JPMorgan began considering India’s inclusion in its global bond index in 2021, owing to Russia’s recent exclusion. It is surprising, considering India is one of the largest bond markets among emerging-market economies, with more than $800 billion in outstanding debt. Last year it included China yuan-denominated debt.

Expectations were that India’s weight would be at 10%, the maximum for a country in the index, resulting in the potential inflows of $30 billion from the move. However, getting included in these indices that financial firms or index holders manage is not easy. There is a strict criterion that has to be met.

Reserve Bank of India has taken steps to alleviate some concerns. It introduced a fully accessible route (FAR) in 2020, under which foreign investors and institutions can invest in Indian bonds without restrictions and investment caps. However, with the recent announcement, JP Morgan dashed hopes of inclusion, citing a heavy regulatory compliance burden.

On 30th September, Adani Enterprises replaced Shree Cement in Nifty 50, following its semi-annual review. Several other key indices have been rebalanced, including Nifty Next 50 or Junior Nifty, Nifty Bank, Nifty 500, Nifty 200, and Nifty 100.

The indices’ rebalancing happens twice in one year – in January and July based on multiple criteria, including market capitalization and liquidity.

Adani Total Gas, Bharat Electronics, Hindustan Aeronautics, IRCTC, Mphasis, Samvardhana Motherson International, and Shree Cements will be the new entrants of the Nifty Next 50. At the same time, Adani Enterprises, Jubilant Foodworks, Lupin, MindTree,  PNB, SAIL, and Zydus Lifesciences will be removed from the index.

It is easily observable that the entrant stocks witness massive fund inflows and the ones replaced see net outflows. However, it is worth noting that there is no change in the fundamentals per se to drive the prices of stocks to be included. More often than not, the premiums are temporary.

Then, what explains this price response, and what are its implications? 

First, from the theoretical point of view, such a price response violates the Efficient Market Hypothesis (EMH). Read this to understand better what EMH means https://www.alphacapital.in/blog/understanding-efficient-market-hypothesis/

With the rise in passive and index investing, index reconstitution is increasingly viewed as critical information. Many large institutional investors track indexes. Once a stock is known to be added to the index, it is argued that demand will increase dramatically—and the share price—as institutional investors rebalance their portfolios.

It is also valid for active funds and shareholders, who base their decisions on market capitalization. Taking a cue from this phenomenon, one would expect an upward price pattern in the days before the inclusion and vice versa for exclusions, accompanied by changes in volume. 

Index inclusion or exclusion announcements typically contain information that changes the public’s perception of the stock’s investment appeal. Investors perceive index inclusion to indicate lower risk and hidden positive details on management quality, longevity, or company health, increasing its future expected performance.

Inclusion in the index raises investor expectations about increased liquidity of the stock, making it less risky to invest in it. Secondly, stocks that are part of an index receive greater investor interest and advanced monitoring, raising the stock price. These explanations align with the Information Signalling Hypothesis and the Liquidity Hypothesis.

Though NIFTY 50, NIFTY 100, and NIFTY Next 50 are all large-cap indices, they are pretty different in how they have been constructed. It is better to understand them better to make informed investment decisions.

NIFTY 100 index is a basket of India’s 100 large-cap companies in total market capitalization (including shares held by the promoters and the ones freely available to trade), with Financial Services, IT, and Consumer Goods dominating it. While rebalancing, emerging stocks with increased market cap automatically replace poor-performing companies whose stock prices dropped significantly.

Nifty 100 is subdivided into Nifty 50 and Nifty Next 50. For a Nifty 50 constituent, the challenge will be presented by the constituent stocks of Next 50. Similarly, for the Next 50, the Nifty Midcap 100 stocks in NSE 200 would be the challengers. Unicorns in India would act as challengers to these Nifty Midcap 100 stocks.

One can see a similar trend in the US: Facebook, Apple, Amazon, Netflix, and Google (FAANG) overshadow the previous giants, General Electric (GE), Pfizer, ExxonMobil, etc., in S&P 500. Investors have traveled from FAANG to MATANA (Microsoft, Apple, Tesla, Alphabet (Google), Nvidia, and Amazon). It is often said that the returns of the largest companies tend to suck after they become the largest (https://www.linkedin.com/posts/drmukeshjindal_the-curse-of-being-the-largest-company-the-activity-6975694633947291648-EXcZ/)  

My dear readers,

Focus on the crossovers, for instance, between Nifty 50 and Nifty Next 50 to generate superior returns apart from solely mapping the index.

Emerging sectors and stocks would gradually be added, replacing the incumbent stocks to reflect the economic activity truly.

Understanding disruptive innovation can be a powerful tool in the hands of investors for making investment decisions.

Vulnerable incumbent companies may not reap the earlier benefits in the present disruptive circumstances.

Identifying companies that pre-empt disruption and take advantage of it will be essential to earn abnormal returns. (See https://www.alphacapital.in/blog/economic-disruption-or-creative-destruction/)

Be bullish on India and believe in the India growth story. The abnormal returns are not earned after the inlcusion but taking action before it happens be it any asset class – equity or bonds.

Best Regards

Ms. Tarunika Jain Agarwal Ph.D. 

Alpha Research