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Index membership has its privileges

In my opinion the biggest market-related news over the weekend wasn't economic data out of the US which suggested the Federal might delay its first interest rate hike. Instead, it was an announcement of a revised liquidity requirement for membership in the Straits Times Index, from 0.05 per cent of issued capital to 0.1 per cent. Straight off, three stocks are in danger of failing to meet the new guideline - Jardine Matheson, Jardine Strategic and Cycle & Carriage, all of which are tightly held and, from observation of daily trades, illiquid. In fact, traders have for years criticised the inclusion of the Jardine stable in the index on the grounds that a) it doesn't represent the Singapore economy and b) it is not actively traded. Criticism a) is actually unfounded - modern thinking surrounding the construction of market benchmarks is that they have to represent the market and market interest first, and not the economy. Citicism b) on the other hand, is justified since activity is the best gauge of interest.

Index construction has always been a controversial issue with no clearcut, one-size-fits all solution. When I started as a reporter in 1992, the STI was known as the ST Industrials Index - it was price-weighted like the Dow Jones Industrial Average, and did not include the banks. This method came under scrutiny and no small amount of criticism over the years because in order to manipulate the index, all that was needed was to shift prices in one or two large-priced stocks. As a result, 1998 saw the introduction of the new, market-cap weighted STI in which the "Industrials'' was dropped to allow inclusion of the banks. It also marked a radical shift in thinking about what the index should represent, from representing the economy to representing the market. Over the years, two main criteria emerged for index membership - size and liquidity.

The first is easy to establish since it's readily measurable and cannot be disputed. You want an index that is small enough to be manageable but whose constituents cover a large proportion of the whole market. Manageable because when there are spilts, dividends and bonus issues, it becomes tedious to perform the correct adjustments.

The second however, is more subjective. If the bar is set too high then large cap stocks which normally would have been included might not qualify, in which case more smaller companies would have to be used thus causing management problems. If too low, then illiquid counters would qualify but there'd be constant criticism that they are not truly indicative of market interest. This is what befell Jardine, whose large size ensures they are clear contenders for inclusion, but whose trading history suggests otherwise.

As I write this, the STI is down more than 30 points (just into the red for the year), dragged lower by large losses in the three affected Jardine stocks. The fourth Jardine index stock, Hongkong Land, is actively traded so it appears not be be under any threat of being dropped. 

Not surprising really, given that membership has its privileges.