Explained | Why do index makers attract SEBI’s attention?

With thousands of stocks traded on stock markets around the world and their prices often moving in different directions, most observers judge a market’s overall trajectory amid these individual price swings by looking at broader benchmark indices. | Photo credit: Getty Images/iStockphoto

The story so far: Following a report by US-based Hindenburg Research raising various allegations against the Adani group, global index providers such as MSCI are reviewing the inclusion of some of these stocks in their indices that are replicated by many foreign portfolio managers. India’s National Stock Exchange (NSE), on the other hand, has announced that the shares of five Adani group companies will be added to 14 different indices managed by a subsidiary called NSE Indices, while retaining the group’s flagship Adani Enterprises and Adani Ports and SEZ in the Handy 50.

Why are indices important and what are index funds?

With thousands of stocks traded on stock markets around the world and their prices often moving in different directions, most observers judge a market’s overall trajectory amid these individual price swings by looking at broader benchmark indices. For example, the Sensex represents the 30 largest and most actively traded stocks on the Bombay Stock Exchange (BSE). While economists and governments view the movements of market indices as a barometer of the level of confidence in the economy, individual investors and fund managers use them as a gauge to compare the performance of their own portfolios. Mutual funds and portfolio managers often pitch to potential investors that their investment strategies have outperformed the Sensex or other relevant benchmarks. It has always been a challenge for retail investors to select individual stocks or mutual funds. In 1976, John Bogle, a US fund industry veteran and founder of the Vanguard Group, attempted to address this problem by launching the world’s first index fund. His idea was simple: if you can’t find the needle in a haystack, buy the whole haystack! And this could be achieved at a much lower cost than that charged by fund managers actively trading portfolios, as it was a “passive” approach to buying the index and owning it. Now such low-cost passive index funds and similar structured exchange-traded funds (that can be traded intraday like a stock) manage trillions of dollars worldwide.

How popular are such funds in India?

While index funds and exchange-traded funds (ETFs) have been an option for Indian investors for about two decades, they have seen exponential growth in assets since 2015. Of the eight such funds in 2008, there are now as many as 200 options. About 16% of the assets of about ₹41 lakh crore managed by the Indian Mutual Funds are parked in index funds and ETFs.

How are indexes created and what do providers do?

Indices can be based on different industries, the size of companies (small-cap, mid-cap, etc.) and quantitative parameters such as liquidity and trading volumes and the weight assigned to each stock in an index can vary based on their market capitalization or other gauges that index providers employ. NSE Indices owns and manages more than 350 indices, with 117 Indian-listed ETFs and 12 foreign-listed ETFs using these products as benchmarks. Similarly, a joint venture of BSE-S&P Dow Jones Indices called Asia Index Pvt Ltd offers a range of indices used by global and domestic investors. Each index is periodically reviewed and follows a method of adding or dropping stocks based on periodic trading data and other defined parameters. MSCI and other global providers build indices that are used by international fund managers to allocate assets to stocks in various markets. The methodologies usually provide for index composition revision or discontinuation of specific indices due to factors such as ‘exceptional circumstances’, ‘market disruptions’ or difficulties in replicating the indices. However, they are not regulated by the Securities Exchange Board of India (SEBI).

What did SEBI propose?

Given the “growing dominance of index providers due to proliferation” of passive funds directing capital flows to assets included in a particular market index, SEBI has proposed bringing them under its regulatory purview. While there is “an element of transparency” in their operation, SEBI believes it is possible for index makers “to exercise discretion through changes in methodology that result in the exclusion or inclusion of a stock in the index or change in the weights of the constituent shares”. Their decisions affect not only the volumes, liquidity and price of such stocks, but also the returns of index funds for investors. Concerned about potential conflicts of interest that may arise in the management and administration of indices, SEBI has proposed introducing an accountability mechanism for this. The plan, which is likely to be implemented soon, includes requiring SEBI registration for index providers and subjecting them to standards regarding eligibility criteria, compliance, disclosures and periodic audits. In the event of non-compliance and incorrect statements, SEBI is considering criminal prosecution.

(With input from Prashanth Perumal)