New dynamism: Singapore needs a market index without Reits to support passive flows

[SINGAPORE] As the Singapore market has become more dynamic, I have increasingly turned to exchange-traded funds (ETFs) to manage my exposure to locally listed stocks.

Many fundamentally sound stocks that I had purchased years ago – such as ST Engineering , Singapore Exchange (SGX) and OCBC – have rallied so dramatically since the pandemic that they no longer appear all that attractive to me.

On the other hand, some stocks that I had avoided for years because they appeared to be going nowhere – such as Keppel , Sembcorp Industries and Singtel – have unlocked value and repositioned their businesses, and delivered very strong returns.

The way I see it, maintaining broad and diversified exposure to the largest Singapore-listed companies now makes more sense than attempting to pick winners.

With the slew of initiatives that have been introduced to rejuvenate the Singapore market – the S$6.5 billion Equity Market Development Programme not least among them – companies are now clearly paying more attention to driving shareholder value and communicating with investors.

This is likely to translate to stronger corporate profitability and higher stock valuations. But figuring out which companies will deliver the strongest returns at any particular moment could be a challenge.

One solution is to tap the skills of paid professionals by investing in an actively managed fund focused on Singapore-listed stocks. My own preference is to passively invest in the constituent stocks of a broad market index through an ETF.

As it happens, a portfolio comprising the 30 components of the Straits Times Index (STI) can be efficiently replicated by buying units in the Amova Singapore STI ETF, or the State Street SPDR STI ETF.

Some market watchers have also recently called for ETFs based on the iEdge Singapore Next 50 Index (N50) – a market benchmark SGX launched in September last year to boost interest in large and liquid mainboard stocks not included in the STI.

In my view, the creation of ETF products based on the N50 would further enable investors to ride the market revitalisation trend while neutralising the risks of picking the wrong companies and abandoning the best performers too early.

Excessive S-Reit weightings

One drawback of mirroring the STI and the N50, however, is that both indices have significant exposure to Singapore-listed real estate investment trusts (S-Reits) – which detracts from the growth narrative the authorities have been fostering.

The STI has eight S-Reits among its 30 constituents, with a combined weighting of about 9.6 per cent. The N50 has 16 S-Reits among its 50 constituents, with a combined weighting of about 37.8 per cent.

This column previously noted that S-Reits delivered relatively strong returns prior to the pandemic. With the surge in interest rates since then, and the increased focus on shareholder value at many large companies, S-Reits have lagged well behind the broader market.

As an investor, I would now much rather own an ETF tracking a market index that does not include any S-Reits than one based on the STI or N50.

Perhaps, SGX should create this index – by combining the constituents of the STI and N50, sans the S-Reits.

It wouldn’t surprise me if many market watchers baulk at my suggestion. For one thing, even if the popularity of S-Reits has waned, they are still a big part of the Singapore market’s investable universe and should not be ignored.

Some may also argue that DBS, OCBC and UOB currently pose a far bigger risk to market sentiment than S-Reits. The three banks have seen their combined weighting in the STI soar from less than 40 per cent before the pandemic to more than 51.1 per cent currently.

As the elevated profitability that drove this increased weighting normalises in the months ahead, these three big counters could weigh on the performance of the STI and sap investor enthusiasm.

Nevertheless, my sense is that an ETF based on a broad market index that excludes S-Reits would fill a gap in the market.

For instance, investors could use it alongside ETFs offering broad exposure to S-Reits – such as the Lion-Phillip S-Reit ETF or the CSOP iEdge S-Reit Leaders Index ETF. This would give them significant control over their exposure to stocks versus S-Reits.

Build a better index

The development of a stock-only market index could also be an opportunity to address some of the shortcomings of Singapore’s existing market indices.

Market cap-weighted indices such as the STI are often said to channel more capital towards stocks as they rise – leading to overvaluation and concentration risks.

One remedy that has been mooted in the past is for constituents of an index to be weighted on the basis of their revenue, earnings or book value instead of their market value. A simpler solution might be to cap the weighting of each constituent.

The N50 caps the weighting of its constituents at 5 per cent. During each quarterly review, constituents with weightings of more than 5 per cent have their “excess index weight” proportionally distributed to the remaining constituents.

What impact would capping have on the performance of an index? Clearly, a lot depends on what exactly is happening in the market.

However, a study by S&P Dow Jones Indices in 2024 found that the S&P 500 3% Capped Index had remarkably similar characteristics as the uncapped S&P 500.

Notably, the annualised returns from the capped index lagged the uncapped index by only 31 basis points over the preceding three-year period, and 62 basis points over the preceding five-year period.

The uncapped S&P 500 clocked an annualised return of 11.9 per cent over the three-year period, and nearly 16 per cent over the five-year period.

If a new market index is created, it should be explicitly positioned to include stocks that list on the new Global Listing Board (GLB), under the much-anticipated dual-listed arrangement with Nasdaq.

Given that companies seeking to use this facility must have market caps of at least S$2 billion, many of them are likely to immediately be in the same league as constituents of the N50 and even the STI.

At the moment, however, constituents of the STI and N50 are drawn exclusively from the mainboard.

As Singapore implements measures to attract new listings, prime its fund management sector, and push corporate boards to focus on shareholder value, many small investors like me are likely to want a means of maintaining broad and low-cost exposure to the local market through an ETF.

Coming up with a robust all-stock index would be an important step in facilitating these passive flows into the local market.