In today’s Finshots, we explain why Reliance’s newly demerged entity was in the firing line of passively managed funds.

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The Story

Jio Financial Services can finally breathe. The stock is in the green.

You see, for a few days after this newly demerged Reliance entity hit the stock exchange, things weren’t good. It kept dropping 5% every day. And that’s due to a simple fact — forced selling by index funds.

Let us explain.

When JFS was demerged from Reliance Industries, it ended up on stock market indices such as the Sensex 30 and the Nifty 50. It didn’t really deserve to be there. It didn’t meet any of the typical criteria laid out for inclusion in these prime benchmarks. But, a small change in the rulebook meant that it landed up here anyway. The new rule simply said that in case a stock that’s part of an index is involved in a demerger, the new stock or the demerged stock will also find a temporary home in the index. And since Reliance Industries was the biggie within the index, its spawn found a place too.

So for a brief period, the Sensex 30 became the Sensex 31.*

Now, for the uninitiated, index funds don’t have a fund manager at the helm to pick good stocks and dump bad ones. No one’s doing the research and pulling the strings. There’s no one behind the curtain who’ll dump a stock when a scathing new report alleging misdeeds at a company. Or who'll buy a stock when a company snags a big deal too. Instead, these funds are “passively managed.”They simply buy and hold stocks in the same proportion as an index such as Sensex 30. If a stock drops out of the index, they sell too. They copy, they mimic, and they mirror the index. That’s it.

So you know what they would’ve had to do with JFS, right?

If the index was dumping it, they’d have to exit too. They didn’t care if the stock had a sound business or not. They’d break up with it once it leaves the index. That’s the forced selling we alluded to at the start.

But what if they chose not to sell for a while? What if they took their own sweet time?

Well, they could. But on the flip side, if they didn’t sell, it would introduce something called a tracking error. Which, simply put, is the difference between the returns of the index and the fund mirroring it. And investors don’t like a large tracking error in these funds. They want it to be as close to each other as possible. So if an index fund begins to exhibit these deviations, investors will lose trust. They’ll look for alternatives. And that’ll affect its business prospects too.

But what the JFS incident also goes to show is the power of index funds. Even in a nascent market like India, these funds were able to drive down the price of a stock quite easily. No one else stood a chance against the relentless selling pressure. After all, by some estimates, there’s over ₹5 lakh crores in funds tracking the various Nifty indices. That’s quite a bit of ‘mindless’ money that’s buying and selling stocks without a care in the world.

Now some folks might point to this ‘attack’ on JFS and remark, “Look at the harm caused by the mindless mimicry by index funds. It’s distorting the market.”

But what if we told you that these events might actually be good for active fund managers? You know, the ones who spend hours poring through annual reports and speaking to management before making a buy or sell decision.

You see, the breed of active management has been going through some tough times. People are questioning whether the fees they pay for these funds are worth it. And that’s because the performance of these actively managed funds has been quite underwhelming. Take this stat for instance — in 2022, 88% of such funds that pick stocks of large companies failed to beat the benchmark. And if you extend the timeline to 3, 5, or even 10 years, you’ll see a similar trend. They just can’t seem to outperform the index.

But think of these situations. Such as when the stock is being deleted from an index. Passive funds have no option but to sell en masse. It could knock down the share price. And if the fundamentals are strong, it gives a perfect buying opportunity for an active fund. They might be able to snag it for a bargain.

Or it could happen in reverse too when a stock is added to an index. Now this addition doesn’t happen out of the blue. Investors know about it a few weeks in advance. And active fund managers can start buying the stock in the lead-up to that event. Because they know that passive funds have to wait on the sidelines. They’ll take action only once the stock makes its appearance in the index. And once it does, the massive influx of passive fund money can drive up the price. It’s called the “Index Inclusion Effect.” And the active fund manager who entered earlier benefits.

Heck, there are actually funds out there globally that bet on such situations. The active fund manager can basically ride the passive wave for their own benefit. Sure, you could argue that these events don’t happen every day. And that’s true. But hey, when it does, it’s exciting times for sure.

So yeah, the next time you hear a fund manager complain about how passive funds are spoiling their party, maybe think about this story, eh?

Until then…

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*As of 1st September, JFS has been dropped from the Sensex 30. But, it still continues to be part of the Nifty 50 and could exit this week.

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