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Why are most ETFs based on large-cap indices?

Dhirendra Kumar highlights the challenges related to small- and mid-cap ETFs and index funds.

What is the reason that most ETFs and index funds are in the large-cap space only? Why don't we have them in the mid- or small-cap space?
- Ajay

Recently, some fund companies have launched small- and mid-cap ETFs and index funds. Around 10-15 years ago, the BSE 500 benchmark came into being and it was very difficult to replicate the BSE 500 index. The index comprised about 50 stocks and if the corresponding index fund got about Rs 15-20 crore incremental money in a month, the fund was unable to buy the underlying stocks because of the absence of liquidity in the underlying stocks. The Nifty and Sensex are easy to replicate, as they comprise the top 50 and top 30 companies, respectively. These companies are highly liquid and if the funds replicating such indices get Rs 50 crore or Rs 100 crore or even Rs 500 crore on a daily basis, they will be able to deploy the money easily.

However, it is very difficult to deploy this amount of money in the mid- as well as small-cap index, as these indices act merely as a barometer to understand how the stocks are doing. But they are not designed in a manner that one should be able to invest in those indices in exactly the same proportion. Hence, replicating these indices by index funds is difficult. One may deploy Rs 10-25 crore on a daily basis in these indices without much impact cost. But when you buy stocks of a small company in a large quantity, the stocks will have no liquidity and the act of buying will drive up the index, leading to an impact cost. It is a chicken and egg story. Until we have more money coming in such index funds or more index funds getting created, there won't be liquidity.

Also for Indian small- and mid-cap companies, promoters have a very significant holding and there is not enough liquidity in the market. Even if the price goes up, there are not too many sellers. I know of companies that are a part of the index with a worth of Rs 5000-crore capitalisation or Rs 7000-crore capitalisation but it is extremely difficult to buy stocks of these companies even for a crore of rupees every day. These can be a good investment option for small investors coming up with small investment amounts on a daily basis. But their daily liquidity can be so small that it cannot support meaningful investments from index funds, making it difficult for the funds to replicate the corresponding index. So, my sense is that such ETFs and index funds will be very hard to run. Open-ended small-cap index funds may still be possible but beyond a certain scale, it will not be possible to sustain them. There is a modest beginning of the launch of some of these small- and mid-cap index funds. Let's see how it shapes up.

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