Does it make sense to place caps on sector weights in indices?

  • The National Stock Exchange may cap individual sectors in the Nifty 50 index, according to reports
  • Neil Borate asks experts if caps on individual sector is beneficial or would run contrary to the principle of free float market cap-based indexing

The National Stock Exchange may cap individual sectors in the Nifty 50 index, according to reports. This comes at a time when the banking and finance sector has assumed a huge share of the index—around 37% weight. Such a cap would have huge implications for instruments that are benchmarked to indices, such as exchange-traded funds that replicate the composition of the index they track. Even actively managed funds don’t stray too far from the index they are benchmarked against. Neil Borate asks experts if such a cap is beneficial or would run contrary to the principle of free float market cap-based indexing.

Nilesh Shah, Chief executive officer, Kotak Mahindra Asset Management

Nilesh Shah,CEO, Kotak Mahindra Asset Management
Nilesh Shah,CEO, Kotak Mahindra Asset Management

Staying with global best practices is perhaps safer

There is a demand to cap sectoral weights in an index to lower volatility, but consider the following.

First, globally, most indices don’t have a sectoral cap. NASDAQ, Taiwan and Korea are tilted towards tech, while Brazil and Russia towards commodities. The index should represent the economy in a way. Second, capping sectoral weight will distort returns if the better performing sector is capped in favour of a non-performing sector. For instance, if financials were capped in favour of textiles or real estate, then the index return could be vastly different. Third, volatility and speculation are like salt in food. Any excess is harmful but its absence is not desirable either.

Fourth, if we put sectoral caps on the local index contrary to global indices, it will ensure that local funds won’t be able to attract FII (foreign institutional investor) money. FIIs would prefer a non-capped index. Sectoral cap on index is not an easy decision but maybe staying with the global best practices is a safer bet.

Aashish P. Somaiyaa, Managing director and CEO, Motilal Oswal Asset Management

Aashish P. Somaiyaa, Motilal Oswal Asset Management
Aashish P. Somaiyaa, Motilal Oswal Asset Management

Sector capping is against grain of free market principles

Is the purpose of an index to be reflective of the current economic composition or to reflect the collective opinion of the markets as to where the growth is likely to be in the foreseeable future? Apart from this, the issue of “investability" and free float automatically results in higher representation of sectors and stocks that have lower promoter holdings or caps; for instance, banks. So the need for “investability" and free float at some level seems to be at loggerheads with the idea of having broader representation of sectors and capping sector weights.

Throw into this a debate on free market principle, prices being reflective of human judgment. Indirect impact of capping weights is to cap prices because many an “active" closet indexers have benchmark positions and passives anyway mimic the index. Capping a stock or sector just because the authorities feel that it’s not good for people to own so much of it because its “over-valued" is against the very grain of free market principles.

Koel Ghosh, Head of business, APAC, S&P Dow Jones

Koel Ghosh, APAC, S&P Dow Jones
Koel Ghosh, APAC, S&P Dow Jones

Sector capping is against grain of free market principles

Imposing limits on the structure or the rules of an index that deviate from the market will result in less applicability, credibility and, in some cases, liquidity (particularly if using derivatives to hedge as they are configured for more capitalization weighted frameworks). If the concern is that investors of products, which reference broad-based indices, are at greater risk, then this will not be solved or mitigated by specific index construction rules.

Introducing sector cap requirements on broad-based indices will impact products linked to those indices. For example, this could alter the risk-return profile of a product linked to that index (as constituents will be selected based on sector caps and not market capitalization, which is linked to performance). It could also alter the liquidity profile of the index.

Finally, it could also have implications for the wider economy as constituents that no longer qualify for indices potentially lose access to investor capital.

Kalpesh Ashar, CFP, proprietor, Full Circle Financial Planners and Advisors

Kalpesh Ashar, Full Circle Financial Planners and Advisors
Kalpesh Ashar, Full Circle Financial Planners and Advisors

Capping will bring more stability and diversification

I feel that the Nifty 50 that consists of the largest and best companies from various sectors should somehow come closer to mirroring the real growth in the economy.

Regarding capping a sector, I feel it would be a workable idea as presently financials constitute almost 37% of the index. Though banks are the lifeline of our economy, we can’t also turn our heads away from the issues non-banking finance companies are facing. These situations, both positive and negative, would be prevailing in every sector at a point of time and how the companies in that sector react to those situations should also be considered.

Hence, apart from market cap and price, the ongoing events being faced by a sector need to be considered before adding or reducing weightage to sectors. The world is watching the governance and ethics in our large corporates apart from their stock price. With a certain cap, it would bring more stability and diversification in our index.

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