Decoded: What is index rebalancing, and how does it impact stocks?

Key index providers such as MSCI, FTSE, and the homegrown Nifty undergo quarterly, or semi-annual rejig of their indices. Read more to find out what it means and how it affects stocks

If you track financial news, you would have read or heard the term "index rebalancing" in the past few weeks. This would have been in relation to the MSCI and the Adani group. Key index providers such as MSCI, FTSE, and the homegrown Nifty undergo quarterly, or semi-annual rejig of their indices. But what exactly is index rebalancing, and how does it affect a stock?

What is an index?

An index is a gauge of the performance of a basket of securities. For instance, the MSCI India or Nifty or the BSE Sensex indices are the gauges that tell us the performance of the Indian markets. Similarly, MSCI Emerging Market or MSCI Asia are indices that tell us how the Asian markets or the developing markets are doing. There can be a sector or theme-specific index as well, e.g., the Bank Nifty or the Nifty IT—indices that signal how the domestic banking stocks or tech stocks are doing.

How are these indices formed?

An index provider has set rules and eligibility criteria for formulating an index. Factors such as market capitalisation, free float, investment cap on foreign portfolio investors (FPIs), liquidity and sectoral composition are key for a stock to qualify. The most important criterion, however, is the free float market cap or public float. You can learn more about it here.

Take the example of the benchmark Nifty 50 index. As the name suggests, the index comprises 50 stocks listed in India with the highest free float market cap (mcap). The greater the free float mcap, the higher will be the weightage of the stock. Reliance Industries is currently the highest-weighted stock in the Nifty 50 index. The company with the lowest free float mcap will have the lowest weightage. Also, index providers give importance to sector composition to ensure that the index has a representation of companies belonging to diverse sectors. For a globe index like MSCI India, the broad principles are the same. However, such indices give importance to FPI legroom as these indices are used by funds outside India.

What is an exchange-traded fund or an ETF?

An ETF is a passive way of investing in the stock markets. Instead of selecting stocks individually, an investor can simply invest in a basket of stocks through an ETF. The Nifty 50 index is the most popular in India, with assets under management (AUM) of over Rs 2 trillion. This essentially means investments worth Rs 2 trillion have been indirectly made in the Nifty 50 stocks through the ETF route. Similarly, the MSCI EM index has an AUM of $300 billion.

What is rebalancing an index?

A company that is not part of an index may do so well that it may become bigger than the companies that are part of an index. So how does that company make it to the index? For that to happen, index providers conduct so-called rebalancing or review of their indices every quarter. During a review, they assess if a stock or stocks which are not part of their index can dislodge a stock which is part of the index. This is done based on pre-determined quantitative parameters like free-float market cap, sector composition etc. For instance, Tata Consumer Products replaced state-owned Gail India in the benchmark Nifty 50 index in March 2021. This was because the former's free float mcap had surpassed that of Gail during the review period.

What are the implications of index rebalancing?

Typically, a stock that gets added to a large index tends to do well, while the one that gets removed tends to underperform. This is because whenever a stock is added or removed from an index, the ETFs tracking the index also have to realign their portfolios. In other words, they have to sell a stock that is removed and buy a stock that gets added. Analysts try to predict which stock will get added and removed based on publicly available data ahead of an official announcement so that they can position themselves to benefit from the ensuing rebalancing by ETFs.

What is a foreign inclusion factor (FIF)?

FIF is a term used in the context of global indices. As mentioned earlier, indices compiled by MSCI and FTSE are mostly tracked by foreign funds, so the availability of investment room for FPIs is critical. A stock cannot be added to a global index if the FPI investment limit is exhausted or close to getting exhausted. 

FIF is a key metric which takes into account the actual free float available for FPIs. For instance, HDFC Bank being such a large corporation, isn't part of the MSCI indices as there is not enough legroom in the company for FPIs. 

More recently, MSCI announced that it will reduce the FIF of certain Adani group stocks after market feedback that the actual FPI holding should be treated as less than what is publicly stated due to the presence of certain "friendly FPIs." The FIF reduction in Adani group stocks was to take place this month. However, as some of the stocks have been consistently hitting lower circuits has got pushed to May.