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NSE to cap sectoral indices weightage in India – Is it required?
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NSE is considering placing caps on sectoral weights in the benchmark Nifty 50 index in order to provide more diversity and reducing sector concentration. Nifty 50 represents 13 sectors through 50 stocks. However, financials; comprising of banks and non-banking financial companies, account for around 37% of the index weight; thereby exerting a relatively high influence on the market. The financial services sector accounted for the highest weightage in the last 10 years, according to NSE data.

Sectoral break-up for Nifty 50 index and for all NSE listed stocks

Weights (%)

Mar-19

Mar-16

Mar-14

Jun-09

Sector

All NSE listed stocks

Nifty 50

All NSE listed stocks

Nifty 50

All NSE listed stocks

Nifty 50

All NSE listed stocks

Nifty 50

Financial Services

31.88

37.36

25.71

30.30

23.75

25.95

20.72

21.87

Energy

11.77

14.59

9.95

11.71

12.21

14.35

19.13

24.78

IT

10.92

14.14

12.65

16.91

14.07

17.83

8.83

10.51

Consumer Goods

13.31

11.54

12.25

10.20

13.30

12.73

9.23

8.19

Automobile

7.10

6.90

9.20

9.68

8.30

8.86

4.67

3.88

Metals

3.58

4.09

2.86

2.79

4.62

4.83

5.18

5.45

Construction

4.07

3.79

4.18

3.80

4.29

4.37

7.46

7.60

Pharma

4.82

2.58

8.15

7.44

6.71

5.74

4.42

2.48

Cement & Cement products

2.31

1.66

2.71

2.90

2.70

2.87

3.25

2.73

Telecom

1.37

1.50

2.26

2.14

2.41

1.84

5.85

8.01

Fertilizers & Pesticides

0.85

0.65

0.70

-

0.56

-

0.68

-

Services

1.97

0.64

2.33

0.83

1.73

-

2.02

-

Media & Entertainment

0.82

0.57

1.19

0.80

1.16

-

0.97

-

Industrial Manufacturing

2.82

-

3.71

0.51

2.74

0.61

5.38

4.49

Chemical

1.18

-

0.83

-

0.61

-

0.61

-

Textile

0.73

-

0.89

-

0.49

-

0.46

-

Healthcare Services

0.40

-

0.37

-

0.27

-

0.19

-

Paper

0.09

-

0.08

-

0.08

-

0.10

-

Free float market capitalization coverage

 

66%

 

65%

 

71%

 

65%

*Based on average FF market cap for 6 months ending corresponding dates

NSE Market Consultation Paper


Not reflective of the real economy:

Improper weights skew the performance of the index which may not be reflective of the real economy. Sectors like metal and mining don’t have adequate representation in the Nifty50. The financial services sector's weight is also much higher as compared to the sector’s weight in Indian economy while taking into account its contribution to our GDP. Thus, realignment of the stock market with the real economy becomes essential.

While this may be a good idea, one may also note that most popular global indices don’t have a sectoral cap, but the weight of the top sector in markets like the US and the UK is also little compared to India. For instance, in the Dow Jones Industrial Average, the technology sector has the highest weight at 24.93%, followed by financials at 21%. Similarly, the FTSE 100 index of the London Stock Exchange has technology as the biggest sector with 19.6% weight, followed by consumer durables and real estate at ~15% each.

Considering the issues listed above, NSE has floated a consultation paper seeking whether to cap sectoral weightage at 25%, 30%, 35%, 40% or peg it to the sectoral market capitalization of all the listed companies on the NSE. For instance, if the market cap of all listed companies in the financial services space is 25% of NSE’s total market cap, then the sector is capped at 25% in the index. The proposal may or may not lead to any changes in the way indices are structured.

While the 'sector-capping' move could lead to a sell-off in financial stocks, some of the other arguments against the action include the following:

1) The largest sector may not have adequate representation and a broad-based index may not represent actual market performance if a sectoral cap is introduced.

2) Sectoral caps could change the risk profile of the index as its constituents would no longer be chosen based on market capitalization; which would lead to lower liquidity. Imposing a limit will also impact applicability, credibility, and in some cases, liquidity of the index in an adverse manner; particularly if derivatives used to hedge are configured for more capitalisation-weighted frameworks. A scenario analysis of the S&P BSE Sensex showed it took nearly three days to liquidate a basket of Sensex stocks worth Rs 500 crore if the sectoral cap is at 25% compared to two days now.

3) The cap on sectoral limits may lead to frequent churn in portfolio as index sectoral caps will be reviewed every quarter. This will remove the cost-effectiveness of passive funds like ETFs, which currently have low-cost management and require limited fund manager intervention.

4) The introduction of sector-wise caps for benchmark indices will impact the investment products linked to such indices, while increasing the trading time and costs in case of liquidation.

5) Capping weight of a sector will affect returns adversely if the better performing sector is capped in favour of a non-performing sector. For instance, capping financials in favour of textiles will have a substantial impact on the index return.

Capping a sector to avoid concentration on the grounds that it is over-valued is against the principles of free market.  Further, the move will only result in less applicability, credibility and, even liquidity (particularly if using derivatives to hedge as they are configured for more capitalization weighted frameworks). While 'capping' sectoral weightage may bring more stability and diversification in the index, staying with the global best practices may be a safer bet.

 

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