How will reducing the number of constituent stocks in an index affect the index?
Will that affect share prices of STI ETF 100?
Thanks!
Answers:
With all due respect, I disagree with the above person.
The STI should experience higher volatility with only 30 constituents compared to before. While there is a high degree of cross-correlation between the current 50 members of the STI. Furthermore, the 50 STI members tend to have a lower Beta compared to the SGX Composite.
The argument that the Dow has a lower volatility than the Nasdaq is not a fair comparison. The DJIA has a much lower Beta compared to NASDAQ Composite. On the other hand, the DJIA has higher system (diversifiable, company specific risk) compared to the Nasdaq composite. That is, NASDAQ is more sensitive to the "market". In other word, the NASDAQ composite has higher market risk, but lower systemic company risk. The DJIA has lower market risk, but higher systemic risk.
Mathematically, you need about 80 stocks to really remove a lot of the system risk. By reducing the number of stocks from 50 to 30, the index will have a higher degree of volatility. However, the STI components currently have a high degree of cross-correlation - so there should be very little change in beta.
The change may not make the STI more volatile. Just
because an index has less stocks in it does not mean it is
more volatile.
Look at the difference between the DJ industrial average and
the the Nasdaq 100. The Dow only has 30 stocks in the index compared to the 100 in the Nasdaq index but is much
more stable.
Also, remember that the blue chips are big companies that
are well known and are the most actively traded. So they will
represent a large percentage of the market's activity even
though they are small number of the total companies that
are listed on the exchange.
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