Joseph Massey, MD and CEO, MCX Stock Exchange, talks to Dipak Mondal about the firm's first index in India, the SX40, and how it is different from its peers in the country.

Q. In terms of diversification, how is SX40 different from benchmark indices such as Nifty and Sensex?
A. The benefit of diversification that benchmark Indian stock market indices offer investors has remained much below the optimal level required by the classical mean-variance portfolio theory.

Historical evidence of correlation breakdown (variability and correlation of returns on assets held in a portfolio) and subsequent preference for optimal asset allocation using behavioural approach indicates that modern-day investors require an index that can provide for adaptive and cost-effective fund allocation in an effort to achieve dynamic portfolio optimisation that better reflects economic and business dynamism.

Put simply, SX40 will offer more diversification that is cost effective as compared with its Indian peers and capture market trends without sectoral biases.

Q. Why a 40-stock index? How is having 40 stocks more beneficial than having 30 or 50 stocks?
A. A benchmark index is both tracked and traded. Combining diagonally opposite characteristics was a challenge while finalising the methodology (for picking stocks) and the optimal number of stocks in indices.

The decision about the number of stocks is based on numerous factors, such as cost, convenience of portfolio replication, diversification, minimised drag effect of constituent scrips and reflection of the economy with a balanced distribution of industry weights.

(However), the real benefit of an index is only partly in the number. It is largely the index's ability to cater to varied interests that are reflected in the Indian stock market ecosystem.

Q. How is the fee charged by the MCX-SX more persuasive to investors than those of other exchanges?
A. MCX-SX transaction costs are lower by almost 50% in most categories and the recently announced incentives will have a catalytic effect, enabling all categories of participants, including retail and institutional investors, jobbers and members, to trade on the MCX-SX.

Q. What are the advantages of taking bets on SX40 futures over other index futures?
A. The SX40 offers higher risk-adjusted returns as compared with other popular Indian indices.

This index exhibits a fully transparent criteria for selecting the constituent stocks without any subjective judgment and, thereby, making the index amenable to easy replication, which is a character that most analysts in derivative markets would yearn for. A rule-based index is more reliable for all participants because of the transparency it provides and the subjective judgment it avoids when selecting or avoiding any company's scrip.

(Further), the cost of portfolio management is lower for managers structuring passive investment vehicles around the SX40 because of its comparatively lower churn of companies and its infrequent change in weight structure (of sectors).

Global practices followed in constructing the SX40 makes it easy for domestic and global fund managers to track market growth. Also, there will be lower tracking error on SX40 funds compared with peers.

Higher rate of returns, lower tracking error, and lower cost of asset management make SX40 an ideal index for structuring more efficient exchange-traded funds or ETFs.

Q. Have mutual funds shown interest in launching index funds or ETFs based on SX40?
A. Yes, we are in advanced levels of talks with a few leading asset managers on developing ETFs on SX40 as well as structure investment products around it. The feedback suggests that fund managers have understood the advantages of the index and are confident that it will attract a following due to its technical superiority, global practices and higher rate of risk-adjusted return.

Q. Why would retail investors prefer SX40?
A. The current leading indices have a significant weight for some sectors, disproportionate to the sectors' contribution to the economy and, hence, creating higher risks for retail investors.

In fact, the contribution of any segment of the industry in India's GDP, or Gross Domestic Product, as classified by Industry Classification Benchmark does not exceed 20%.

As SX40 offers higher risk-adjusted return, even a retail investor would feel comfortable opting for SX40 as a preferred index for both investment and trading.

Q. SX40 is a large-cap index. Do you have plans to launch mid-cap, small-cap and sectoral indices?
A. MCX-SX believes in product innovation and we will gradually announce more indices that will fill the current void between the (market) participants' needs, the products available and the market's need for an index that represents a more stable underlying real economy.