The Hindu Business Line : Index funds have a `weighty' problem

ONGC will be included in the S&P CNX Nifty from April 12. The composition of the Nifty index has changed nearly 40 times since 1996. Such reconstitution hurts index funds. Each time there is a change in the benchmark index, index funds will have to buy the newly included stock to mirror the index returns. The problem is that an index fund buys on the day the stock enters the index.

Now, research studies on index reconstitution have documented that a stock typically moves up on the day it is included in the index. Thereafter, the abnormal return fades away and the stock price aligns itself with the broad market movement. This means that the index reconstitution effect could lead to lower returns for index funds. We can call this as the index reconstitution risk. With frequent changes in the market index, index funds should devise measures to lower this risk. This article discusses one such measure: The sector neutral exposure.

Sector-neutral weights: Index funds should buy the stock that is newly included in the index over a longer period instead of on the day it is included. This way, drag on returns due to high impact cost can be lowered. There is of course a trade-off. The index fund's tracking error will be higher, longer the fund takes to buy the stock. The objective then is to lower impact cost and tracking error risk. This can be somewhat achieved by using sector returns as a proxy for market returns. Market returns refer to the movement in a stock price due to general factors. Suppose Bank of Baroda (BOB) is included in the Nifty.

An index fund can buy the stock at a higher price on the day it is included. Or it can buy other stocks in the banking sector that form part of the index. Since interest rates are likely to impact all stocks in the banking sector in the same way, buying other banking stocks instead of BOB will expose the index fund to the same systematic (or market) risk. The important point is that the index fund has to equally distribute the weight of the newly included stock among other stocks in the same sector. Four stocks constitute the banking sector in the Nifty index. Assume BOB has a 2 per cent weight in the index. The index fund then has to distribute the 2 per cent exposure among 3 remaining stocks in the banking sector. If it takes more exposure in one or more, it may be inadvertently taking exposure to stock-specific risk.

Related sector weights: Such direct sector-neutrality is not always possible because not all sectors are represented in the market index. Take ONGC. From April 12, it will be the only stock in the petroleum sector. In such cases, index funds have to take exposure in closely related sectors to lower impact cost- tracking-error trade-off.

The nearest related sector to ONGC is refinery. The refinery sector has a 5 per cent weight in the Nifty. Suppose the refinery sector and ONGC move 0.75 point and 0.90 point respectively for every point move in the Nifty. This means that a 10 per cent weight of ONGC in the Nifty is equivalent to a 12 per cent weight of the refinery sector in the same index. So, instead of ONGC, the index fund can take 17 per cent (12 per cent plus 5 per cent) exposure in the refinery sector. In the above cases, the index fund can well substitute single-stock futures for the stock itself.

Non- specific risk: Of course, sector neutral exposure is not without its problems. For one, non-systematic or the stock-specific risk of HPCL and BPCL (part of the refinery sector in the Nifty) may be different from that of ONGC. So, even if an index fund neutralises the effect of non-exposure or low exposure to ONGC, the difference in non-systematic risk can lead to high tracking error.

For another, the relationship that the refinery sector and ONGC have with the market index can change. Despite these shortcomings, a sector-neutral exposure may be worthwhile. The objective is to provide the index fund some time to buy into the stock that is newly included in the index without increasing the tracking error.

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