Index makers attracting attention from SEBI

(MainsGS3:Effects of liberalization on the economy, changes in industrial policy and their effects on industrial growth.)

Context:

Following a report by the U.S.-based Hindenburg Research levelling several allegations against the Adani group, global index providers like MSCI are reviewing some of these stocks’ inclusion in its indices that are replicated by many foreign portfolio managers.

About index funds:

With thousands of stocks traded in stock markets around the world and their prices often moving in different directions, most observers assess a market’s general trajectory amid these individual price swings by looking at broader benchmark indices.
For instance, the Sensex represents the 30 largest and most actively traded stocks on the Bombay Stock Exchange (BSE).
While economists and governments look at market indices’ movements as a barometer of the confidence levels in the economy, individual investors and fund managers use them as a gauge to compare their own portfolios’ performance.

Mutual funds and portfolio managers often pitch to prospective investors that their investment strategies have outperformed the Sensex or other relevant benchmarks.
For retail investors, selecting single stocks or mutual fund schemes has always been a challenge.
In 1976, American fund industry veteran and Vanguard Group founder John Bogle sought to address this by launching the world’s first index fund.
His idea was simple: if you can’t find the needle in a haystack, buy the whole haystack! And this could be achieved at much lower costs than those charged by fund managers actively trading portfolios, as it was a “passive” approach of buying the index and holding.
Now, such low-cost passive index funds and similarly structured exchange traded funds (that can be traded intra-day like a stock) manage trillions of dollars globally.

Making of indices:

Indices could be based on different industry sectors, size of companies (small-cap, mid-cap, etc) and quantitative parameters like liquidity and trading volumes and the weightage assigned to each stock in an index may vary based on their market capitalization or other gauges that index providers adopt.
NSE Indices owns and manages over 350 indices, with 117 ETFs listed in India and 12 ETFs listed abroad using these products as benchmarks.
Similarly, A BSE-S&P Dow Jones Indices joint venture called Asia Index Pvt Ltd, offers an array of indices used by global and domestic investors.
Each index is reviewed periodically and follows a methodology to add or drop stocks based on periodic trading data and other defined parameters.
MSCI and other global providers build indices that are used by international fund managers to earmark assets to stocks in different markets.
The methodologies usually provide for a review of the index composition or cessation of specific indices owing to factors such as ‘exceptional circumstances’, ‘market disruptions’ or difficulty in replicating the indices, however, they are not regulated by the Securities Exchange Board of India (SEBI).

Index funds in India:

While index funds and exchange-traded funds (ETFs) have been an option for Indian investors for about two decades, they have seen an exponential growth in assets since 2015.
From eight such funds in 2008, there are as many as 200 options now and about 16% of the roughly ₹41 lakh crore assets managed by India’s mutual funds are parked in index funds and ETFs.

SEBI’s proposal:

Noting the “growing dominance of Index Providers due to proliferation” of passive funds that drive capital flows towards assets that are part of a particular market index, SEBI has proposed to bring them under its regulatory purview.
While there is “an element of transparency” in their functioning, SEBI believes it is possible for index makers “to exercise discretion through changes in methodology resulting in exclusion or inclusion of a stock in the index or change in the weights of the constituent stocks”.
Their decisions not only impact volumes, liquidity and price of such stocks but also impact index funds’ returns to investors.
Concerned about possibilities of conflict of interest arising in the governance and administration of indices, SEBI has proposed to introduce an accountability mechanism for them.
The plan, likely to be implemented soon, includes mandating SEBI registration for index providers and subjecting them to norms pertaining to eligibility criterion, compliance, disclosures and periodic audits.
Penal action is envisaged by SEBI in case of non-compliance and incorrect disclosures, among other things.