Tracking The Action

Sowmya Kamath | Print Edition: March 2012

It's one move that can make or break a stock. Inclusion in or exclusion from an index, or a change in its weight in an index, is a strong hint about where a stock is headed, especially in the short term.

In addition to Sensex, S&P CNX Nifty, S&P CNX Nifty Junior and S&P CNX Nifty Midcap, indices by Morgan Stanley Capital International, or MSCI, are keenly watched. The reason is that MSCI indices are widely tracked by foreign funds.

"A lot of funds are benchmarked against these indices," says Suresh Mahadevan, managing director and head of equities, India, UBS. This means these funds, known as passive funds, invest on the basis of the composition of MSCI indices and the weight assigned to each stock in these indices. Any change in the index leads to a corresponding change in their portfolios. So, if a stock is included in the index, these funds will automatically adjust their portfolios and buy it, that too according to the weight it has been given in the index.

Suppose a stock, with a 3 per cent weight, is dropped from an MSCI index. Now, if funds worth $10 billion are benchmarked to it, 3 per cent of the amount will go out of the stock and its price will fall.

"The addition of a stock in an index results in higher volumes & liquidity and ensures inclusion in index fund/exchange-traded fund portfolios," says Siva Subramanian KN, chief investment officer, India, Franklin Templeton Investments.

Entry or exit from local indices has a similar impact, but in India the ratio of index funds to total assets is minuscule.

"Stocks normally take a few weeks to adjust after inclusion in or exclusion from indices," says Mahadevan of UBS.

In mid-November 2011, MSCI announced changes in MSCI India index. It decided to include Bharti Airtel, Idea Cellular and Power Finance Corp and dropped Steel Authority of India (SAIL), Indiabulls Real Estate and Housing Development & Infrastructure (HDIL) from close of November 30.

Two-way Street: Stocks that were included in and dropped from the MSCI India index in November 2011
The stocks that were included rose 0.5-4 per cent on the announcement day, when the market fell. The stocks that were dropped underperformed the market and fell 3-5 per cent.

The impact may not always be one way. For example, on 10 October 2011, Coal India replaced Reliance Capital in Nifty. Coal India rose 2 per cent whereas Reliance Capital gained 4.49 per cent.

Any move to include or drop a stock is normally announced in advance by the organisation managing the index.

"Passively managed funds react slowly to the news but actively managed ones react immediately," says Hemant Kanawala, head of equities, Kotak Life Insurance. Due to this, a stock may take a few weeks to settle after the announcement.

When a stock goes out of an index , its price falls, but that does it mean that its fundamentals have changed.

"While the announcement of inclusion/exclusion may result in short-term volatility, the medium- to long-term performance of the stock remains aligned with the fundamental factors," says Siva Subramanian of Franklin Templeton. However, most of the times, a stock's inclusion in an index is a result of it having performed well, says Mahadevan of UBS.

But this does not hold true every time. The organisation managing the index has its own criterion, mainly the stock's fundamentals, market capitalisation, etc. "The stock may be excluded or included for some technical reasons. You have to see if the reason is fundamental or technical," says Kanawala.

One should not consider inclusion or exclusion as the sole trigger to buy or sell a stock, according to experts. One should instead focus on fundamentals, business model and future prospects of the company before taking a call.

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