January 14, 2019

Stock Caps In Index Funds

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.

Read more at http://mfcritic.blogspot.com/2019/01/stock-caps-in-index-funds.html

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