Photo: iStock
Photo: iStock

Opinion | How Indian indices are maturing

In India, the quality and design of indices has evolved a lot over time

As large sums of money flow now follows global indices, it is important to understand how global index providers decide on country classifications and weightages. A global equity index typically has two components: a developed market index and an emerging market index. Until the ’90s, emerging market investments were not considered mandatory for all large institutional investors, but that has changed and global investment portfolios are now the norm.

Another change is that markets used to be classified on the basis of their GDP per capita, size of the stock market, and accessibility criteria, since most of these parameters were in sync with each other. However, given the growing size of global fund flows and the growth of emerging markets, a number of criteria are now reviewed, including the presence of a strong regulatory authority, ease of repatriation of funds, custody, clearing and settlement infrastructure, and transparency in decision-making, liquidity and transaction costs. While index providers specify the classification criteria, the actual decision-making depends on large market consultations. Market participants—including asset managers, traders and asset owners—are polled in their views for each of the market criteria annually or biannually. Based on the feedback, markets are classified as developed, emerging or frontier. The market’s weight within the index is derived from its float-adjusted market capitalisation. This means that the sum of the float-adjusted market cap of the stocks included in the market defines each market’s weight in the index. Countries that have restrictions on foreign investors have a percent limit applied to the market capitalisation to give a clear picture of what is actually available to foreign investors. Recently, this issue has been muddied considerably by the multiplicity of restrictions and access provided by markets like China, where it is hard to pin down a single number.

Earlier, we spoke of frontier markets, a category in which markets are typically small or accessible in a limited way. Markets like Ghana, Tunisia, Bangladesh, and Sri Lanka fall in this category. Markets graduating from frontier to emerging and emerging to developed can cause a big change in fund flows to a country. While a move from frontier to emerging is welcomed across the board, the story can be different for a move from emerging to developed. Israel had an approximate 3% weight in an emerging market index a few years ago. When it graduated in 2010, it fell to 0.4% of a developed market index. This kind of a move can cause fund flows to considerably dry up for a market.

A stipulation by Sebi for the mutual fund industry outlines how to treat size classifications, suggesting that funds need to be explicit in their stock selection and fund categorisation. Sebi laid down rules for categorising funds based on component stock sizes, and fund houses have to adopt the rules by Q1 2018. Index providers in India have been offering size indices for many years, but asset managers have tended to disregard these criteria in favour of more customised approaches. As investor attention in India has focused more on indices, the natural value that indices can bring has become more evident. Indices provide transparency, rules and a clean structure to the investment landscape, and the result can be beneficial for investors.

In India, the quality and design of indices has evolved considerably over time. Over time, smart beta indices for low volatility, value, momentum and other factors are also available. An environmental, social and governance (ESG) index that selects stocks based on their ESG scores has also been launched. In addition, fixed income indices are available from Crisil and have been popular with investors.

While the use of indices is just beginning to take off in India, the rapid growth in the number of index launches has grown exponentially, with the expectation that markets will mature rapidly and demand for well-designed indices will ratchet up. The world of indexing is constantly growing and evolving, and Indian index providers have geared up to match the global pace.

Alka Banerjee is CEO, Asia Index Pvt. Ltd

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