For retail investors who are into direct stocks, buying one when it enters the index can be a good strategy.
Most direct investors in stocks watch the benchmark indices - the BSE exchange's Sensitive Index or Sensex and National Stock Exchange's Nifty 50 - closely for clues on the market.
For a good reason - the stocks in these are supposed to be the best, in performance, earnings and other key parameters.
More important, most domestic and foreign institutional investors own large chunks of these companies in their portfolios, thereby making it more difficult to push up or down very fast.
Obviously, retail investors carefully look at the stocks comprising these benchmark indices. Some even try to ape the index by investing in these same stocks.
So, when a stock goes out or enters the index, there is a lot of buzz. Recently, BSE announced the removal of Hindalco and Vedanta from the Sensex, replacing these with Asian Paints and Adani Ports.
Immediately, the ousted stocks started falling sharply, whereas the those coming in started rising.
Says investment consultant Arun Kejriwal: "Investors initially treat a stock entering the indices like gold; there is a frenzy to buy. Similarly, the ones which go out take an initial hit."
Entry delight, exit woes
The main reason for the fillip to stocks which enter is that a number of global and domestic index funds mirror the benchmark indices.
In addition, many global funds restrict themselves to investing in stocks that comprise the main indices.
Since index funds mirror the underlying index, they have to buy all the stocks and in the same proportion. So, fund managers rush to buy these, to follow the mandate of their respective schemes.
As a former fund manager of a foreign brokerage firm says: "When such entries happen, our investors expect us to immediately buy the stock because they are quite uncomfortable with tracking errors, even if the returns is better than the underlying index."The same applies for domestic fund houses. Though the pressure on them about tracking errors isn't very high unless they do worse than the index.
For stocks exiting the index, there is a sharp fall because fund managers want to/have to exit these stocks to balance their portfolios.
As a result, they sell, sometimes in big tranches. So, from being over-owned, these stocks become under-owned.
Tips for retail investors
Investment experts say for retail (individual) investors who are into direct stocks, buying one when it enters the index can be a good strategy.
But, it has to be within a day or two of the announcement, as fund managers rush to rebalance their portfolios. If you miss the bus in the initial days, it makes more sense to wait for the first quarterly results.
"From being under-owned, the stock entering the index will become over-owned in a matter of days, due to the herd mentality. So, if you haven't got it before the fund managers step in, it is better to wait till the first quarterly result," adds Kejriwal.
According to him, after the first quarterly numbers, fund managers will start taking a view on the stock and whether they should increase their position or decrease it. This will provide an opportunity to the investor.
There's a different advice for retail investors when stocks exit an index.
While investment experts believe that a stock that has entered the index can be bought, the converse isn't true.
"A stock might be exiting the index because it has not done well for some time. However, it does not mean the stocks are bad. They could be suffering due to sector performance. For example, both Vendanta and Hindalco have been caught by the bad commodity cycle," says a fund manager.
So, the decision to exit a stock can be tricky. Many of these companies will have assets and strong management but are stuck due to global issues.
Fund managers say one has to decide on the basis of the company and the sector outlook.
Some believe for long-term investors it could even be a good opportunity to buy these, when everyone else is selling.
However, there would be stocks whose fall might get accentuated after being dropped because few believe in its prospects. Whether to buy or sell such a stock, take advice from an investment expert.
