Earlier this month, market regulator Securities and Exchange Board of India (Sebi) came out with a circular setting out the changes that index funds and exchange-traded funds (ETFs) need to make in their portfolios to reduce the risk of concentration in stocks.

How will mutual funds implement these changes in passively managed funds where the selection of stocks and their weightage is done in line with the index it tracks? Will it lead to a re-positioning of index funds and the role they play in the portfolios of investors?

Index funds and ETFs have made it into more and more investor portfolios as a low-cost, lower-risk option to actively-managed funds. Passively-managed funds invest in line with an index they track. So, an index fund or an ETF tracking the Nifty will invest in the same 50 shares that constitute the index and in the same weightage that they hold in the index. The selection risk arising from stock picks of the fund manager or from the extent of exposure taken in the stocks is eliminated in passively managed funds. The returns from such funds closely track the return from the index they track. But it does not take away the risk of concentration that may exist in the index itself.

The new rules

The new rules require that the index that a passively managed fund—an index fund or an ETF—tracks has to have a minimum of 10 stocks and the weight of each stock in the portfolio has been capped at 35% for sectoral indices and 25% for other indices.

Also, the top three constituents of the index shall together not represent more than 65% of the portfolio. Sebi has also specified liquidity eligibility norms for the stocks included in the portfolio.

The implications

The risk of concentration that the regulations seek to correct currently exists in some sectoral indices. The ETFs and index funds tracking the Nifty Bank Index, Nifty PSU bank Index and the Nifty Infrastructure Index are some of the portfolios that have to be rejigged to comply with the new guidelines (see graph). “The construction of some indices available in the market was not viable for running a live fund on it. The Nifty PSU Bank Index is one such index where SBI alone has a weight of 72%. Such concentration defeats the purpose of a portfolio," said Anil Ghelani, CFA, head of passive investments and products, DSP Investment Managers.

Index funds and ETFs that track bellwether indices such as the Sensex or the Nifty 50, and other broad market indices will not be impacted by these regulations since the individual stock holding as well as their exposure to the top three constituents are well below the prescribed limits of 25% and 65%, respectively.

Index funds and ETFs are required to report compliance every quarter and make the list of stocks in the index available on the website of the mutual fund. However, the first move has to come from index providers who have to reconstruct the indices to be compliant with these regulations after which the passive funds will realign the portfolios to the revised index.

The bigger concern will be the quarterly reporting of compliance. “Indices are typically rebalanced every six months. However, the guidelines require compliance at the end of every calendar quarter. Since the portfolios of index funds need to be aligned with the underlying indices, there might be some review needed for the periodicity. A more frequent review may also lead to higher costs of rebalancing the portfolios," said Ghelani.

Ghelani is not worried about a possible compromise in the quality of stocks coming into the index to meet the new guidelines.

“There have been additional filters put in by defining the upper limit on impact cost and minimum trading frequency to ensure the quality of stocks that come in," he said.

One side-effect of the regulations would be the excess supply of some stocks being in the market as affected funds reduce exposure once the indices are reconstructed to meet the regulatory requirements.

However, given that assets under management (AUMs) involved are small and the stocks whose concentration in the portfolios have to be reduced, such as SBI and HDFC Bank, enjoy high level of liquidity and investor interest, the market should be able to absorb the excess supply without a significant impact on prices.

Mint’s Take

It is important to let winners run and not put an artificial cap on the exposure in the index of stocks that are performing, particularly in the case of bellwether indices like the Sensex and the Nifty that are seen as leading economic indicators. That said, it is equally important to balance it against the prudence of diversification.

Internationally, the accepted method is to have a variant of an index with constraints applied to be suitable as benchmarks for funds that have to be compliant with regulatory guidelines for diversification. For example, the basic MSCI indices needs to comply with the UCITS III directives that govern funds incorporated in member states of the European Union.

According to Mukesh Aggarwal, chief executive officer of NSE Indices, “We are working on the details. In the case of some indices we may reconstruct it in line with the regulatory requirements. In others, we may decide to go for a variant of the existing index that is compliant with the regulations." If a variant is being introduced, then the challenge is to construct the modified indices in a way that the tracking error, or the variation in the return of the modified index relative to the return from the main index, is kept to a minimum.

Renu Maheshwari, CEO and principal advisor at Finscholarz Wealth Managers LLP, sees the diversification of the indices as a positive development for investors since it improves the risk quotient of the index funds and ETFs by being more representative of the market. “Regulations that finely define the criteria based on which index portfolios are constructed will help investors build their own portfolio in a better manner," she added.

A better diversified portfolio with quality stocks and lower costs associated with passively managed funds should translate into better experience for investors.