Off-Balance: How Global Equity Indices Undermine India Story

INDIAN EQUITY MARKET, the fourth largest in the world, contributes 3.6% to global market cap, while Indian economy is the fifth largest and contributes 4% to global gross domestic product (GDP). Indian stock indices have also outperformed global indices over last few decades. However, Indian equities are getting less than their fair share of funds allocated by index-based funds and exchange-traded funds (ETFs) globally. Reason is under-representation or low weight on Morgan Stanley Capital Index (MSCI) indices to which about $14.9 trillion assets under management (AUM) are benchmarked. For instance, MSCI All Country World Index (ACWI) captures large, mid, and small caps across developed and emerging market economies. About $4.3 trillion AUM was benchmarked to ACWI in June 2023. Fund managers use MSCI ACWI as a guide for asset allocation and a benchmark for performance of global equity funds. MSCI ACWI comprises stocks of nearly 3,000 companies from 23 developed and 24 emerging markets (as on December 29, 2023). At present, India’s weight in ACWI is just 1.69%; smaller economies U.K. and France are at 3.6% and 2.9%, respectively.

The stark dichotomy between the size of the market/economy and country weight is visible in many cases. For instance, capitalisation of Germany’s stock market ($2.3 trillion) is 38% less than India’s ($3.7 trillion). Yet, Germany has 2% weight in the index.

While it can be argued that ACWI comprises both developed and emerging markets, India is under-represented even in the emerging market index, MSCI EM, where its weight is 17.63%. Compare this with Taiwan whose $0.8 trillion GDP is roughly 22% of India’s $3.7 trillion and market cap of $1.9 trillion is about 50% of India’s $3.7 trillion. However, Taiwan’s weight on MSCI EM Index is 16.73%, roughly 91% of India’s weight. Similarly, South Korea’s GDP ($1.7 trillion) and market cap ($1.8 trillion) are 46% of India’s but its weight in the index is 70.6% of India’s weight. In last 20 years, India has delivered an annualised return of 12.4% while MSCI EM and MSCI ACWI have yielded 7% and 7.8%, respectively. France, Germany and U.K. have given 6.6%, 6.8% and 4.8% returns, respectively. Emerging market peers Taiwan and Korea have returned 9.2% and 6.7%, respectively, during the period.

MSCI India is also much more diversified. Top three sectors contribute 50.8% to MSCI India compared to 60-70% for other emerging market countries, providing global investors a well-diversified investment option.

This begs the question: Why does India lag at 10th position in MSCI ACWI despite being a far larger economy than many developed peers and why is it under-represented on MSCI EM Index despite offering a more diversified stock market than emerging market peers? More important, how is it losing out due to under-representation in MSCI EM as well as MSCI ACWI?

Why Index Service Providers Matter

Global index service providers like MSCI, FTSE and S&P have built benchmark indices that are tracked by passive funds around the globe. Each decimal point change in weight of a nation in MSCI indices triggers huge fund flows.

Passive investment products (ETFs and index funds) have become popular in India, too. At February-end, total AUM of Indian mutual fund industry was ₹55.7 lakh crore, of which ₹8.83 lakh crore was in ETFs and index funds. Nuvama Alternative & Quantitative Research says nearly 16% of India equity AUM ($483 billion) is passive (India has nearly 260 passive equity schemes).

A big chunk of funds now rely on index providers like MSCI as higher regulatory vigil and reduced scope for innovation has reduced the space for alpha creation by active funds. Passive investing has four advantages — automated selection & allocation, low intervention of human intellect, reasonable servicing costs and scalability, says Enam AMC.

About $75-80 billion allocated for global and emerging markets is linked to Indian equities through MSCI indices, says Sharwan Goel, head, Passive, Arbitrage and Quant Strategies, UTI AMC. “With 17.63% weight in MSCI EM Index, a 0.1% increase leads to $400-500 million flows into Indian stock markets,” says Goel.

Index providers such as MSCI set rules deciding which securities to include, how to manage the index and how to add or remove securities. Thus, they play a pivotal role in growth of passive funds, says Goel.

