The down­side of pas­sive in­vest­ing

The Pak Banker - - OPINION - Swanand Kelkar

THE lure of pre­dict­ing short-term price move­ments is hard to re­sist for mar­ket par­tic­i­pants. Whether or not it ben­e­fits in­vest­ing out­comes is highly de­bat­able but it's an en­joy­able pas­time none­the­less. With the rise of pas­sive in­vest­ing over the past few decades, al­beit to a smaller de­gree in In­dia, a re­cent ad­di­tion to this has been the game of pre­dict­ing which stocks will get in­cluded in the bench­mark indices at their pe­ri­odic re­views. To the unini­ti­ated, pas­sive in­vest­ing is an ap­proach that seeks to match, not beat, the re­turn of a par­tic­u­lar stock in­dex by at­tempt­ing to to­tally or sub­stan­tially mimic the in­dex. While lo­cal in­vestors are fo­cused on the CNX Nifty or S&P BSE Sen­sex, for­eign in­vestors bench­mark to indices cre­ated and main­tained by the MSCI or FTSE.

The game is that if one is able to guess the in­clu­sion prob­a­bles and buy those be­fore pas­sive money is forced to buy, one stands to make a hand­some short-term profit. Just be­fore the an­nounce­ment date, fre­netic ac­tiv­ity starts in try­ing to pre­dict such in­clu­sions. The time gap be­tween the an­nounce­ment and the in­clu­sion date is typ­i­cally two to three weeks and that's the pe­riod over which one is try­ing to make a quick buck. To be sure, this has ab­so­lutely noth­ing to do with the fun­da­men­tals of the stock. What it does, how­ever, is ramp up the share price of in­clu­sion prob­a­bles ahead of the in­dex in­clu­sion date. Mor­gan Stan­ley re­search that an­a­lysed 50 in­stances of MSCI in­clu­sions from 2010 shows that in the month lead­ing up to the in­clu­sion, the me­dian out­per- for­mance over MSCI In­dex was 5%. On the other hand, in the one month af­ter the in­clu­sion, the same stocks un­der­per­formed the in­dex by 3%. Sim­ply put, this means if you have in­vested in an MSCI track­ing ex­change traded fund (ETF), by ad­ver­tis­ing the amount and date on which you were go­ing to buy a cer­tain stock, you en­sured that you bought it pretty much at the peak of its rel­a­tive per­for­mance. Put char­i­ta­bly, this is mo­men­tum in­vest­ing. Put plainly, this is dumb in­vest­ing.

There are facets of how the com­po­si­tion for MSCI indices is de­ter­mined that are puz­zling. Like most indices, the MSCI uses the free float mar­ket cap­i­tal­iza­tion to de­cide weights of stocks in its indices. This im­plies that mar­ket cap­i­tal­iza­tion ex­clud­ing the share of the founders or pro­moter will be con­sid­ered since that is what is avail­able for other in­vestors to trade in. How­ever, un­like do­mes­tic indices, MSCI also uses a spe­cial ad­just­ment called For­eign In­clu­sion Fac­tor (FIF) and for­eign room. What this means is that it con­sid­ers the head­room avail­able for new for­eign in­vestors to in­vest in the stock. Be­fore we get into why that is a big deal, see what this ad­just­ment costs the MSCI ETF in­vestors. Ver­sus the BSE 100, MSCI In­dia has un­der­per­formed by 1.5% an­nu­al­ized over the past five years and by 1.3% ver­sus the Nifty. This is sig­nif­i­cant as the Nifty re­turn over that pe­riod was 5.3% while the MSCI In­dia re­turn was only 4%. Mind you, both th­ese are indices with a sim­i­lar com­po­si­tion phi­los­o­phy ex­cept for the FIF ad­just­ment and we are not even get­ting into the ac­tive ver­sus pas­sive in­vest­ing de­bate here.

It is eas­ier to ex­plain the con­cept of FIF with an ex­am­ple. Let's take the case of HDFC Bank, which does not find rep­re­sen­ta­tion in the MSCI In­dex de­spite be­ing the fourth largest stock in In­dia with a mar­ket cap­i­tal­iza­tion of $40 bil­lion. As of end De­cem­ber 2015, 47.4% of HDFC Bank's equity was owned by for­eign port­fo­lio in­vestors (FPIs). The over­all limit for for­eign­ers to own a bank­ing stock, as im­posed by the Re­serve Bank of In­dia, is 74%, so if you add Hous­ing De­vel­op­ment Fi­nance Corp. Ltd's hold­ing of 26.5% to the FPI hold­ing of 47.4%, for­eign­ers can­not buy fresh stock from the mar­ket. How­ever, the stock is freely traded on the for­eign win­dow-one for­eign in­vestor can buy from an­other in the mar­ket. Av­er­age daily traded value on the for­eign win­dow is close to $14 mil­lion ver­sus $23 mil­lion on the lo­cal win­dow. In HDFC Bank's case, the value of FPI hold­ing in the stock is al­most $19 bil­lion and that float is freely avail­able to for­eign­ers. As the FPI share­hold­ing in In­dian eq­ui­ties is go­ing up, this has and will cre­ate more such head­room is­sues es­pe­cially in sec­tors with reg­u­la­tory caps like bank­ing.

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