The Myth of an Ideal Index

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Edgar Hart
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1 Luncheon Presentation for Actuarial Society of Hong Kong The Myth of an Ideal Index Vincent Kwan Director and General Manager 20 July 2005

2 Unveiling the Myth of an Ideal Index An Ideal Index = A Rising Index = A Can-Be-Beaten Index = HANG SENG INDEX What Do You Think?

3 The Myth of an Ideal Index What is an IDEAL INDEX? Constructing an IDEAL index? Is there any IDEAL index?

4 Question 1 What is an IDEAL index?

5 See Their Differences Indexed (1995 = 100) Index A Index B (As at 30 June 2005) Annualised % Change over Index Return (%) 1 year 3 years 5 years 10 years 20 years A B

6 More Differences No. of Constituents Market Capitalization (as at 30 Jun 2005) DJIA 30 USD 3,646 Bn S&P USD 10,982 Bn Methodology Simple Average (Price-weighted) Market Capitalization Weighted US Market No. of Listed Stocks Total Market Capitalization (As at 31 May 2005) 6,057 USD 16,276 Bn

7 Index Explosion Hang Seng Index Number of Indexes 25 Years Ago Now 1 56 Standard & Poor s Dow Jones FTSE ,500 60,000

8 Why? The Power of Computing Moore s Law by Gordon Moore, Intel co-founder: the number of transistors (computing power) on chip doubles about every two years. The increase in the number of indexes matches the Moore s Law The Countless Uses of an Equity Index

9 101 Ways of Using An Index Benchmarking Fund Performance Active Fund Benchmarking Index Funds Return Guaranteed Fund ETFs Stock Market Index Enhanced Indexing Index-linked Derivatives Index Betting Index Futures Index Options Index/Basket of Indexeslinked Instruments Mini-Futures Mini-Options Notes Deposits Warrants

10 Any IDEAL index in Hong Kong? Hang Seng Index Finance Hang Seng Composite Index Series Hang Seng Composite Index Hang Seng Freefloat Index Series Hang Seng Freefloat Composite Index Utilities Industry Indexes Hang Seng Hong Kong Composite Index Hang Seng 50 Properties Commerce and Industry Oil & Resources Industrial Goods Consumer Goods Services Utilities Financials Properties & Construction Information Technology Conglomerates Hang Seng HK LargeCap Index Hang Seng HK MidCap Index Hang Seng HK SmallCap Index Hang Seng Mainland Composite Index Hang Seng China Enterprises Index Hang Seng HK Freefloat Index Hang Seng HK 25 Hang Seng Mainland Freefloat Index Hang Seng Mainland 25 Hang Seng China-Affiliated Corporations Index

11 An Ideal Index, if Any A good market benchmark Point of reference Something being known and can be used as a standard Being used widely

12 Question 2 Constructing an IDEAL index

13 Different Users, Different Requirements Benchmarking Underlying Index for Products Simple Objective Reflect Market Tradable Good Liquidity Meeting specific requirement Full Market Capitalization Weighted Freefloat Weighted (+ Capped)

14 Full Market Capitalization Weighted Today s Index = Yesterday s Closing Index x Today s Total MV Yesterday s Total MV MV = Price x Issued Shares Simple Objective Only 2 pieces of info required No human manipulations Reflect Market Reflecting change in total market capitalization as a result of price change

15 Freefloat Market Capitalization Weighted Today s Index = Yesterday s Closing Index x (MV t x Freefloat Factor x Cap Factor) (MV t-1 x Freefloat Factor x Cap Factor) Benefits Tradable Good Liquidity Reflect Institutional Investors Difficulties Freefloat is not well-defined Cap level can be artificial It reflects a portfolio, not the market We call this a Portfolio Indicator

16 HSI s Freefloat Definition Exclusion of shares not readily available for trading from index calculation: Strategic holdings shares held by strategic shareholder(s) who individually or collectively control more than 30% of the shareholdings; Director s holdings shares held by director(s) who individually control more than 5% of the shareholdings; and Cross-holdings shares held by a Hong Kong listed company which controls more than 5% of the shareholdings as investments. Any freefloat definition is an approximation Are passive funds holdings of shares freefloat or not?

