Compared to its peers while India offers a better sectoral mix of companies, its weightage in the MSCI Equity AC World Index and Emerging Markets Index, as of September 2023, is only around 1.66 percent and 15.7 percent, respectively. This is because the MSCI indices are structurally flawed as weightage is assigned based on free float factor of companies rather than the opportunities available, Samir Arora’s Helios Capital has said in a report. Investors end up end up making sub-optimal decisions and also under-allocating to India.
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Compared to other countries, India’s weightage, is not based on the GDP or market cap, the report says. For example, Taiwan whose GDP is 22 percent of India's and market cap is approximately 49 percent of India's, has almost the same weightage as India. Similarly, Korea's GDP is 49 percent and the market cap 47 percent of that of India but its weight in the index is 79 percent of India's weight.
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The India advantage
According to the report, returns from Indian equities have grown due to the quality of the listed companies, which are boosted by GDP growth, reforms and demographics. India also offers new sectors for investing, which were previously reserved for state-owned companies, to private sector companies, and various reforms related to formalization and financialization of the economy that “have led to emergence and rapid growth of hundreds of companies across infrastructure, financial and consumer sectors in India”.
The free float factor
The question the report asks is why is India’s weightage low. The answer is because of the free-float factor, which in simple terms refers to the shares that are available for investors.
In India, especially in larger companies, the free-float factor is lower either due to the owners owning large stakes in the company or because companies have reached foreign ownership limits.
The MSCI methodology, the report adds, in essence, penalises companies that grow without diluting shareholders and therefore are more likely to have a lower free float.
According to Helios Capital, the fact that MSCI methodology also removes a company from its indices if it reaches the foreign ownership limit is amusing, as once a firm reaches that point, foreign investors start selling stakes. The result, as ownership comes down, the MSCI ends up adding a company back into the index.
Also read: Foreign investors continue to reduce stake in HDFC Bank; can stock's weight double on MSCI?
Why the free-float factor is flawed
According to the report, there are multiple reasons why the methodology is wrong. One is that it artificially reduces the weight of good companies and countries.
The report says that usually, a good, capital-efficient company will have large insider ownership as it doesn't need to dilute its share to support growth. On the other hand, companies, where owners dilute their stakes, are viewed positively by MSCI, even though “any bottom-up investor would view this dilution of stake as a negative development relative to companies that achieve the same level of growth and market capitalization without diluting their shareholders”.
The report also questions whether there has ever been a case where an investor has invested in a country or company only because the free float is high.
Due to a systematically flawed MSCI Index that gives too much weight to the free-float factor, foreign funds do not invest on the basis of the size of the opportunity or the scale of the transformation of an economy but based on a non-economic free float calculation by an index provider, it adds.
This, the report says, does more harm than benefit to the investors as the size of opportunity and expected transformation in India are much higher. But adds that the under-allocation to India will change over time as investors understand the issue, “bringing foreign inflows into India as the weight of India rises in MSCI indices and investors move to 'actively' allocate to the India opportunity.”
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