Index weighting conundrum: Mutual fund industry knock on Sebi's door

They feel regulator should allow active funds to invest above the prescribed single-stock limit

The mutual fund industry has approached the Securities and Exchange Board of India (Sebi) to highlight concerns over higher weighting of individual stocks in benchmark indices, said three people familiar with the matter.

The problem has come to the fore after the recent run-up in the Reliance Industries (RIL) stock, which has posed a challenge to fund managers, as active funds aren’t permitted to hold more than 10 per cent in a single stock in a particular scheme. In addition, individual fund houses could have softer limits that prevent buying a stock above certain thresholds, say 5 per cent or 7.5 per cent of the overall scheme holding.

RIL had a weighting of 14.9 in the Nifty50 as of September 30. HDFC Bank, till recently, also had a weighting of over 10 per cent.  

The industry wants Sebi to allow active funds to invest more than the prescribed single-stock limit, to the extent of the stock’s weighting at a given point of time. This means that if stock A’s weighting in an index goes up to, say, 12 per cent, equity schemes should be allowed to up their holding in A to 12 per cent. 

“There’s been an active discussion between Sebi and Amfi on the issue. If a stock’s weight rises over 10 per cent, it creates a ‘forced underweight’ situation for the scheme on that stock. This is a serious issue that needs to be addressed; else in a year or two every large-cap fund will be underperforming the benchmark indices,” said a senior industry official, speaking on the condition of anonymity.

The official added that equity schemes investing above the 10 per cent limit in a stock that has surpassed the limit will not be taking any additional risk as the stock would have enough liquidity because of its higher weight. At present, only index funds and exchange-traded funds can invest above the 10 per cent limit in a single stock.

MFs do have the liberty to invest higher than the index weight of a stock. So, if a stock has a weight of 4 per cent or 3 per cent, schemes can still invest up to 10 per cent. “The regulator could counter argue that if a scheme can invest more than the index weight, it should be okay with a lower-than-index holding as well. Also, a holding above 10 per cent could backfire if the stock sees a sudden reversal of fortune,” said the official quoted above. 

“The 10 per cent cap is prescribed keeping the diversification principle in mind. It may be perfectly fine for a PMS today to have 30 per cent RIL in its portfolio. MFs, on the other hand, are a predominantly retail-oriented and long-term investment product and it is better not to tinker with the current limits,” said another senior official.

Another possible solution could be to cap the weighting of stocks on benchmark indices to 10 per cent. “Stocks that have a weighting higher than 10 per cent on the Nifty50 index could pose a challenge to fund managers owing to existing regulatory and soft limits on exposure to a single stock. For now, this is not a significant set of companies, but some cap on single-stock weighting will be helpful, so that it does not impact the performance of large-cap schemes,” Neelesh Surana, CIO, Mirae Asset Global Investment, had told Business Standard a few months ago.

A little over half of the 37 large-cap schemes have underperformed the Nifty100 index in the nine months to September, according to data from Value Research. Experts believe that large-cap schemes, which largely have to focus their investments in the top 100 stocks in terms of market value, will bear the brunt of the current RIL weighting. These schemes might underperform the indices unless market breadth improves and a sizeable number of stocks start to rally. A diversified equity scheme typically invests in 45-60 stocks.