Last week, SEBI made a groundbreaking announcement, defining the criteria for an equity index to be eligible for being tracked by an index fund or an ETF. Among other things, it capped the weight of a single stock in such an index at 25% (35% in the case of a sectoral/ thematic index). It also capped the combined weight of the top three constituents in such an index at 65%. I may be wrong but I don’t think that there is any precedent worldwide for such a regulatory intervention. In this post, I share my initial thoughts on this.
2018 was a very good year for those rooting for index funds and ETFs in India. For the first time since 2013, a comparable ETF (actually, 3 ETFs) gave a higher return than any actively managed, diversified, domestic equity fund. And almost all actively managed, large cap funds underperformed the BSE Sensex and Nifty 50 (in terms of returns). However, there were some uncomfortable questions that lurked beneath the surface. For instance, were it not for the superlative returns of a handful of stocks, would such outperformance by index funds and ETFs been possible? And how was one to look at the fact that there was a difference of over 2.5% in the returns of the best performing and worst performing Nifty 50 index funds?
There were also questions about the construction and maintenance of indices. For example, what was one to make of the massive churn that some indices went through? By my count, in April last year, the Nifty Midcap 100 had 46 of its constituents changed at one go while the Nifty Smallcap 100 had 55 of its constituents changed at one go. Then, there was the question about the suitability of Vakrangee to be part of the (erstwhile?) Nifty Quality 30 Index and what that said about strategy indices per se. But it would seem that the thing that caught SEBI’s attention the most was the absence of caps on individual stock weightings in most indices, and how that might impact investors in funds that tracked these indices.
Having caps on exposure to individual stocks is a key part of prudent portfolio management. Some indices have such caps, most do not. Since index funds are intended to replicate indices, the absence of such caps exposes investors in index funds to concentration risk. While this risk has always been known, it is only in recent years, with the rise of the FAANG stocks, that the global conversations around this have begun somewhat seriously. But there are some parts of the world where this has already become a hot button issue. For instance, in South Africa, media giant Naspers currently makes up 22% of the JSE Top 40 Index and 18% of the JSE All-Share Index. What’s more, its weighting in the former index is greater than all of the super sectors that make up that index; in the latter it is greater than all but one.
In India, while the broad based indices are not under immediate threat of such a domination, some thematic/ sectoral indices are already being questionably influenced by their top constituents. For example, in the Nifty Infrastructure Index, L&T alone has a weight of 36%. Similarly, in the Nifty Bank Index, HDFC Bank alone has a weight of 36%. If you add the weights of ICICI Bank and Kotak Mahindra Bank, these 3 banks make up 68% of the index. Then there is the Nifty PSU Bank Index in which SBI alone has a weight of 72%. More importantly, each of these indices has one or more index funds / ETFs tracking it. In this backdrop, SEBI’s decision would appear to be necessary or, at the very least, justified. Personally speaking, I have would have preferred the caps to be lower. Still, it’s much better than not having any caps.
One of the arguments that I heard against SEBI’s decision was that the construction and maintenance of indices is the domain and prerogative of stock exchanges and index companies, and that the regulator has no business or authority to decide the rules that govern an index. It isn’t an argument that is altogether without merit but, strictly speaking, SEBI hasn’t directly asked stock exchanges or index companies to make such changes. What it seems to have done is to indirectly put pressure on them by placing the onus of compliance on fund houses. As I read it, if an index doesn’t meet the criteria set by SEBI, it can’t be the basis of an index fund or an ETF (at least, one that is managed by an Indian fund house). In other words, if an index company values the business that comes from licensing its indices to Indian fund houses, it will have to comply with SEBI’s requirements. Of course, the index companies are free to keep their current indices as they are, and create separate indices exclusively for Indian fund houses. But if they do, well, we might be in for interesting times.
There is also the question of how this might impact the performance of indices. I don’t have the means to do back testing but I am sure, sooner or later, someone will tell us how such changes, had they happened in the past, could have impacted historical returns. For now, my guess is that after SEBI’s announcement, active equity fund managers are feeling a little bit relieved.
