Stock market investment: Here's the biggest problem with rule-based index investing that you should know

economictimes.indiatimes.com:

HDFC Bank shares, the FII ownership falls, MSCI doubles the weight of the bank in the indices, forcing many FIIs/ETFs/index funds and funds following the benchmark to buy. If you don’t sell, MSCI does nothing, and there is no additional buying’.”

Can you understand what is happening here? MSCI is an American company that runs many stock market indices, which are followed by global investors. MSCI periodically adjusts the weightage of stocks in its indices based on factors like the free float. In this instance, Arora creatively uses a movie dialogue to explain the dynamics with HDFC Bank shares. If FIIs sell a few HDFC Bank shares, it could paradoxically trigger increased buying. How? Selling would reduce the free float. MSCI’s methodology would then call for increasing the stock’s weightage in the index. This would compel index funds and ETFs, which mirror the index, to buy more shares to match the higher weightage. Active funds benchmarked to the index may also feel the pressure to add to their positions.

On the other hand, if FIIs refrain from selling, MSCI is likely to maintain the HDFC Bank’s current weightage, resulting in no incremental buying pressure from indextracking funds. This happened last week. If the FIIs had collectively sold just 0.05% of the stock, it would have doubled the stock’s weightage. If that had happened, a lot of ETFs and other investors, who were obligated to shadow the index, would have had to double their holdings.

This was widely reported in the investing media and commented upon