Treasure Chest | Jul 09 2012
By Greg Peel
The constituents of the Standard & Poor's ASX indices, of which the ASX 200 is the most widely followed, are determined by Standard & Poor's. Fundamentally, the ASX 200 represents the top 200 stocks listed on the ASX by market capitalisation, meaning share price times number of shares on issue. This puts the ASX 200 on par with the S&P 500 in the US, and both differ from the Dow Jones Industrial Average which is a simple arithmetic average of the prices of the top 30 US-listed stocks.
The ASX 200 is adjusted for capital events such as raisings, rights issues, share splits etc in order to maintain smooth pricing. When it comes to “number of shares”, however, S&P considers only those shares which are sufficiently free-floating, meaning not tied up by a large majority shareholder. Thus for inclusion in the ASX 200, or any index, liquidity is another factor used to determine constituents, beyond that of simple market cap.
There is also a more subjective criterion implemented as well. The purpose of the ASX 200 or any broad market index is to represent the underlying economy. The publishers will thus attempt to provide some balance across sectors as much as possible as a counter to overly concentrated weightings in any particular sector. Of course when your constituents include some of the world's largest mining companies, a former government telco, and a well capitalised but concentrated banking sector, there is only so much diversification the publishers can achieve.
The ASX 200 does not represent the top 200 at any given moment, as obviously intraday price movements would have the bottom handful of stocks jumping in and out on market cap with frustrating regularity. The index is instead changed in make-up roughly each quarter, unless a big capital event forces a more immediate adjustment. Bear in mind that constituents are always being taken over, demerging, or in rare cases even going bust before the next scheduled change. And although it's called the ASX 200, sometimes the index can contain 199 or 201 stocks or even less/more.
Once upon a time, notes UBS, an easy profit-making strategy for short-term traders was to buy those stocks announced as about to be included in the index (there's always a warning period) and/or to sell those stocks about to be excluded. The strategy is simple: index-tracking fund managers must dutifully buy/sell those stocks so as to remain accurate index-trackers, thus creating potentially large price moves shortly after the changes are made.
However this lark was never going to last too long, as quickly traders began to move earlier and earlier in an attempt to get ahead of the pack. One can only be as early as the initial announcement, unless of course one is able to predict which stocks are about to be included/excluded. And such “predictions” require more than just market cap calculations, as the aforementioned criteria dictate.
UBS has conducted some research into index-related price moves going back to 2004, and has found that additions typically outperform by 3.4% over four days after the announced changes while deletions underperform by minus 1.1%. The lower the liquidity of the stocks in question, the more pronounced the over/underperformance. The quant boffins at UBS then decided to build a prediction model so they could, in theory, get ahead of the pack.
The model made predictions one month ahead of the scheduled index changes, and proved to be 45% correct on additions and 70% on deletions. The model outperformed by 3.1% on additions and underperformed by minus 6% (meaning short positions outperformed) over the one month. If limited to lower liquidity stocks, returns were double for additions and increased by 50% for deletions.
So there's one for the traders. Note that some brokers publish their index predictions in plenty of time, and FNArena is ever vigilant.
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