Booming passive investments and Baahubalis in market indices

Heavyweights dominating the direction of indices

Indian markets are agog with many commentaries and analyses about emergence of a new #Baahubali in banking industry after successful reverse merger of #HDFC with its subsidiary #HDFCBank in recent weeks. With an estimated valuation of $172 billion, HDFC would be the fourth largest bank in the world. As trading in HDFC shares discontinued on listed stock exchanges w.e.f. 13 July, it substantially changes the composition of market indices – broad market index #Nifty50 and sectoral index #BankNifty. With a combined post-merger weight of 14.43% (earlier individual weight of HDFC Bank 8.59% and HDFC 5.93%), HDFC Bank has emerged as the stock with the highest weight in Nifty 50 index. While RIL is still having the largest market capitalization of ~INR 18.7 lakh crore versus ~12.2 lakh crore of HDFC Bank, the banking giant ranks ahead in Nifty 50 (calculated based on free-float market capitalization weighted method) for reason of size of its free float – far ahead of RIL. The merger has also changed the composition of Bank Nifty index - weight of HDFC Bank rising to 29.10% level from earlier 26.90%. Taking it in a broader market view, top 5 stocks in Nifty 50 now constitute almost 44% and top 10 stocks forming close to 60%.

Passive flow of passive investments

In the backdrop of growing pattern of few heavyweight stocks dominating broad market indices, the issues of efficient and transparent #benchmarkadministration for limiting increased concentration of individual stocks and minimizing sectoral skewness have once again comes at the centerstage. Given the excessive reliance of #passiveinvestment funds comprising #ETFs and #Indexfunds (following broad market indices, sectoral, thematic and customized indices), it requires institutional objectivity and transparency in index methodology adopted by index providers in selecting stocks, inclusion, exclusion, rebalancing across index management lifecyle. It is estimated passive investment industry AUM stood at INR 6. 24 lakh crore (Nov 2022) forming almost 15+% of total AUM of the fund industry with net inflow of INR 1.02 (Apr - Nov 2022).

While we talk about market indices and concentration of heavy weight stocks, NASDAQ planning a #specialrebalancing of its flagship #NASDAQ100 index before next week (24 Jul) opening reflects the overwhelming pattern and its unmanageable impacts. Special rebalancing has been triggered to comply with SEC 75-5-10 rule on fund diversification under Investment company act 1940, which stipulates that 75% of a diversified mutual fund's assets to be invested in other issuers securities, not more than 5% in one single company and less than 10% of an issuer's outstanding securities. Earlier such special rebalancing in NASDAQ 100 has taken place in 1998 and 2011. It is estimated top 5 stocks in NASDAQ index together constitute a weight of almost 43.8% or more - Microsoft 12.9%, Apple 12.5%, Nvidia 7.0%, Amazon 6.9%, Tesla 4.5%. The idiosyncratic behavior of an index and associated risk skewness can be analyzed from a basic comparison of tech dominated NASDAQ 100 growing by 37.5% versus 14.8% gain made by the broad-based S&P 500 in 2023.

Regulatory framework for Benchmark Administration

Incidentally, other than nominal self-governance and controlled disclosures about the methodology by the #indexproviders, regulatory framework on the functioning of benchmark administration to check conflict of interest and manipulative practices is still missing in India. Market observers might recall, after #IOSCO publishing an overarching framework of #PrinciplesofFinancialBenchmarks used in financial markets in July 2013, SEBI had released a Discussion paper on Draft Code of Conduct for Index Providers (May 2017), followed with a consultation paper on Compliance Standards for Index Providers (Dec 2020). Further, a new consultation paper on Regulatory Framework for Index Providers has been issued in Dec 2022. Indian markets - in particular mutual fund industry, coming under heavy turmoil on count of passively exposed to single corporate group at excessively high levels?during recent Hindenburg Research saga, excepts a holistic benchmark administration framework in place sooner than later

Among global jurisdictions, EU took an early lead to adopt a comprehensive framework in form of Benchmark Regulation in 2016, and applied effective Jan 2018. USA being the home of some of leading financial market indices from S&P Dow Jones, MSCI, FTSE Russell and others, the index providers mostly enjoy the status as data publishers than index providers. However, the regulatory evaluation is underway – particularly considerations for objectivity of ESG ranking and indices and growing passive investment, to frame a regulatory framework for index providers.