in this segment. But as the fund size starts growing, fund managers may need to foray deeper into mid-cap territory in search of more investible ideas. Investors can, therefore, expect fund managers to take a generous bite out of the midcap pie. For instance, both HDFC and ICICI Prudential Pension Fund currently run a portfolio of around 90 stocks in their equity plans, comprising mostly large-caps.

This expansion in investible universe will carry implications for NPS subscribers. Mid-cap companies offer longer runway for fast growth. Conventional wisdom says mid-cap stocks tend to outperform large-caps over the long run. This brings potential for higher return for subscribers. Mostly restricted to the large-cap segment till now, NPS equity plans have struggled to outperform over the past few years. The ability to tap mid-caps will give scope to fund managers to generate alpha. At the same time, mid-cap stocks tend to exhibit higher volatility than large-caps. This basket is also prone to higher drawdown during downturns. This will get reflected in NPS equity portfolios.

However, experts say introduction of mid-caps should not unnerve investors. It should serve NPS subscribers well over longer horizons. There are several quality businesses among midcaps. Those with 10, 20 or more years’ time horizon can benefit from higher wealth creation over such long time frames.

Pension fund managers have also been given the leeway to invest in IPOs meeting a certain market cap threshold. Companies whose full-float market cap (based on lower band of IPO issue price) is higher than the market cap of the 200th company will be eligible as investment in NPS. At current market prices, NPS fund managers will be able to target IPOs with market cap greater than ₹21,200 crore. This opens up another avenue for pension fund managers to pick high-growth investment ideas.

However, experts have reservations about bringing IPOs into the NPS fold. IPOs tend to be priced high particularly during boom periods. This leaves very little margin of safety for the stocks post listing. Also, the information asymmetry associated with lesser known private companies brings in higher risk in the portfolio.

Another change is the relaxation in norms governing investment in group companies. Till now, NPS funds were allowed to park up to 5% of equity corpus in group companies. This will now be extended to 5% of entire corpus. This gives more leeway to invest in listed group entities. This could benefit subscribers only if group companies boast sound fundamentals.

For relative newcomers in NPS, these recent changes may seem nominal. But for older subscribers, the product flavour has changed visibly from early days. Few may remember that NPS had initially started out as a purely passive investment vehicle. It allowed pension fund managers to invest only in index funds that replicated either BSE Sensex or the Nifty50 index. There was no active fund management involved. Along the way, the PFRDA allowed fund managers to invest in shares listed on BSE or NSE, having a market capitalisation of at least ₹5,000 crore and which are eligible for trading in derivatives. This shift to active management was on the basis of recommendation of the G.N. Bajpai Committee. Its argument was that India is a relatively inefficient market, which gives fund managers enough opportunity to beat indices by actively managing the portfolio.

Further, the product initially allowed subscribers option of equity exposure only up to 50% of their investments. The rest could be parked in a mix of government securities and corporate bonds. Later, the maximum equity allocation was hiked to 75% for subscribers up to the age of 50. There have been discussions on enhancing this limit to 100% . Together with the recent revision in investment norms, these incremental changes have given a distinct makeover to the NPS. It has definitely come a long way from its early passive-only days.

Some maintain that passive investing is most suited for this avenue as it not only eliminates fund manager risk but also helps keep expenses low.

The new investment landscape also makes NPS less of a fill-it, shut-it, forget-it kind of vehicle. Introduction of mid-caps will likely create more divergence in returns among different pension fund managers. Equity plans across fund managers largely resemble each other today owing to the large-cap focus. But as they start diversifying into mid-caps to different degrees, fund profiles will take different shapes. This may require subscribers to keep a closer eye on the portfolio construct.


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