Realignment of NSE indices to widen index funds' tracking errors

The proposal to realign NSE indices on the basis of free-float market capitalisation will put index funds and exchange-traded funds in a spot of bother. According to mutual fund analysts, the exchange-proposed changes in stock weightages will result in widening of tracking error in index funds.

Index funds are passively-managed funds, wherein the fund manager attempts to mirror the performance of a benchmark index, by investing the corpus in the index components in proportion to their weightage in the index.

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Tracking error is the difference between returns from the index fund to that of the index. Lower the tracking error, closer are the returns of the fund to that of the target index.

Funds with tracking error lower than 1% are considered good performers, according to mutual fund analysts. The NSE-proposed shift in stock weightages could deviate fund returns (from index returns) in the range of 6-10%, industry sources said.

"There could be some tracking error as weightage realignment of the whole index would mean a lot of buying and selling of shares," said an index fund manager.

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"Unlike in other times when one stock is excluded from the index, the whole benchmark is being revamped this time round. However, the realignment process won’t take long as net AUM in index funds and ETFs are just over Rs 1,300 crore," the fund manager said.

According to analysts, stocks that were heavyweights, but had low floating stock will be adversely impacted because of the realignment. HDFC (+2.7%), ITC (+5.2%), Infosys (3.8%) and ICICI Bank (+2.8%) would be the major beneficiaries while NTPC (-6.7%), ONGC (-3.5) and Bharti Airtel (-1.7) would lose their weightage in the index. Sector-wise, a positive shift in weightage would be witnessed in banking and FMCG while power and oil & gas would be major losers.

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