More than just a number

BURSA Malaysia recently announced a proposal to increase the number of constituents in the FBM KLCI from 30 to 50, while also introducing a 10% cap for any index constituent that exceeds the threshold.

To recap, the FBM KLCI was first introduced on July 6, 2009, replacing the 100-stock Kuala Lumpur Composite Index (KLCI) which had been in existence since April 1995.

Ranking positions

There are several issues with respect to the current FBM KLCI, and it is not just about the number of constituents.

While introducing a 10% cap is a welcome move to ensure fairer representation for smaller constituents, there are several other issues that need to be addressed under its ground rules.

Under the current full market capitalisation ranking methodology, a constituent is added to the index if it is ranked 25th and above, and removed if it falls to 36th and below.

Over the years, this ground rule has caused many constituents to move in and out of the index multiple times.

This includes AMMB Holdings Bhd’s three exits and re-entries, as well as Westports Holdings Bhd and KLCC Real Estate Investment Trust (KLCC-REIT), which have each exited and re-entered twice.

The ground rules ought to be amended to allow index inclusion and exclusion at a wider buffer, like the one adopted by Singapore’s Straits Times Index (STI), whereby inclusion and exclusion apply for constituents ranked 20th and above and at 41st and below, respectively.

As it is, frequent inclusion and exclusion can also distort index values, as constituents are typically added at higher market capitalisation levels and removed when their market capitalisation declines below critical thresholds.

Hence, by widening the ranking bands for both inclusion and exclusion, there would be a lower probability of constituents moving in and out of the index too frequently, which can cause greater loss in the FBM KLCI’s value.

Spinoffs

The rule on spinoffs came to light recently following the listing of Sunway Healthcare Holdings Bhd, as the newly listed company was added to the

FBM KLCI after its market capitalisation exceeded that of the

lowest-ranked constituent at the close of trading on its first day of listing.

While the ground rules are clear on the inclusion of the company into the benchmark index, the impact on the share price on the effective date was staggering, to say the least.

Sunway Healthcare’s share price, which closed at RM2 before the inclusion on March 25, rose to an intraday high of RM2.46 two days later before profit-taking kicked-in.

The stock were heavily sought after, as only a limited number of shares were available for institutional investors.

While one can understand that there are ground rules to be strictly observed, the case of Sunway Healthcare brings into question the ground rules themselves, as index inclusion has artificially skewed demand for the shares , with fundamental valuations difficult to justify.

Is 50 better?

Among major indices regionally and globally, having a 30-stock benchmark index is common, and it is well accepted as an optimal size for an equity portfolio.

A larger pool of constituents may not provide additional benefit, taking into consideration the resources required to keep track of the performance of up to 40 or even 50 companies.

Among key barometers, the Dow Jones Industrial Average is the most widely known 30-stock index, while others with similar constituent sizes include the STI and India’s S&P BSE Sensex.

There are also benchmark indices with higher constituent counts, and these include the Hang Seng Index with 90 constituents, as well as several major European indices with between 35 and 40 stocks.

Changes in the number of index constituents are rather common across exchanges.

There are no right or wrong answers as to whether 30 or 50 is better for the Malaysian context but one thing is for sure, due to the nature of conglomerates and their main subsidiaries that are also listed on Bursa Malaysia, a 50-stock FBM KLCI (assuming Hong Leong Financial Group Bhd and KLCC Stapled Group fail to meet the liquidity test requirement) will see the Sunway Group having the most number of index constituents.

This would include Sunway Construction Bhd, Sunway Real Estate Investment Trust and Sunway Healthcare, alongside Sunway Bhd itself.

The issue here is that while the index is adjusted for free-float purposes, the underlying financial performance of Sunway is very much dependent on its three subsidiaries. Fund managers, although they do adjust for free-float exposure, remains fully exposed directly to to each constituent in their portfolios.

The other double counting will be YTL Corp Bhd, as Malayan Cement Bhd will be a new constituent, joining YTL Power International Bhd, which is already an index stock.

IOI Corp Bhd will be joined by IOI Properties Group Bhd (IOIPG), while Genting Bhd, Genting Malaysia Bhd, and QL Resources Bhd – recently eliminated from the FBM KLCI – will re-enter the index.

Finally, Batu Kawan Bhd, the holding company of Kuala Lumpur Kepong Bhd, will also join the elite-50 club.

In conclusion, beyond the ground rules, which can be amended to suit the local peculiarities of the FBM KLCI, the expansion to a 50-stock index makes little sense for portfolio construction or tracking error purposes, as several companies to be added would already be well represented by their holding companies or subsidiaries.

Having said that, the expanded index would see representation from sectors presently absent, namely technology via ViTrox Corp Bhd, oil and gas via Dialog Group Bhd, property via Sime Darby Property Bhd and IOIPG, and IGB Real Estate Investment Trust and S-REIT for the REITs sector.

If FBM KLCI is expanded, it is more than just expanding the number of constituents, as there will be a one-time rebalancing of the current constituents to be dealt with first.

Second, due to the number of large conglomerates with listed subsidiaries listed that would also qualify for inclusion in a top-50 index, the incremental benefit to investors will likely be limited.

The only plus point is that we may see the emergence of non-representative sectors into the benchmark index, but the weightings of these new sectors will not be significant enough to make a difference.