Amay Hattangadi, Managing Director, and Swanand Kelkar, Executive Director, Morgan Stanley Investment Management, lay the facts bare.
With the rise of passive investing over the last few decades, albeit to a smaller degree in India, has been the game of predicting which stocks will get included in the benchmark indices at their periodic reviews.
The game is that if one is able to guess the inclusion probables and buy those names before passive money is forced to buy, one stands to make a handsome short term profit. Just before the announcement date, frenetic activity starts in trying to predict such inclusions. The time gap between the announcement and the inclusion date is typically two to three weeks and that’s the period over which one is trying to make a quick buck. To be sure, this has absolutely nothing to do with the fundamentals of the stock. What it does, however, is ramp up the share price of inclusion probables ahead of the index inclusion date.
Morgan Stanley analysed 50 instances of MSCI inclusions from 2010. It showed that in the month leading up to the inclusion, the median outperformance over MSCI Index was 5%. On the other hand, in the one month after the inclusion the same stocks underperformed the index by 3%. Simply put, this means if you have invested in an MSCI tracking exchange traded fund (ETF), by advertising the amount and date on which you were going to buy a certain stock, you ensured that you bought it pretty much at the peak of its relative performance.
Put charitably, this is momentum investing.
Put plainly, this is dumb investing.
There are facets of how the composition for MSCI indices is determined, that are puzzling. Like most indices, MSCI uses the free float market capitalisation to decide weights of stocks in its indices. This implies that market capitalization, excluding the share of the founders or promoter, will be considered since that is what is available for other investors to trade in. However unlike domestic indices, MSCI also uses a special adjustment called Foreign Inclusion Factor (FIF) and foreign room.
What this means is that it will consider the headroom available for new foreign investors to invest in the stock. Before we get into why that is a big deal, see what this adjustment cost the MSCI ETF investors. Versus the BSE 100, MSCI India has underperformed by 1.5 % annualised over last five years and by 1.3% versus Nifty. This is significant as Nifty return over that period was 5.3% while MSCI India return was only 4%. Mind you, both these are indices with similar composition philosophy except for the FIF adjustment and we are not even getting into active versus passive investing debate here.
Check Visual: Local indices outperform MSCI India
It is easier to explain the concept of FIF with an example – HDFC Bank.
HDFC Bank does not find representation in the MSCI Index despite being the fourth largest stock in India with a market capitalisation of $40 billion. As of end December 2015, 47.4% of the HDFC Bank’s equity is owned by foreign portfolio investors (FPIs). The overall limit for foreigners to own a banking stock, as imposed by the Reserve Bank of India is 74% so if you add HDFC Limited’s holding of 26.5% to the FPI holding of 47.4%, foreigners cannot buy fresh stock from the market. However, the stock is freely traded on the foreign window i.e. one foreign investor can buy from another in the market.
Average daily traded value DOTS over last six months on the foreign window is close to $14 million versus $23 million on the local window. In HDFC Bank’s case the value of FPI holding in the stock is almost $19 billion and that float is freely available to foreigners. As the FPI shareholding in Indian equities has kept going up, this has and will create more such headroom issues especially in sectors with regulatory caps like banking.
It is the result of this process that the weight of banks in MSCI India is a meagre 3% with only two banks viz. ICICI Bank and State Bank of India finding representation.
Another example – Maruti Suzuki India.
Even more curious is the case of Maruti Suzuki India. The stock was excluded from MSCI Index in February 2013 citing lack of foreign headroom. Maruti subsequently increased its foreign ownership limit post which the stock got re-included in the index in November 2015.
Maruti’s stock price was Rs 1,404 on the date of exclusion and Rs 4,556 on the date of re-inclusion. As an investor with money tracking the MSCI Index, one effectively sold at 1,400 and bought it back more than three times higher within three years, a period in which the MSCI Index returned only 30%.
Check Visual: Price chart of Maruti Suzuki India
On a country level, when compared to either the GDP of a country or its market capitalisation, MSCI weightages in Emerging Markets (EM) indices are also skewed. We find it remarkable that for a lower total market cap than India, Korea’s weight in the MSCI EM Index is over 80% higher. For India to be fully represented in the index in line with the share of EM market cap, India’s weight should be over 10% versus 8.9% now.
Check Visual: Comparison of India and Korea in MSCI EM Index
How MSCI decides to assign weights to stocks, sectors and countries is entirely their prerogative.
As per last count, about $13 billion to $15 billion was invested in Indian equities through MSCI benchmarked funds. Our simple submission to the owners of those $15 billion is that if you are investing money in a MSCI linked ETF beware of the distortions it creates and let the lure of low fees not make you penny wise and pound foolish.
