FBM KLCI benchmark is only a reference

Business & Market 2009

Written by Ang Kok Heng

Sunday, 23 August 2009 23:34

Commentary by Ang Kok Heng

THE 100-stock KLSE Composite Index (KLCI) was replaced by the FBM KLCI from July 6 onwards. As the new index replaced the old index, it commenced from the same level where the old index ended. This is made possible by choosing a base such that the market cap of the FBM KLCI divided by the new base equalled the KLCI.

The old KLCI used the total market capitalisation or market value (denoted by MV_old) of all the 100 component stocks divided by a base (denoted by B_old). MVold is computed by multiplying the number of stocks issued by the share price. For the closing value of the KLCI, the closing prices of component stocks were used. In this way, stocks with the higher number of shares will have a higher influence on the index for every 10 sen change in price. Looking from another angle, stocks with higher market capitalisation will have higher impact for every 1% change in price. In this way, KLCI is said to be size-weighted as bigger stocks having bigger market value will have stronger influence on the direction of the index.

When the KLCI was instituted in 1977, the base was chosen such that the index commenced at 100 points. Over the years, due to changes in number of shares issued, the base was adjusted regularly.

The new FBM KLCI does not use all the shares issued in computing the index. It only uses a portion of the shares issued depending on the freefloat in each of the component company.

Prior to July 6, the KLCI closed at 1,108 points, and this is computed by the formula:

1,108 = MV_old/B_old

As the formula used to compute the index remains the same, the ratio of MV/B for the FBM KLCI should also be 1,108 after taking over from the KLCI. The new index, the FBM KLCI, has its own market value, MVnew, based on certain weightings of the 30 component stocks and the corresponding closing share prices such that,

1,108 = MV_new/B_new

A simple rearrangement shows that:

B_new = (MV_new/MV_old) x B_old

FBM KLCI — new benchmark
From July 6, 2009, onwards, FBM KLCI becomes the key benchmark representing Malaysian stock market. Everyday, commentators and newspapers worldwide will quote the performance of the FBM KLCI to denote the performance of the Malaysian market. When we look at other foreign bourses, we will also look at the performance of the key benchmark like the Hang Seng Index for Hong Kong, the Nikkei 225 for Japan, the ST Industrial for Singapore etc.

Using a single benchmark to denote the performance of a market is a simple and convenient method to monitor a stock market. It provides the direction and relative performance of a market compared with other bourses. However, investors should always take note that a benchmark is as good as what it contains.

For the new FBM KLCI, it is a much narrower 30-stock index compared with the predecessor, the KLCI, which encompassed a more extensive 100 stocks covering a wider range of sectors. Some of the sectors not included in FBM KLCI are construction, property, timber, IT etc.

Dow is only a reference
Other than the FBM KLCI, the Dow Jones Industrial Average (DJIA) is also a rather narrow 30-stock index which has been in use for 113 years. While the FBM KLCI is size-weighted, DJ is just a simple average index where each of the 30 components has equal weighting. Despite of its less scientific method of computation, the DJIA is still widely followed by investors worldwide. Due to its lesser representation of the huge US market, the DJIA is only as good as a reference. For more serious analysis on the performance of New York Stock Exchange, a broader S&P 500 is always a more appropriate index to use as the later incorporates a wider 500 stocks and computed on size-weighted basis.

Portfolio of assets
Every investor has a portfolio of assets which will probably comprise cash/FD, shares, unit trusts, property etc. Each of the asset is denoted by A1, A2, A3, A4 etc and the percentage of each of the corresponding asset is denoted by w1, w2, w3, w4 etc. The value of the portfolio (P$) is represented by:

P$ = A1 + A2 + A3 + A4 + ...

The proportions in the different asset classes are denoted by:

P% = w1 + w2 + w3 + w4 + ... = 100%

For a portfolio of shares, it may comprise several shares plus cash balance (C). The value of each of the share can be denoted by X1, X2, X3, X4 etc and the percentage of each of the corresponding asset is denoted by w1, w2, w3, w4. The value of the portfolio of shares (PX,$) is represented by:

PX,$ = X1 + X2 + X3 + X4 + ... + C

The portfolio breakdown in percentage term is shown as follow:

P% = w1 + w2 + w3 + w4 + ... + wC = 100%, where wC denotes the percentage held in cash.

The portfolio can be shown by way of sector such as consumer, industrial, trading services, plantation, construction, property etc where ws1 denotes the percentage invested in sector 1.

P% = ws1 + ws2 + ws3 + ws4 + ... + wC = 100%

Single stock portfolio
There are also some investors who believe in a stock and invest only in that stock. The stock so chosen must have gained a lot of conviction from the investor. It could be due to sentimental value, trust that the investor has on the stock or simply out of superstitious belief in providing luck to the investor from previous experience. There are many owners of listed companies who invest only in their own company as they do not trust the management of other listed companies.

