MSCI rebalancing threatens to turn ‘Messy’ in new Indian auction

The quarterly rebalancing of MSCI Inc. indexes on Monday will be a key test of whether the mechanism can absorb large institutional orders without producing the sharp price swings that have unsettled traders since its launch earlier this month.

The index changes may spur about $5 billion in trading turnover by global passive funds, with roughly $4 billion passing through the Closing Auction Session, according to Brian Freitas, founder of Auckland-based Periscope Analytics.

“It could get pretty messy,” Freitas said. “The expected flow is almost 30 times what the CAS window has typically been handling.”

The scale of the event is significant compared with what the auction has handled so far. The mechanism has typically been seeing about $125 million of daily turnover.

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The rebalance will put the Securities and Exchange Board of India’s most consequential market reform in recent years under fresh scrutiny after backlash from traders. The BSE Sensex gauge saw a “flash crash” during the 20-minute auction last Thursday, exacerbating concerns over thin liquidity and manipulation during the trading window.
Passive funds are required to track their benchmarks closely, meaning index changes can trigger large orders to buy stocks being added or increased in weight and sell those being cut or reduced. The trades are typically executed around the effective close to minimize tracking error, concentrating a large amount of demand and supply inside the auction.MSCI said in an emailed statement it will monitor the “practical effectiveness” of the new closing auction, informed by feedback from market participants that include its clients and index users.

India’s market regulator has said that the auction is designed to reduce tracking error for passive funds and to align the stock market with global standards. Last week, Chairman Tuhin Kanta Pandey reiterated that the new mechanism will remain in place despite growing calls for changes.

Following its latest quarterly review, MSCI announced that Lenskart Solutions Ltd., Laurus Labs Ltd., Adani Energy Solutions Ltd. and Billionbrains Garage Ventures Ltd. will be added to its standard indexes, while Balkrishna Industries Ltd., SBI Cards & Payment Services Ltd. and Astral Ltd. will be removed. Among other changes, a reduction in the weight of Reliance Industries Ltd. is expected to trigger about $500 million of outflows, according to Abhilash Pagaria of Nuvama Wealth Management Ltd.

Most passive funds are likely to execute the bulk of those trades through the auction window because it allows them to transact closer to the official closing price, according to Pratik Oswal, chief of passive business at Motilal Oswal Mutual Fund. But the scale of the rebalance means some orders may have to be handled differently.

“The primary execution risk is liquidity, particularly in a small number of less-traded stocks where absorbing large orders without materially impacting prices may be challenging,” Oswal said. “For relatively less liquid names, funds may need to execute part of their trades during the regular market session.”

The risk is less pronounced for index heavyweights with deeper order books, so stocks like Reliance should be able to absorb larger trades more smoothly, Oswal said.

One of the biggest challenges is getting enough investors into the auction to provide liquidity, something other markets have grappled with when introducing similar systems. For example, Australia also saw sharp swings early after implementation, including a Covid-era session when nearly 3 percentage points of a 4.4% gain in the S&P/ASX 200 came during the auction.

“It’s a chicken-and-egg problem,” said Andrew Sullivan, founder of Hong Kong-based Asian Market Sense. “Institutions want to see the system works, is fair and free from manipulation before participating. Once they see that they will participate and liquidity will deepen.”