With the mega-merger of HDFC Bank and HDFC Ltd. happening in the coming months and considering the challenges involved in the treatment of merged and demerged constituents in the indices, NSE has proposed changes in the way mergers and demergers are handled during adding or removing these stocks from Nifty Indices.
Currently, NSE does event-based index reconstitution for mergers/demergers, where once shareholders approval is received, it is considered as a trigger to initiate replacement of such stocks in the index and exclusion of stocks going through merger/demerger is done much ahead of ex-date.
In case of event-based reconstitution on account of merger, index reconstitution takes place at the time of exclusion of the transferor company and weight rebalancing of the stocks in the index takes place when the shareholders of transferor company are allotted shares of merged entity and they are available for trading on the exchanges. This results in churning of stocks twice in case passive funds like ETFs and Index funds that are tracking such index.
And in case of event-based reconstitution on account of demerger, index reconstitution and weight rebalancing take place at the time exclusion of the demerged company (irrespective of its size in terms of market capitalization or demerged business).
Keeping this in mind, NSE has proposed revision in treatment of merger and demerger of index constituents for equity indices.
Treatment of merger in Nifty equity indices;
Current treatment of merger in Nifty equity indices;
Currently, NSE follows below method for reconstitution of indices in case of merger of any index constituents with another constituent of the same index or with a company which is not part of the same index or any other index.
Step 1: Exclusion of transferor company from the index
- Shareholders approval of the scheme of arrangement for merger of a company is considered as trigger for making the changes in index constitution or weight rebalancing
- Soon after the approval of shareholders, exclusion of transferor company which is involved in scheme of arrangement for merger is initiated from respective indices
- In case the transferor company is part of index on which F&O contracts are traded, changes are announced at least four weeks prior
- The transferor company is excluded from the respective indices and is replaced with another eligible stock (in case of indices with fixed number of constituents). This results into reconstitution and weight rebalancing of the index
Step 2: Increasing the number of equity shares of the merged entity
Currently, upon allotment of the shares of merged entity to the shareholders of transferor company and getting permission to trade on the exchange;
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If the shares alloted to the shareholders of the transferor company account for more than or equal to 5% of the current equity of the merged entity, these shares are updated for calculation of market cap. from the last trading day of the calendar month.
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And if the shares alloted to the shareholders of the transferor company account for less than or equal to 5% of the current equity of merged entity, these shares are updated for calculation of market cap. from last trading day of the corresponding calendar quarter (March, June, September and December)
In the above approach, when a transferor company is part of an index and is merged with another company which is part of the same index, index reconstitution and weight rebalancing in triggered on two instances;
- First, when the transferor company is excluded from the index and another is added
- Second, when weight rebalancing is done when shareholders of the transferor company are allotted shares of the merged entity.
In both the above instances, funds that are tracking the index have to make the necessary changes on both the occasions which results in additional buying and selling in a short span of time.
Another issue is, the transferor company is excluded from the index much ahead of its ex-date of the merger.
Proposed treatment of merger in Nifty equity indices
To avoid the above challenges, NSE has proposed below changes;
- Transferor company to be excluded from the index on the ex-date (T Day) of the merger, i.e closing of the T -1 day.
- And investable weight factor of the merged entity to be updated based on the terms of merger on the ex-date of the merger, i.e closing of T -1 day.
In case of replacement in indices;
- Indices with fixed number of constituents: On ex-date, a replacement of company will be made based on the eligibility criteria of respective indices in place of transferor company which is being excluded
- Indices with variable number of constituents: On ex-date, no replacement will be made in place of the transferor company which is being excluded
- Announcement of the above changes to be made minimum 3 working days in advance for change in the constituents of indices including the indices on which F&O contracts are traded.
Treatment of demerger in Nifty equity indices;
Current treatment of demerger in Nifty equity indices:
The current process for the exclusion of a demerged company from the index remains the same as it is for a company that is going through a merger;
- Shareholders approval of the scheme of arrangement for demerger of a company is considered as trigger for making the changes in index constitution or weight rebalancing
- Soon after the approval of shareholders, exclusion of demerged company which is involved in scheme of arrangement for demerger is initiated from respective indices
- In case the demerged company is part of index on which F&O contracts are traded, changes are announced at least four weeks prior
- The demerged company is excluded from the respective indices and is replaced with another eligible stock (in case of indices with fixed number of constituents). This results into reconstitution and weight rebalancing of the index
The challenges with this approach remain the same too, the demerged company is excluded from the index much before its ex-date of demerger. Along with this though, companies with large market cap. may get excluded and become eligible again for inclusion later on, increasing the churn in index and funds tracking that index.
Proposed treatment of demerger in Nifty equity indices
- In case a special trading session is held for demerged company on stock exchanges for price discovery, the company will be retained in the index and the index divisor (figure used to compute the nominal value of a price-weighted market index) will be adjusted before the opening of ex-date of demerger based on the price discovered during the special trading session.
- The demerged company will be screened for its continued eligibility by taking data for the period starting ex-date till the last trading day of the next calendar month. The company will be replaced from the index if suitable replacement is available
- In case a special trading session is not conducted after shareholders approval, the demerged company will be excluded from the index on the ex-date of the demerger or during the next scheduled review of indices.
In case of replacement in indices;
- Indices with fixed number of constituents: On ex-date, a replacement of company will be made based on the eligibility criteria of respective indices in place of transferor company which is being excluded
- Indices with variable number of constituents: On ex-date, no replacement will be made in place of the transferor company which is being excluded
- Announcement of the above changes to be made minimum 3 working days in advance for change in the constituents of indices including the indices on which F&O contracts are traded.
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