Overview Of MSCI

MSCI has three flagship indices — MSCI World Index, MSCI EM Index and MSCI ACWI. MSCI World Index, launched in 1986, is one of the most followed global stock indices and tracks large and mid-cap companies in 23 developed markets. MSCI EM was introduced in 1988 for investors looking to diversify. It is one of the first emerging market equity benchmarks and captures large and mid-cap segments in 28 emerging markets. The most striking change in MSCI EM has been the colossal rise of China’s weight from 0.8% in 1998 to 25.76%. Its allocation peaked at 40% in 2020. Three Indian companies, Reliance Industries, ICICI Bank and Infosys, are part of Top 10 companies in the index with weights of 1.34%, 0.91% and 0.87%, respectively.

MSCI ACWI was launched in 1990 by combining constituents of MSCI World and MSCI EM indices. It captures large and mid-cap companies across 23 developed and 24 emerging markets. With 2,948 constituents, it covers approximately 85% investable equities globally. Share of emerging markets in MSCI ACWI has reached 12% (24 EM countries) from less than 1% (10 EM countries) at inception, says Rohit Sarin, co-founder, Client Associates.

Developed markets and China are top five in MSCI ACWI with U.S. accounting for the lion’s share of 62.6%, up from 52% in 2015. Japan’s allocation reduced from 8% to 5.4% during the period. Post inclusion of China’s A-shares, it has remained in top five and is currently at 4th place (3.1%), while U.K. and France occupy 3rd and 5th spots, respectively. India, with 1.69% allocation, has the 10th largest allocation in MSCI ACWI.

India’s Three-decade Journey

When India was first included in MSCI EM and MSCI ACWI in 1993, its initial weights were 8.50% and 0.6%, respectively. While India’s share has more than doubled in MSCI EM and almost tripled in MSCI ACWI since then, the increase does not correspond to the growth of its economy and equity market relative to the rest of the world. In 1993, India was the 15th largest economy in the world; it is now 5th. In terms of market capitalisation, it is fourth, larger than three of the top developed countries in ACWI.

Abhilash Pagaria, head, Nuvama Alternative & Quantitative Research, says until 2019, India’s weight in MSCI EM was around 8%; it later soared to an impressive 18.2%. “A more accurate perspective emerges when we focus on rise of India’s share in MSCI EM index where number of Indian stocks surged from 84 at 2019-end to 136 today,” he says.

The reasons for the bump are obvious. India is among the few large economies with a positive real rate as inflation is below short-term interest rates. High-frequency economic indicators such as credit growth, GST collections, services/manufacturing PMIs, UPI transactions, e-way bills, air traffic, capacity utilisation, electricity/industrial production indicate sustained recovery in domestic economic activity. The macro profile is strong due to benign external debt and moderate inflationary expectations. Superior risk-adjusted returns in the past and healthy GDP and earnings growth outlook in near to medium term warrant a much higher representation of Indian equity market in MSCI ACWI and MSCI EM indices, says a report by Client Associates.

Reasons for Under Allocation to India

India’s sub-optimal allocation in MSCI ACWI is part of a larger issue that results in overall lower representation of emerging markets. As MSCI indices are weighted on the basis of free-float market cap, emerging markets get a lower allocation in ACWI due to lower share of free-float compared to developed markets. Lower free float implies that promoters hold bulk of the shares, restricting supply in the open market. India mandates that promoters should not hold more than 75% stake in listed companies.

But lower free float may have put India in an unenviable position. The free float factor in MSCI methodology for index construction is disadvantageous for companies that grow without diluting shareholding, says Sarin from Client Associates.

This is also counterintuitive from a bottom-up investment approach that would perhaps see less dilution of promoter shareholding as an indication of capital efficiency of a company and its ability to support growth without external capital. “MSCI’s free-float factor weighting in index construction is certainly a key drag for relative under-allocation in emerging markets in general, and India in particular,” adds Sarin. This could risk global portfolios being under-allocated to Indian equities and deprive investors of larger opportunities that India has to offer. This may be just the opportune time for MSCI to re-look at its methodology and let global investors enjoy a bigger share of India’s growth story.