The FBM KLCI only a reference, incomplete and important information left out, FBMKLCI volatility.

From The Edge Malaysia:

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 MVold) of all the 100 component stocks divided by a base (denoted by Bold). 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 = MVold/Bold

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 = MVnew/Bnew

A simple rearrangement shows that:

Bnew = (MVnew/MVold) x Bold

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.

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.

This article by Philips Capital fails to emphasize the effect of free float. They barely glance over a critical part of the the FBM KLCI that all investors need to know. The index is weighted by free float factor. This is why in the index, BCHB is the most heavily weighted stock although it doesn't have the largest market cap.

Why is free float market weight important? Well, if I have a 100 billion market cap company with 15% of shares in free float, how does the index treat it? My company is only considered a 20 billion dollar market cap company in the new index.

If I have a 20 billion dollar company with 75% or more shares in free float? It's considered a 20 billion dollar company in the new index due to the free float methodology. Free float market weight makes a HUGE difference. If I do not consider free float and build based on market cap, my effort to recreate the index will be completely wrong! Furthermore, the top 10 stocks would only compose of 61% or so of the index weight, compared to the 70% officially listed on the FTSE website in June.

Not only is the index composed of fewer companies to 30 as correctly mentioned, it weighs heavily the companies with the largest number of free floating shares, which happens to be the top 10 stocks of the FBMKLCI.

What else would you like to know? 4 out of the largest 10 stocks of the FBMKLCI have a 1-year-beta of over 1 as reported on Bloomberg. In addition, 2 of the stocks have the beta listed as undefined but am reasonably sure the beta is over 1. Sime and Axiata are incredibly volatile stocks. When you have 6 stocks in the top 10 with a beta of over 1, with a heavier weighting on the top 10, you can be reasonably sure the free float market weighted index will be much more volatile compared to the normal market weighted index.