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Passive paradox: To buy more, sell a bit

Unintended consequences of mindless rules-based investing

Passive paradox: To buy more, sell a bitAnand Kumar

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The other day, Helios CEO and Fund Manager Samir Arora tweeted these cryptic lines, "Adapting the dialogue from the movie Speed: 'There's a bomb on a bus. Once the bus goes 50 miles an hour, the bomb is armed. If it drops below 50, it blows up. What do you do? What do you do?" Market to FIIs: "If you sell more HDFC Banks shares, the FII ownership falls, MSCI doubles the weight of the bank in the indices, forcing many FIIs/ETFs/Index funds and funds following the benchmark to buy. If you don't sell, MSCI does nothing, and there is no additional buying...'

Can you understand what is happening here? MSCI is an American company that runs many stock market indexes, which are followed by many global investors. MSCI periodically adjusts the weightage of stocks in its indexes based on factors like the free float. In this instance, Samir Arora creatively uses a movie dialogue to explain a dynamic with HDFC Bank shares. If FIIs sold a tiny amount of HDFC Bank shares, it could paradoxically trigger increased buying. How so? Selling would reduce free float. MSCI's methodology would then call for increasing the stock's weightage in the index. This would compel index funds and ETFs that mirror the index to buy more shares to match the higher weight. Active funds benchmarked to the index may also feel pressure to add to their positions.

On the other hand, if FIIs refrain from selling, MSCI would likely maintain HDFC Bank's current weightage, resulting in no incremental buying pressure from index-tracking funds. In this case, that happened last week. If the FIIs had collectively sold just 0.05 per cent of the stock, it would have doubled the stock's weightage. If that happened, then a lot of ETFs and other investors who were obligated to shadow the index would have to double their holdings.

This was widely reported in the investing media and commented upon on social media. Most people saw it as an interesting fact of life in the markets, just the way investing works. However, a handful called it out for what it is-foolishness. Here is an index that large investors are following, and one of the rules of the index means that if some investors sell a tiny amount then a whole lot of people would have to buy more-a lot more. If they did that, then the price would very likely go up.

What is the point of investing like this? This is a prime example of how the mechanics of index investing can sometimes lead to outcomes that seem divorced from a fundamental analysis of a company's prospects. In principle, investors should buy or sell a stock based on their assessment of the company's intrinsic value and future potential. However, the rise of passive investing through index funds and ETFs has created a new dynamic. These funds don't make active decisions about individual stocks; they simply aim to match the composition of an index. When an index provider like MSCI makes a rule-based change to the weightage of a stock, it can trigger significant buying or selling pressure that has nothing to do with the company's fundamentals.

This seems counterintuitive and, in fact, irrational from any sensible investing perspective. It's a situation where the tail (index rules) may be wagging the dog (stock prices). This kind of mechanical, rules-based investing can contribute to market distortions and even bubbles. This is not necessarily an indictment of index investing as a whole, but it does highlight some of the potential unintended consequences and inefficiencies that can arise.

Indexes are fine as far as simple ones like the Sensex, Nifty or the corresponding midcap indexes go. However, indexes constructed specifically as investment portfolios (as has become the trend now) make no sense. Those constructed at the fringes of the market, like microcap indexes, also make a poor model for an actual investment portfolio.

Investors who want to invest in passive funds should stick to mainline indexes and not dabble in the fringe ones.

Also read: Panic and sudden meltdowns

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