You will be able to explain how indexes choose and weight members and why inclusion moves prices.
One evening an index provider announces that Larkspur, Marcus's small SGX supplier, will join a regional small-cap index at the next review. Nothing about the business has changed. Its customers, margins and debts are the same as yesterday. The next morning the shares open 6% higher. These are made-up events, but the pattern is real, and it comes from who has to buy.
Build and run an ETF portfolio explains indexes from the buyer's side in lesson 2.1, What an index is and how it decides weights. This lesson looks at the same rulebooks from the side of the stocks inside them.
Most major indexes weight members by free-float market value: the share price times the number of shares available to trade, leaving out blocks held by founders, governments, parent companies and other long-term holders.
Larkspur has 300 million shares at a made-up price of S$1.60, so its full market value is S$480 million. Its founding family owns 55% and never trades, so the free float is 45%, or 135 million shares. Its float-adjusted value, the figure an index uses for weighting, is S$216 million, less than half the headline figure.
Free float explains why some large Singapore companies carry less weight in an index than their market value suggests, and why a company can gain weight without its price moving: if a big holder sells a block to the public, the float rises and so does the weight.
Indexes also differ in how they treat foreign ownership limits, multiple share classes and very large single holdings, and the methodology document spells out each rule. Weighting by free-float value means an index fund never has to buy shares that don't trade, which keeps the index investable.
Membership follows published rules, usually on size, liquidity and float. A company must be big enough, trade often enough and have enough shares in public hands. Some indexes add other tests. The S&P 500, for example, is chosen by a committee and requires a record of positive earnings, so a large but loss-making US company can sit outside it for years.
The STI, which tracks 30 large Singapore companies, is calculated by FTSE Russell under published ground rules covering eligibility, liquidity tests and how often it's reviewed. Most providers review on a fixed schedule and announce changes some days or weeks before the change date, so the market knows what's coming.
That gap between the announcement and the change date is where prices move.
A fund tracking an index aims to match it, so it must hold the new member at its index weight by the time the change takes effect. If it buys later, it risks lagging the index. Most such buying happens near the close on the last day before the change, at the closing auction from lesson 5.2, Order types beyond limit and market, and when each helps.
Now put numbers on it. Suppose, with made-up figures, funds tracking the small-cap index together hold 8% of every member's free float. To add Larkspur they need 8% of 135 million shares: 10.8 million shares. If Larkspur's average daily volume is 0.6 million shares, that's 18 days of normal trading, all wanted on one afternoon.
Traders know this. Between the announcement and the change date, some buy the stock expecting to sell it to the index funds at the close. That's why the price tends to rise before the change rather than on it. Research on index additions has generally found a price effect around inclusion, but how big it is and whether it lasts has varied by market and period, and much of it has been arbitraged away as more traders watch for it. Deletions work the same way in reverse: index funds must sell, and the price is pushed down.
For you, three lessons follow. Don't treat an index-driven price jump as news about the business. Don't assume it lasts, because the extra buyers are gone after the change date. And if you hold a thin stock that leaves an index, expect weak prices and poor liquidity around the change.
Market-value weighting has a second consequence. The largest companies get the largest weights, and as their prices rise their weights grow without anyone buying more. When a handful of companies make up a big share of an index, an index fund becomes a large bet on those few names.
Singapore investors see this in two places. The STI gives large weights to the three local banks, which is why Marcus's bank shares and his STI ETF moved together in the correlation matrix from lesson 2.4, Beta, correlation and why diversification shrinks in a crisis. And a world index gives large weights to the biggest US technology companies, which overlap with his US chip designer. Check the top ten holdings and their combined weight on the latest factsheet for each index you own; providers publish them monthly.
Concentration isn't a flaw in the index. It's what the market looks like. But it changes how you should count your exposure when you set position limits, which lesson 11.3, Position and sector limits, and concentration risk, turns into rules.
Marcus opened the methodology document for the world index his ETF tracks and found four facts in twenty minutes: the selection rules, the weighting method, how often it rebalances and how far ahead changes are announced. Do the same for one index you hold.
Read the published rules for one index you hold and note how it chooses members, weights them and how often it reviews.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).