Will F&O stocks in Nifty Next 50 reduce tracking error for index funds? 

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The National Stock Exchange (NSE) recently released an important advisory paper on selecting stocks for inclusion in the Nifty Next 50 Index. According to the proposal, NSE wants to include only stocks that are part of the F&O in the index. The main reason behind this suggestion, according to the paper, is to reduce tracking error for the ETFs/Index Funds that measure the Nifty Next 50.

Currently, out of the 50 stocks, 11 stocks with a cumulative weight of 9.05 percent as on May 16 are not available in the derivatives sector.

According to the NSE, the index’s exposure to such non-financial and banking stocks, which frequently hits price ranges, reduces the ability to efficiently replicate the index portfolio and thus increases tracking error.

stocks out of the index

The Nifty Next 50 Index represents the balance of 50 companies from the Nifty 100 Index after excluding the Nifty 50 companies. If the proposal is made, stocks like Varun Beverages, Adani Green, Zomato, Adani Transmission, Nykaa, Adani Wilmar, Adani Total Gas, P&G Hygiene, Bajaj Holdings, Life Insurance Corporation of India and DMart will have to be excluded from the Nifty Next 50, since there are no Future contracts and associated options.

The cumulative weighting of non-financial and industrial stocks is currently capped at 10 percent and a maximum cumulative weighting is capped at 4.5 percent each on a quarterly basis. There are 20 passive funds tracking the Nifty Next 50 index with total assets under management (AUM) of ₹11,600 crore as of March 31 – seven ETFs with an AUM of ₹5,560 crores and 13 index funds with an AUM of ₹6,040 crores.

“With the increase in the number and size of assets of passive funds tracking the Nifty Next 50 index, ensuring the liquidity of the index components and the ease of index replication by passive funds is gaining more importance,” she said.

One way to solve the index duplication problem is to include only derivatives-traded stocks in the Nifty Next 50 index. F&O stocks are usually more liquid and accessible than non-F&O stocks. Owning only those stocks that are available for F&O trading in the Nifty Next 50 index will improve the ease of repeating the index with passive funds.”

implementation roadmap

Accordingly, NSE plans to reduce the cumulative weight of non-F&O manufacturing stocks in the Nifty Next 50 index from the current 10 percent to 5 percent as of June 30. Futures and options section.

However, the motion did not hold on four counts. First, the fact that only F&O stocks are the most liquid is not true. Some non-F&O stocks are more liquid than derivative stocks, especially during corporate events.

Second, stocks that are part of an index with linked derivative contracts do not attract traditional circuit filters. So listing such non-oil-and-oxygen stocks wouldn’t lead to greater volatility, the NSE claims.

Third, trading stops and bans are not limited to non-F&O stocks. F&O shares will also be subject to a trading ban if market-wide open interest exceeds 95 percent in the derivatives segment; This will limit the movement of the underlying shares as well.

Fourth, the tracking error between Nifty 50 index funds and Nifty Next 50 index funds is not that great. For example, IDBI’s Nifty ETF has a tracking error of 0.10 percent, while the IDBI Nifty Next 50 has an error of 0.14 percent. This weakens the case for excluding non-F&O stocks from the Nifty Next 50 Index.

However, index fund investors can prepare for volatility, if the proposal ultimately works.