Should There Be A Sectoral Cap For The Nifty 50 Index?

A consultation paper released by the National Stock Exchange of India Ltd. this week, which seeks public opinion on sectoral caps for benchmark indices, has stirred a debate. The paper includes a proposal to cap sectoral weightage in a benchmark index based on the representation that firms from the sector among all listed firms.

Independently, Asia Index Pvt. Ltd., a joint venture between BSE Ltd. and global index manager, S&P Dow Jones Indices LLC, made public its response to SEBI about its views on this issue. The index manager said that the introduction of sector-wise caps for benchmark indices will impact the investment products linked to such indices. It will also increase the trading time and costs in case of liquidation, AIPL said.

In addition, BSE has separately put out a market consultation paper seeking whether the way equity broad based indices are constituted, require a change. Broad-based indices are those which have more than 10 or more securities with no single stock constituting more than 25 percent of the weight and the three largest securities exceeding 65 percent of the index weight. BSE has sought the response before May 17.

To be sure, the NSE has made it clear that the proposals may or may not lead to any changes in the way indices are structured.

The consultation paper and response by the two index managers follows directions from market regulator, Securities and Exchange Board of India, to look at sectoral caps for benchmark indices. In January, SEBI had come out with guidelines on portfolio concentration on equity exchange traded funds and index funds. Both exchanges modified their methodology to incorporate these changes in their sectoral indices. This resulted in capping of stock weightages in these indices.

Issues Faced By Indices

Currently, Nifty 50 tracks the performance of 50 companies from 13 sectors. These stocks are selected based on their free-float market capitalisation. Nifty 50, at the end of March 2019, represented 67 percent of the average free-float market capitalisation of all the stocks listed on NSE and 50 percent of the NSE turnover for the preceding six-month period.

The financial services sector has retained the highest weightage in the last 10 years, according to NSE data. The sector currently has a 37.36 percent weightage in the Nifty 50 and 31.88 percent weightage among all the NSE-listed companies.

Energy, information technology, consumer goods and automobiles are the next four in terms of weightage in the index and across all the NSE-listed companies.

NSE Consultation Paper

In order to address any skew that may creep in, NSE, in its consultation paper is seeking public opinion on two options.

• Cap sectoral weightage at 25 percent, 30 percent, 35 percent, 40 percent.
• Or peg it to the sectoral market capitalisation of the all listed companies on the NSE.

For example, if the market cap of all listed companies in the financial services space is 32 percent of NSE’s total market cap, then the sector is capped at 32 percent in the Index.

But the move has its shortcomings.

The largest sector may not have adequate representation and a broad-based index may not represent actual market performance if a sectoral cap is introduced. The cap on sectoral limits may lead to frequent churn in portfolio as index sectoral caps will be reviewed every quarter. Globally, indices do not have sectoral caps.

NSE will seek public comments till May 31.

Views of AIPL

AIPL, in its response to the SEBI, said that sectoral caps could alter the risk profile as constituents would no longer be picked based on market capitalisation. This would lead to lower liquidity, AIPL said.

The global index manager said that imposition of limits will result in the index having less applicability, credibility, and in some cases, liquidity, particularly if derivatives used to hedge are configured for more capitalisation-weighted frameworks.

A scenario analysis of the S&P BSE Sensex showed it took nearly three days to liquidate a basket of Sensex stocks worth Rs 500 crore if the sectoral cap is at 25 percent compared to two days now. Similarly, for BSE 500 Index it took 12 days compared to 10 days.

For the BSE 100 Index, however, it took six days compared to eight days. In the case of BSE 100, the duration was lower because of Bajaj Holdings and Investment Ltd., which is part of the financial sector and is less liquid. After capping the finance sector it received less weight. Excluding Bajaj Holding, the BSE 100 Index basket took more time to liquidate as well in the event of sectoral caps.

The impact of sectoral capping will also lead to higher index turnover in the short term and long term, AIPL said. In the short term, the exchange traded funds will have to realign their portfolio to the sectoral caps. And in the longer run, these funds will be have to continuously churn their portfolio, in line with quarterly alignment of sectoral caps.

The move, according to AIPL, will remove the cost-effectiveness of passive funds like ETFs, which currently have low-cost management and require limited fund manager intervention. “Constant churn in the index will increase the cost of management for investors like Employee Provident Fund Organisation which invests in ETFs of S&P BSE Sensex, S&P BSE 100 and S&P BSE 500.”