The National Stock Exchange (NSE) recently came out with an important consultation paper on selection of stocks to include in Nifty Next 50 index. According to the proposal, the NSE wants to include only stocks that are part of F&O in the index. The main reason behind the proposal, according to the paper, is to minimise the tracking error for ETFs/index funds that benchmarks Nifty Next 50.

Currently, of 50 stocks, 11 with a cumulative weight of 9.05 per cent as on May 16 are not available in the derivative segment.

According to the NSE, the exposure of the index to such non-F&O stocks, frequently hitting the price bands, lowers the ability to replicate the index portfolio efficiently and thus increases the tracking error.

Stocks to exit from index

The Nifty Next 50 index represents the balance 50 companies from Nifty 100 index after excluding the Nifty 50 companies. If the proposal comes through, stocks such as Varun Beverages, Adani Green, Zomato, Adani Transmission, Nykaa, Adani Wilmar, Adani Total Gas, P&G Hygiene, Bajaj Holdings, Life Insurance Corporation of India and DMart will have to be excluded from Nifty Next 50, since they do not have futures and options attached to them.

The cumulative weight of the non-F&O stocks is currently capped at 10 per cent and are individually capped at 4.5 per cent each on a quarterly basis. There are 20 passive funds tracking the Nifty Next 50 index with a total assets under management (AUM) of ₹11,600 crore as of March 31 — seven ETFs with AUM of ₹5,560 crore and 13 index funds with AUM of ₹6,040 crore.

“With the number and asset size of passive funds tracking the Nifty Next 50 index increasing, ensuring index constituents liquidity and ease of index replication by passive funds gains more importance,” it said.

One way to resolve this issue of index replication is to include only those stocks available for derivative trading in the Nifty Next 50 index. “Stocks that are available for F&O trading are typically more liquid and accessible than other stocks that are not available for F&O trading. Having only those stocks that are available for F&O trading into the Nifty Next 50 index shall improve the ease of replication of the index by passive funds,” it said.

Roadmap for implementaion

Accordingly, the NSE plans to reduce the cumulative weight of non-F&O stocks in Nifty Next 50 index from the existing 10 per cent to 5 per cent with effect from June 30. And from September 29, it will consider only stocks that are part of futures and options segment.

However, the proposal does not hold water on four counts. First, the fact that only F&O stocks are more liquid is not true. Some non-F&O stocks are more liquid than derivative stocks, especially during corporate events.

Second, stocks which are part of an index with linked derivative contracts, do not attract the conventional circuit filters. So, the inclusion of such non-F&O stocks will not induce greater volatility, as the NSE claims.

Third, trading halts and bans are not limited to non-F&O stocks. F&O stocks will also come under trading ban if the overall market-wide open interest crosses 95 per cent in the derivative segment; this will limit the movement of underlying stocks too.

Fourth, the tracking error between Nifty 50 Index funds and Nifty Next 50 index funds is not that wide. For instance, IDBI’s Nifty ETF’s tracking error is 0.10 per cent, while that of IDBI Nifty Next 50 is 0.14 per cent. This weakens the case for excluding non-F&O stocks from the Nifty Next 50 index further.

However, investors of index funds can brace for volatility, if the proposal sails through, eventually.