Stock market investment: Here's the biggest problem with rule-based index investing that you should know In principle, investors should buy or sell a stock based on their assessment of the companys intrinsic value and future potential
Dhirendra Kumar
CEO, Value Research
The other day, Helios CEO and Fund Manager Samir Arora tweeted this cryptic post: “Adapting the dialogue from the movie Speed: ‘There’s a bomb on a bus. Once the bus goes 50 miles an hour, the bomb is armed. If it drops below 50, it blows up. What do you do? What do you do?’ Market to FIIs: ‘If you sell more HDFC Bank shares, the FII ownership falls, MSCI doubles the weight of the bank in the indices, forcing many FIIs/ETFs/index funds and funds following the benchmark to buy. If you don’t sell, MSCI does nothing, and there is no additional buying’.”
Can you understand what is happening here? MSCI is an American company that runs many stock market indices, which are followed by global investors. MSCI periodically adjusts the weightage of stocks in its indices based on factors like the free float. In this instance, Arora creatively uses a movie dialogue to explain the dynamics with HDFC Bank shares. If FIIs sell a few HDFC Bank shares, it could paradoxically trigger increased buying. How? Selling would reduce the free float. MSCI’s methodology would then call for increasing the stock’s weightage in the index. This would compel index funds and ETFs, which mirror the index, to buy more shares to match the higher weightage. Active funds benchmarked to the index may also feel the pressure to add to their positions.
On the other hand, if FIIs refrain from selling, MSCI is likely to maintain the HDFC Bank’s current weightage, resulting in no incremental buying pressure from indextracking funds. This happened last week. If the FIIs had collectively sold just 0.05% of the stock, it would have doubled the stock’s weightage. If that had happened, a lot of ETFs and other investors, who were obligated to shadow the index, would have had to double their holdings.
This was widely reported in the investing media and commented upon on social media. Most people saw it as an interesting fact of life in the markets, just the way investing works. However, a handful called it out for what it was—foolishness. Here is an index that is being followed by large investors, and one of the rules of the index means that if some investors sell a small amount, a large number of people would have to buy a lot more. If they did that, the price would very likely go up.
What is the point of investing like this? This is a prime example of how the mechanics of index investing can sometimes lead to outcomes that seem divorced from the fundamental analysis of a company’s prospects. In principle, investors should buy or sell a stock based on their assessment of the company’s intrinsic value and future potential. However, the rise of passive investing through index funds and ETFs has created a new dynamic. These funds don’t make active decisions about individual stocks; they simply aim to match the composition of an index. When an index provider like MSCI makes a rule-based change to the weightage of a stock, it can trigger significant buying or selling pressure that has nothing to do with the company’s fundamentals.
This seems counter-intuitive and, in fact, irrational from any sensible investing perspective. It’s a situation where the tail (index rules) may be wagging the dog (stock prices). This kind of mechanical, rule-based investing can contribute to market distortions, and even bubbles. This is not necessarily an indictment of index investing as a whole, but it does highlight some of the potential unintended consequences and inefficiencies that can arise.
Indices are fine as far as simple ones like the Sensex, Nifty or the corresponding mid-cap indices go. However, those constructed specifically as investment portfolios (as is the trend now) make no sense. Those constructed on the fringes of the market, like micro-cap indices, also make a poor model for an actual investment portfolio. Investors who want to invest in passive funds should stick to mainline indices, not dabble in the fringe ones.
The Author is CEO, VALUE RESEARCH
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
This story originally appeared on: India Times - Author:Faqs of Insurances
