Addressing FBM KLCI’s weaknesses

THE FBM KLCI comprises 30 of the largest market-capitalised companies.

It is reviewed semi-annually based on strict ground rules.

On the review date, a new constituent is included in the benchmark index if it is ranked 25th and above, while an existing constituent will be dropped if it falls to 36th and below, based on full market value ranking.

In cases where there is an auto-inclusion (ranked 25th and above), the lowest currently ranked constituent will be dropped, while in cases where there is auto-deletion (ranked 36th and below), the highest ranked non-constituent will be added.

Hence, the FBM KLCI is a 30-stock index that has a buffer zone for companies ranked between 26th and 35th, before a constituent is included or removed.

Constituents falling outside the buffer zone have provided much anxiety among investors, as we have seen in the past with some constituents making entry and exits multiple times.

A previous analysis by this column showed that AMMB Holdings Bhd was the most impacted by this rule, as it exited the index on three separate occasions and re-entered the index three other times over seven years.

Westports Holdings Bhd and KLCCP Stapled Group are also victims, having entered and exited the 30-stock index twice.

These two are currently ranked 26th and 29th in terms of their market value.

They may re-enter the index if their market value keeps improving over the next few semi-annual review dates or if the two current lowest-ranked constituents – QL Resources Bhd and Sime Darby Bhd – currently ranked 33rd and 34th, drop below the buffer zone.

(Note: The above ranking excludes Hong Leong Financial Group Bhd as it failed the liquidity test in the June 2024 semi-annual index review).

More room

Perhaps it is time to review the buffer zone between the 25th and 36th ranked companies by market value to limit index volatility. This can be done as Singapore’s Straits Times Index (also advised by FTSE) has inclusion and exclusion criteria that occur only if a constituent is ranked 20th and above.

It is excluded when a constituent drops to 41st and below.

Hence, the buffer zone is much wider, allowing less disruption to the benchmark index.

There are also special instances when a newly listed company can be included in the FBM KLCI on a fast-track basis, if its full market value is significantly large, for example its full market capitalisation amounts to 2% or more of the full capitalisation of the FTSE Bursa Malaysia EMAS Index based on the closing price on its first day of trading.

This occurred when IHH Healthcare Bhd was listed on Bursa Malaysia in 2012, and none have been observed since then.

It also showed that we have not seen a significantly large public issue that could be considered for a fast-track entry into the benchmark index for almost 14 years.

Liquidity

In addition to the ranking based on full market value, constituents are also measured based on the liquidity factor, whereby companies with higher free float can enjoy a higher net ranking.

Hence, it is not inconceivable to see a lower-ranked constituent, based on full market value, having a larger index weight, simply due to a higher free float factor.

In recent years, some larger new listings were given special exemptions from meeting the public shareholding spread requirement of 25% due to the sheer size of the offerings.

For example, 99 Speed Mart Retail Holdings Bhd saw a free float of just 17% at the time of listing, while MR DIY Group (M) Bhd was at just 15%.

Both eventually made it to the FBM KLCI, but the small free float resulted in only a small net weight on the index itself.

The question is, why should these large offerings in the market be given special permission that allows them to be listed with a lower free float? In addition, there were no conditions imposed on them by the regulators to push for a higher compliance level, post-listing.

Although in the case of MR DIY, the free float improved due to placements carried out by one of its major shareholders.

Hence, when a higher-ranked company based on full market value replaces another constituent with a high free float factor, there is every possibility that funds tracking the index, or passive funds, will see a net selling position in the market.

Higher free float

As some index-linked stocks are held by government-linked investment companies (GLICs), there is an increasing trend of crowding out other investors as these GLICs are still seeing net inflows of funds that they must deploy based on their strategic asset allocation mandates.

Hence, local funds, including other asset management companies and insurance funds, continue to be mostly net buyers in the market.

This has also pushed, to a large extent, the new index constituents to trade at record-high forward price earnings multiples.

As some of these shareholders are seen as strategic shareholders, any increase in their shareholding will result in lower free float as well and thus reduce the weight of the constituent in the index.

There is a dire need for regulators to improve the trading liquidity of our listed companies, starting with companies going for listing with at least 30% or even up to 40% free float.

For existing listed companies, regulators should embark on a journey that will push the public shareholding spread from 25% to 30% and thereafter to 40%.

A higher free float will increase the weight of a constituent in the benchmark index, which in turn will also increase Malaysia’s weight in the widely followed MSCI index series.

Share buyback

This column has spoken about how a share buyback programme can help to create demand for index-linked stocks as companies need to think of capital management and to improve earnings per share (EPS).

A company’s EPS growth can be driven by two factors, and these include organic growth as well as a lower number of shares from a share buyback programme, provided that these shares are cancelled.

While this is contradictory to improving liquidity of the company’s shares, a company can always undertake other capital management exercises to increase liquidity, especially via private placement exercises.

For companies with high liquidity in the market, a share buyback programme can enhance valuation and share price, without having a large impact on the company’s free float.

In conclusion, the FBM KLCI has gone through rapid changes over the years but remained an under-performing index for a long time, as mentioned in last week’s column.

The suggestion this week shows there are measures the regulators could take to ensure the 30-stock index remains relevant and reflective of the overall market and economy.