MSCI’s move and the impact on HDFC and HDFC Bank stocks

Earlier this month, we had the unusual scenario of the usually stable stocks of financial services giant twins – HDFC and HDFC Bank – falling 5-6% on a single day. The trigger? The much sought-after index maker MSCI had decided to give a lower weightage to the merged entity (HDFC Bank) once it is included in the benchmark, after the merger is completed formally.

From a situation where there were expectations of substantial capital inflows into HDFC Bank after the index inclusion, the scenario actually changed to one of possible selling in the stock to maintain the weightage in the MSCI index.

Much of these aspects are better understood if we take stock of how the index is constructed in the first place, get a grip on free float marketization, and make sense of key issues such as foreign room and adjustment factor.

Here’s more on the inclusion of HDFC Bank in the MSCI index and the stock reactions.

Free float market capitalization

Before getting into the index addition part, a brief background would be in order.

HDFC and HDFC Bank decided to merge in April 2022. The ratio of merger was set at 42 shares of HDFC Bank for 25 shares of HDFC. The transaction is expected to be completed by July 2023.

Presently (as of May 16), HDFC has a market capitalization of Rs 5.08 lakh crore and a free float market capitalization of Rs 5.03 lakh crore. HDFC Bank has a market capitalization of Rs 9.35 lakh crore and a free float market capitalization of Rs Rs 7.39 lakh crore. The combined market free float market capitalization is thus around Rs 12.43 lakh crore (7.39+5.03).

Free float market capitalization is calculated by multiplying the market price of a stock with the number of shares (excluding the shareholding of promoters). This gives a clear picture on the liquidity available for a stock in the market.

Now, MSCI indices use the free float market capitalization method to assign weightage to stocks.

Index inclusion and weightage

Now, HDFC is already present in the MSCI India and MSCI Emerging Markets indices. As of April 28, 2023, the index factsheets show that HDFC had a weightage of 6.61% in MSCI India and was the second largest constituent in the index behind Reliance Industries (10.16% weightage). In the MSCI Emerging Markets Index, it carried a weightage of 0.91%. Since HDFC Bank is a listed entity in the Indian markets, after the merger, the combined entity (HDFC Bank) would be included in the MSCI indices as a matter of continuity and HDFC would obviously be removed since it would not exist as a separate entity anymore.

The concept of foreign room becomes important here.

MSCI indices require considerable room for foreign investors (FIIs and FPIs) in buying stocks for them to be included in benchmarks. Foreign room is the portion of the shareholding available for foreign investors in companies.

One of the reasons for HDFC Bank not being included in the MSCI indices pre-merger was that there was no foreign room available for investments, whereas HDFC had the requisite headroom. The RBI limits the total foreign investments in banks at 74% for them to be treated as Indian banks.

Now, for the merged HDFC-HDFC Bank entity is expected to have a foreign room of a little over 17% according to analysts quoted in the media, going by the March 2023 shareholding pattern of the two companies.

Adjustment factor hurts merged entity

The next critical aspect to note is the adjustment factor that MSCI uses for the inclusion of stocks in its indices.

Ideally, after the merger of HDFC Bank and HDFC, the total weightage of the combined entity should have been higher in the MSCI index, going by the total free float capitalization mentioned earlier.

Had the MSCI’s index construction methodology used an adjustment factor of 1, the MSCI India index would have had HDFC Bank (merged) with a weightage of around 13%.

But the index aggregator instead released a statement earlier this month stating that it would use an adjustment factor of only 0.5. The analysis of the reasons cited – estimated post-even foreign room and risk of reverse turnover – indicates that flows into the stock after merger could be volatile and there may be a situation where the foreign room may fall below 15%.

Also mentioned in the methodology document of MSCI was the fact that an adjustment factor of 0.5 can be given for cases where the foreign room is between 15% and 25% based on its reviews.

MSCI reviews weightages and adjustment factors once every quarter.

Thus, HDFC Bank (merged entity) would get only half the weightage in the index compared to the full proportion expected earlier.

According to analysts quoted in the media, an adjustment factor of 0.5 would mean that the merged entity would have lower would have only 6.5% weightage in the index, lower than even the 6.74% weightage that HDFC currently enjoys.

Outflows expected as against inflows

Had the adjustment factor of 1 been applied as expected earlier and the weightage for HDFC Bank (merged) and a weightage of around 13% accorded to it in MSCI India, there were expectations of $3 billion in inflows into the merged entity’s counter.

Since MSCI indices are used by a host of FIIs, FPIs, and mutual funds to participate in various global markets including India, this move was keenly followed.

Now that the weightage of HDFC Bank would only be 6.5%, the situation meant that there would be net outflows of $150-200 million, and limited possibility of any incremental inflows.

This move from the MSCI surprised the markets and as a result there was heavy selling pressure in both HDFC and HDFC Bank, as both stocks fell around 5-6% on May 5. They did recover in the week after, but still trade below their prices recorded on May 4.

For passive investors, there was one key lesson here. Even though passive investing involves mechanically buying the index, there are risks beyond their control and are completely unanticipated such as an index provider changing weights all of a sudden.