NSE’s proposal on mergers and index reconstitution may curb wild swings in share prices

The key rationale behind National Stock Exchange subsidiary NSE Indices’ proposal to revise the treatment of merger and demerger of index constituents its metrics is to stem the volatility in stocks that arises out of the event-led announcement and consequent rebalancing.

If the proposal is approved and implemented, HDFC Bank and Housing Development Finance Corporation (HDFC) are likely to be among the first stocks to fall under the new rubric.

The HDFC-HDFC Bank merger will likely create the third-largest Indian company as measured by market capitalisation.

With HDFC being a part of the Nifty indices, the mortgage company’s scrip could witness massive selling from passive funds, market experts believe. A report from international financial services firm Investec pegged these outflows at $2.4 billion by way of 88 million shares from exchange-traded funds and index funds tracking the underlying indices as of December 2022. Emkay Global Financial Services estimated an outflow of $1.25 billion.

If the proposal by NSE Indices is approved, sharp swings could be avoided in the prices of shares of companies that are in the process of being included or excluded from the indices on account of buying and selling by passive funds that track these indices.

NSE Indices has proposed changes for the inclusion or exclusion of a company from or into the indices closer to the event.

The NSE arm is seeking feedback from the market regarding the methodology.

Read  here | NSE Indices seeks market feedback on existing methodology of merger, demerger in Nifty Indices 

Nuvama Alternative & Quantitative Research (formerly Edelweiss Alternative & Quantitative Research) believes that the proposal should get support from participants. The brokerage has batted for this change as it sees the new methodology avoiding big churning under the current methodology.

Currently, index reconstitution takes place at the time of exclusion of the transferor company and subsequently during the weight rebalancing of the stocks in the index.

“This results into churning of stocks twice in case passive funds (ETF/Index funds) are tracking such index,” NSE Indices said in a press release.

Punit Patni, an equity research analyst at Swastika Investmart, a financial services firm, believes a change in the methodology of merger and demerger of index constituents will prevent needless churn in the index and funds tracking such index.

“This move will be beneficial for HDFC and HDFC Bank shareholders, as the current expected $1.5 billion outflow in HDFC due to index rebalancing would have caused unnecessary loss for investors and traders at least in the short term,” Patni pointed out.

But Koushik Mohan, lead analyst at Ashika Institutional Equities, feels that this proposal “might not bring a revolutionary change”. His reasoning is that this would largely affect arbitrage fund managers who take advantage of special events like mergers and demergers but overall, except averting wild fluctuations in the stock price of the companies concerned, this proposal is unlikely to create any difference.

Nuvama Alternative & Quantitative Research said if the proposed changes are considered after the consultation is over, HDFC will only get excluded on the ex-date which will likely be Q1 of FY24.