MSCI India Index Rebalancing And Returns

Index investing is the most simple way of taking exposure to equity markets, often referred to as passive investing. When you invest in stocks forming an Index assigning funds in stocks on the basis of the weightage they carry in the underlying index, then your investment will mimic the returns of the index. Retail investors who do not understand equity markets very well and neither have a view on sectoral funds, thematic funds etc. can ideally invest in index funds. Index funds are fairly diversified, entail low transaction costs, are relatively low risk and earn returns which replicate the returns of the index. Index investing is passive investing, where the fund manager's role is just to build a portfolio similar to the index in terms of composition and stock weightages. So technically, he is not obliged to beat the underlying index. 

In India, the Nifty and the Sensex are the bellwether equity indices, but MSCI India Domestic is a globally tracked index where MSCI is the world’s largest compiler (Morgan Stanley Capital International). Global investors who are keen to invest in India through Index funds would be more comfortable investing in MSCI India Domestic or invest in stocks which are part of MSCI INDIA. 

On November 7, 2019 MSCI made announcements of some changes in the composition of the MSCI India domestic Index and included Berger Paints, DLF, HDFC AMC, ICICI Prudential Life Insurance Company, Indraprastha Gas, Info Edge, SBI Life, Siemens India. Those excluded from the index were BHEL, Glenmark Pharmaceuticals, Indiabulls Housing Finance, L&T Finance, Vodafone Idea and Yes Bank. Stocks which were included in the Index like HDFC AMC, DLF, Indraprastha gas etc. rallied immediately. 

A company gets included into the index when it qualifies on criteria entailing liquidity, impact cost, listing history, free float market capitalization etc. The index is periodically revised and companies get replaced in the Index. Every index construction has a methodology and is unique in its own way. Generally, it is believed that companies which are included in the Index would do well in the near future, and many investors seek to include them in their portfolio due to higher expectation of return in future. Whenever there are changes in the index composition, index funds need to improvise their portfolios accordingly to match the index composition. This usually results in share price appreciation of stocks that get included in the Index. 

MSCI India Domestic Index was launched on February 23, 2015 and the index comprised of 80 stocks. After the announcement on November 7, 2019, where 8 stocks were included and 6 excluded, there should be effectively 82 stocks as on 26 November, 2019. Since the launch of the index, there have been .

Retail investors who do not understand equity markets very well and neither have a view on sectoral funds, thematic funds etc. can ideally invest in index funds.

changes in the index composition with companies like Siemens India, Tata Motor, Vakrangee, IDFC Bank, Power finance and Punjab National Bank have been replaced with other companies (34 companies). 

Index rebalancing happens at regular intervals and is reported by the exchanges to all the investors in advance. MSCI also announces the next eight index review dates on its website. The literature generally reports a positive price effect on shares included in the index and negative price effect on shares excluded from the Index. We intend to test this hypothesis using the data of MSCI India Index which is sourced from the MSCI website and price of shares on the date of inclusion or exclusion are sourced from Thomson Reuters database. Companies that had merged or amalgamated were removed from calculation. 

Methodology 

In this study, we looked at the share price performance of companies which were included and excluded from the MSCI India Index between the periods of 2015 to 2019. To test this hypothesis, we form two buckets, “Returns of Shares Excluded from Index” and “Returns of Shares Included in the Index”. 

We calculated returns for different time periods like return of one month after inclusion (+1M) and returns of one month before inclusion (-1M). In a similar way, we calculate one year returns pre and post inclusion/exclusion Index rebalancing happens at regular intervals and is reported by the exchanges to all the investors in advance. MSCI also announces the next eight index review dates on its website. The literature generally reports a positive price effect on shares included in the index and negative price effect on shares excluded from the Index. for which the period of one year from the date of inclusion/exclusion is not completed, have been excluded from the sample for calculating annual returns pre and post event. 

Conclusion 

The empirical analysis suggests that an average return for +1 year duration of shares excluded from the index is 16%, whereas, the average return for shares included in the index for +1 year duration is 8%. This is contrary to the belief that shares which are included in an index should appreciate higher compared to the shares that are excluded. Now let’s look at average price returns for one year before the inclusion/exclusion date. The shares which have been excluded have given a negative return of 49% as compared to positive 52% returns on shares included in the index. This strongly suggest that shares which are included depict a strong financial performance and have already date. The average +1 month returns of stocks which are included are higher than the returns on stocks which are excluded; this explains the euphoria in price when a stock gets included in the Index. Our findings on MSCI India Index are very similar to our study on NIFTY Index Inclusion and exclusion. 

A stock which is included in the index is at a premium valuation near the date of its inclusion in the index, and this premium valuation limits it future potential. Whereas, the stock which is excluded from the index is available at a beaten down price and thus, the returns could be much higher if the financial performance of the company improves. To put it simply, investors can find a good pick with reasonable price-value gap amongst the stocks that are excluded from the index. 

Retail investor should look for companies which have potential of turning around and are excluded from the index. These stocks are at beaten down prices close to the event date and there is a strong likelihood of good returns if the company is fundamentally strong and the management is working towards a better financial performance. For higher returns, investors should focus on picking quality stocks from the list of companies which are excluded from the Index. 

Index rebalancing happens at regular intervals and is reported by the exchanges to all the investors in advance. MSCI also announces the next eight index review dates on its website. The literature generally reports a positive price effect on shares included in the index and negative price effect on shares excluded from the Index.