In terms of performance, this one-stock portfolio will behave quite differently from the benchmark index. The performance of this one-stock portfolio will depend entirely on the performance of the stock alone. Unless, the stock is a diversified blue chip, the share price could be very volatile. The risk of investing in a single stock is definitely high. Even a historically low beta stock could turn sour in the future due to unforeseen circumstances. For buy-and-hold strategy, single-stock portfolio does require close scrutiny by investors. This is possible if the investor is also the owner or a senior management of the company such that, he or she is able to keep track on every single movement of the company.

Diversified portfolio
Most investors have a diversified portfolio — having a variety of stocks accumulated over the years either by design or by default. Some investors know exactly what they want. They will choose the appropriate sectors and stocks to invest in. Some may have preference in certain sectors or to avoid certain sectors due to specific reasons. For example, Warren Buffett prefers consumer sector where it is easier to understand.

It is not uncommon to see those involved in property-related trades prefer to invest in property stocks, those working in the estates prefer to buy plantation stocks etc.

A well-diversified portfolio ideally should have stocks from different sectors especially those which are less correlated. Preferably in different business cycles — plantation (which depend on weather and price of palm oil), construction (which is highly dependent on the economy), stockbroking (which is linked to the vigour of the stock market) etc.

Unfortunately, many investors end up with a long list of stocks inherited from the previous bull market. The so-called "stuck" shares probably make up a large portion of the portfolio. The stocks were purchased at high prices and the investors are unwilling to cut loss. This "rojak" portfolio will not help the investors to move forward. A review is needed to re-look at each of the stock in the portfolio objectively such that if a stock is needed to be sold then sell it. There is no point crying over spilt milk. Relying purely on luck to recover past losses is an unwise decision.

Incorporate cash in portfolio
While the FBM KLCI benchmark is an all-stock portfolio, the portfolio of an investor may not be fully invested at all time. Most people will have certain amount of cash not invested. But the portfolio’s cash portion of an investor is usually mixed with other savings. Without a segregated portfolio of equity investment, it will be difficult to determine the portfolio’s return and as such, there is no meaningful comparison with a benchmark. Merely looking at the performance of some of the stocks in the equity portion of a portfolio is difficult to conclude whether a person has done well in share investment.

To have a proper performance comparison, it is necessary to put in the records of available cash for equity investment at the beginning of each year even though the cash is kept in savings or fixed deposit accounts. The share invested plus the allocated cash will form the portfolio at the beginning of each year. All sales proceeds and dividends received will be credited into the cash balance. Likewise, all purchases shall be debited from the cash balance.

The total return of a portfolio is the amalgamation of return from share investment and interest/dividend income. In this arrangement, the total portfolio return will depend on the performance of the equities as well as the percentage invested in equities.

Portfolio performance
The performance of a portfolio Rp is the combined performance of each of the component (R) of the portfolio multiplied by the respective weight (w) where Rp = w1 x R1 + w2 x R2 + w3 x R3 + ... The return from the cash portion may be ignored for simplicity sake since present interest income is relatively small.

In order for a portfolio to perform well, not only the stock must perform well, the weight must also be sufficient to provide a meaningful return. For example, a stock which gained 80%, but if an investor only invested 5% of his money in the stock, the contribution to the portfolio return is only 5% x 80% = 4%. On the other hand, an investor who invested 30% of his money in a stock which appreciated 40% will make 30% x 40% = 12% gain to the portfolio.

The concept of assigning weighting to each stock or even sector is widely used by fund manager to monitor and analyse attributes to portfolio performance. For individual investors, it is also useful as the bottom line impact is the same.

Performance comparison
It is not uncommon to compare a portfolio return with a reference benchmark. The most convenient benchmark is the FBM KLCI which is also a fully-invested portfolio with no cash component and have different weights on each of the 30 component stocks. From the explanation above, it is now clear that the FBM KLCI may not provide meaningful comparison for most investors due to different sets of stock invested. While the FBM KLCI contain the biggest stocks listed on Bursa Malaysia, many individual investors will likely have a small portion invested in these stocks.

While it is true that more money are invested in big-cap stocks and the return of big-cap stocks are important, retail investors are unlikely to be invested only in the big-cap stocks alone. Even most fund managers will not restrict themselves to the 30 stocks in the FBM KLCI. Unless a fund is an index fund linked to the FBM KLCI, most funds will have a much wider spectrum of stocks to invest in. As such, many fund managers find the FBM KLCI to be too narrow for benchmarking purposes.

Use relevant benchmark
A portfolio should compare against a relevant benchmark depending on the objective of the fund and type of stocks to be invested in. Unfortunately, there is no perfect benchmark for most funds. The next alternative is to use the closest possible index as the reference index.

Ang has 20 years’ experience in research and investment. He is currently the chief investment officer of Phillip Capital Management Sdn Bhd.

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Last Updated on Sunday, 23 August 2009 23:40

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