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Dalal Street Investment Journal | Thursday, September 27, 2018
Dr Ruzbeh Bodhanwala & Dr Shernaz Bodhanwala Faculty at FLAME University, Pune


Index investing is a most simple technique of making your money work. In simple language, invest in stocks that are a part of the index and your wealth should move exactly as the index moves. Retail investor who does not understand equity markets and neither have a view on sectoral funds, thematic funds, etc. can invest in index funds. Index funds are fairly diversified, low cost, low risk and earn returns which replicate the returns of the index. 

A company gets included into the index because of factors like liquidity, impact cost, listing history, free float market capitalisation, etc. Index is constantly revised and companies are removed and added to the index. Generally, it is believed that companies which are included in the index would do well in the near future, and many investors seek to include them in their portfolios due to higher expectation of return in future. Whenever a company gets included in an index, all the fund houses which replicate the index performance have to sell the stock of the company that has been removed and include in their portfolio the new stock, and this should lead to share price appreciation of stocks which get included or newly added into the index. 

CNX Nifty comprises of 50 actively traded stocks. The index governance team for CNX Nifty has made over 186 changes since inception, which means at different point of time, close to 93 companies have been included and 93 excluded from the index. Between the study period of 2013-2018, some of the companies like IndusInd Bank , NMDC , Wipro , Tech Mahindra , United Spirits , Zee Entertainment Enterprises , Idea Cellular , Yes Bank , Bosch , Adani Ports and Special Economic Zone , Aurobindo Pharma , Bharti Infratel , Eicher Motors , Tata Motors Ltd DVR, Indiabulls Housing Finance , Indian Oil Corporation , Vedanta , Bajaj Finance , Hindustan Petroleum Corporation , UPL , Bajaj Finserv , Grasim Industries , Titan Company have been included in the index. On the other hand, some of the companies like Siemens , Wipro , Reliance Infrastructure , Jaiprakash Associates , United Spirits , DLF , Jindal Steel & Power , IDFC Ltd, NMDC , Punjab National Bank, Vedanta , Bharat Heavy Electricals , Idea Cellular , Grasim Industries , ACC , Bank of Baroda, Tata Motors Ltd DVR, Tata Power Co. , Ambuja Cements , Aurobindo Pharma , Bosch have been excluded. 

Index rebalancing is not a new thing and it happens at regular intervals and is reported by the exchanges to all the investors at least a month in advance. The studies have generally reported positive price effect on shares included in the index and negative price effect on shares excluded from the index. We intend to test this hypothesis using the data of CNX Nifty which is sourced from NSE database and the price of shares on the date of inclusion or exclusion is sourced from Thomson Reuters database. The companies that had merged or amalgamated were removed from the data. 

Methodology 
In this study, we looked at share price performance of companies which are included and excluded from CNX Nifty from the period 2013 to 2018. To test this hypothesis, we form two buckets, “Returns of Shares Excluded from Index” and “Returns of shares Included in the Index”. 

We calculated returns for different time periods, like return of one month post inclusion/exclusion (indicated as +1M), return of one month prior to the inclusion/ exclusion date (indicated as -1M). In a similar way, we calculate one year returns pre and post inclusion/exclusion (indicated as +1Y and -1Y). Companies that had not completed a period of one year from the date of inclusion/exclusion until August 2018 have been excluded from the sample for calculating annual returns pre and post event. 

Conclusion 
The empirical analysis suggests that average return for +1 year duration of shares excluded from the index is 19%, whereas the average return for shares included in the index for +1 year duration is only 9%. This is contrary to the belief that shares that are included in the index should appreciate higher as compared to the shares that are excluded. Now let us look at the average returns for one year before the event date. The shares which have been excluded have given negative return of 13% as compared to positive 45% returns on shares included in the index. This strongly suggests that shares which are included in the index appreciate one year before the event date and the reason for this appreciation can be attributed to the strong financial performance of these companies. The average one month returns are not very conclusive. 

Profiting From Entry And Exit Of Index Stocks

A stock which is included in the index is at a premium valuation near the date of its inclusion in the index and this premium valuation limits it future potential for appreciation, whereas the stock which is excluded from the index is available at a beaten down price and thus the returns could be much higher if the financial performance of the company improves. To put it simply, investors can find a good pick with reasonable price-value gap among the stocks that are excluded from the index. 

The retail investor should look for companies which have the potential of turning around and are excluded from the index. These stocks are available at beaten down prices close to the event date and there is a strong likelihood of good returns if the company is fundamentally strong and the management is working towards a better financial performance. For higher returns, investor should focus on picking quality stocks from the list of companies excluded from the Index.