Last Updated on August 22, 2022 at 11:11 pm
A reader asks, “Should investors look to reduce/eliminate exposure to Nifty Next 50 because the NSE has recently changed its inclusion criterion that has allowed new companies like Paytm (One 97 Communications Ltd.), Zomato and Nykaa (FSN E-Commerce Ventures Ltd. ) to be part of the index from March 31st 2022?”
On Feb 24th 2022, the NSE announced that the “Minimum listing
history requirement in case of a new listing and companies traded subsequent to the scheme of arrangement for corporate events” was revised from three months to one month”
First of all, this rule applies to all NSE indices and not just Nifty Next 50. Second of all, if the rule had not been changed, Zomato and Paytm would have been included in the next index rejig and they are unlikely to be profitable even then!
Third of all and perhaps the most important takeaway in this is: while active funds are subject to fund manager risk, passive funds are subject to curator risk. Nothing emphasises this better than this guest article: Data Mining in Index Construction: Why Investors need to be cautious.
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The data mining reference applies more to factor indices than to capitalization-weighted indices. For example, today if you look at a factor index like momentum or alpha or quality or low volatility, everything looks hunky-dory. If the future pans out differently, the index curator can happily change the selection rules.
The moral is, the powers that control the stock market keep changing the rules. A debate on whether the change is justified or not is a useless pursuit. The point is, investors, cannot run from selection risks!
For example, in Aug 2019, NSE changed the selection criteria from “only those equity shares that were listed and traded on the exchange were eligible for inclusion in the Nifty indices” to “all equity shares that are traded (listed and traded and not listed but permitted to trade) at the exchange are eligible for inclusion in the Nifty indices,”.
If the NSE site was a bit more user-friendly it would be easy to fish out several such circulars from their archive. I completely agree with the reader that all this leaves a bad taste in the mouth.
I am not too worried about the inclusion of Paytm or Zomato. I don’t think these two companies on their own can bring down Nifty Next 50 returns. The index can do that on its own quite well!
Note: Some readers seem to have misinterpreted our recent article – Is it time to exit from Nifty Next 50? – as a call to exit the index. That is not the case. Yes, when compared to Nifty 50, NN50 has done poorly and we had only urged readers to question if they would like to wait or not.
Not all our calls go right and we must review from time to time and make a call without regret. We have also shown (after the publication of the above article) that the Nifty Next 50 still remains a good mid cap passive fund although a frustrating one: Axis Nifty Midcap 50 Index fund Review.
So, Paytm/Zomato or no Paytm/Zomato, the character of Nifty Next 50 is unlikely to change. It is going to go through periods of no returns and sudden booms. Only those for whom patience is suitable (for their needs) should consider it. There is no need to reconsider investing in NN50 because of the recent changes in the index inclusion criterion. Not much is going to change. Tomorrow there could be loss-makers in the Nifty or Sensex too. This does not mean active funds will do better.
There are of course several deep questions here.
- Should SEBI allow loss-making companies to list?
- Should indices include loss-making companies?
- If loss-making companies are included in the index will their value not be artificially inflated?
We do not have answers or even opinions on this (they are of little value anyway). We are however reminded of this exchange from the movie Margin Call (the contexts are different though).
Sam Rogers: The real question is: who are we selling this to?
John Tuld: The same people we’ve been selling it to for the last two years, and whoever else ever would buy it.
Sam Rogers: But John, if you do this, you will kill the market for years. It’s over.
Sam Rogers: And you’re selling something that you *know* has no value.
John Tuld: We are selling to willing buyers at the current fair market price.
At the end of the day, that is all there is to it – the current fair market price. Does not matter how the underlying business is doing. If # of buyers > # of sellers, the price moves up. If it is the opposite, the price falls. One cannot expect both decisions (buy/sell) to be logical!
Whether it is an active mutual fund or a passive mutual fund, we recommend investors treat them as black boxes with a label (the NAV). If we open the box and look into the portfolio, we will always find something to be unhappy with. It is an unproductive occupation and is best avoided.
It is best to treat the risk and reward of a mutual fund at the NAV level and not fret about things we cannot control. Who knows how the future will pan out! Today’s loss-makers maybe tomorrow’s giants or vice-versa!
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