Not an easy prescription

Sectoral caps in indices need careful examination

The Securities and Exchange Board of India (Sebi) has nudged the stock exchanges to bring out discussion papers on sectoral concentration in the Nifty50 and Sensex indices, which has rekindled an age-old debate — whether showcasing a successful sector aggressively in the benchmark index is right, or whether the index should have a more diverse base to reflect the economy. On its part, the market regulator seems worried about the rising concentration of the financial sector (banks and non-banking financial companies), at 37 per cent in the Nifty50 index and 40 per cent in the Sensex. While not strictly comparable, the financial sector’s contribution to gross value added (GVA) at basic prices has been just 6-6.5 per cent in the past five years, which is significantly lower than the sector’s weight in the two broad-based indices.

Globally, the trend on sector weight is mixed. The Dow Jones Industrial Average in the US and the UK’s FTSE 100 have a weight of 25 per cent and 21 per cent, respectively, of technology, but in Japan’s Nikkei 225, communications and technology account for nearly 60 per cent. Most global indices including the Nifty and Sensex are calculated based on the free-float methodology, which excludes promoters’ holdings and shares held under lock-in to include stocks. The main argument against concentration is the risk to the market when things go awry. For example, when the dot-com bubble burst in 2000, technology had the highest weight, in excess of 30 per cent, in the S&P 500. Similarly, financial stocks’ weight was bloated in US indices when the 2008 crisis erupted. And such instances give credence to some fund managers’ view that an index representing the entire economy would be more diversified and stable, and insulate investors from any sectoral shock such as the recent NBFC liquidity crisis after the IL&FS default.

But having a better representation of the real economy in key indices is not easy to achieve. First, there aren’t enough listed companies of sectors that are the biggest contributors to the economy. For instance, agriculture, forestry and fishing contribute 15 per cent to GVA, but there are hardly any listed stocks available. Besides, Indian companies, unlike in the West, have a large shareholding by promoters, which means their free float, and hence their weight, will be lower. Caps, on their part, will result in a sector not being appropriately represented. For instance, the overall weight of the financial sector is 32 per cent among all NSE-listed stocks, whereas the weight in Nifty50 is 37 per cent. If a sectoral cap of 25 per cent or 30 per cent were to be introduced, the exchange will have to devise a methodology to address the problem. Moreover, the NSE has said the index will be readjusted every quarter to reflect the reality, which could lead to an increase in impact cost, frequent churning and tracking error. This will increase costs for both domestic and global exchange-traded funds, which have seen traction in the past few years. Since these funds operate on wafer-thin margins, they are unlikely to appreciate any additional burden. And, of course, there will be more volatility. Diversifying the benchmark indices is a good idea, but it will need to be thought through well before implementing.