17 Freefloat is Trendy We provide choices HSI vs HS50

18 Hang Seng Constituents with 25 Hong Kong stocks 25 Mainland stocks 13 H-shares 10 Red-chips 2 Other Mainland stocks MV Weighting (As at 30 June 2005) 13 H-shares 15% 10 Red-chips 14% 2 Other Mainland Stocks 2% 30 out of 33 HSI constituents 25 Hong Kong Companies 69% Freefloat adjusted and capped * 30 HSI constituents included for 80%

19 Top Constituents Stock (As at 30 Jun 2005) Weighting (%) HS50 HSI 5 HSBC Hldgs Hutchison China Mobile Cheung Kong SHK Prop PetroChina Hang Seng Bank CLP Hldgs

20 Hang Seng 50 vs Hang Seng Index With 17 more constituents than the HSI, does HS50 perform differently from HSI?

21 Hang Seng 50 24,000 19,500 HSI Index Chart HSI HS50 HS50 2,763 2,245 15,000 1,727 10,500 6, (%) HSI HS50 Closing Index 14, , Cumulative Return Difference (HSI - HS50) -15 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan month months % Change over 12 months Correlation: 98.4% (As at 30 June 2005) 3 years (%) 5 years ,

22 Attribution Analysis Return HS50 vs HSI (2/7/04 30/6/05) HS50 Weighting HSI Return Weighting Total Performance Difference (%) Different Constituents Weighting Total Hang Seng 50 HSI Constituents Non-HSI Constituents Others (HSI, but not HS50)

23 How Good is HSI? Turnover (June 2005) HSI Total Market Market Value (as at 30 June 2005)

24 How Good is HSI? MV Coverage (%) No. of Companies

25 How Good is HSI? 24,000 HSI Index Chart HSCI 2,763 19,500 HSI HSCI 2,245 15,000 1,727 10,500 Correlation: 99.3% 1,209 6,000 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Hang Seng Composite Index 200 Constituents 90% Market Capitalization Coverage

26 Is there any IDEAL index? Different Users Different Index Requirements Many Indexes No Single Index is IDEAL

27 Index Trend More Types of Indexes Style index: growth, value, dividend Geographical and Industry: any combination Specials: corporate governance, social responsibility Tailor-made or Customized Indexes Meeting specific demand of single customer

28 HSI s Strategy We are meeting the challenges Hang Seng Total Return Index Series Hang Seng 50 Hang Seng HK 25 Hang Seng Mainland Hang Seng Freefloat Indexes Series FTSE/Hang Seng Asia Indexes 2001 Hang Seng Composite Index Series Hang Seng Stock Classification System

29 Hang Seng Family of Indexes Hang Seng Index Finance Hang Seng Composite Index Series Hang Seng Composite Index Hang Seng Freefloat Index Series Hang Seng Freefloat Composite Index Utilities Industry Indexes Hang Seng Hong Kong Composite Index Hang Seng 50 Properties Commerce and Industry Oil & Resources Industrial Goods Consumer Goods Services Utilities Financials Properties & Construction Information Technology Conglomerates Hang Seng HK LargeCap Index Hang Seng HK MidCap Index Hang Seng HK SmallCap Index Hang Seng Mainland Composite Index Hang Seng China Enterprises Index Hang Seng HK Freefloat Index Hang Seng HK 25 Hang Seng Mainland Freefloat Index Hang Seng Mainland 25 Hang Seng China-Affiliated Corporations Index With Total Return Index

30 Summary of Our Index Derivatives 2004 Futures & Options (no. of contracts) HSI 12,115,190 HSCEI 1,821, ,846,641 n.a. ETF (NAV HKD Mn) HSI HSCEI 37,627 1,742 33,083 n.a. Listed Warrants in HK (no. of warrants launched) HSI 199 HSCEI 138 Other products (issue size HKD Mn) HSI 38,517 HSCEI 13, n.a. 1,348 n.a.

31 THANK YOU

Summary. Research Paper No. 24

Summary. Research Paper No. 24 A Survey on the Retail Structured Notes Market in Hong Kong Joseph Lee and Veronica Chang, Research Department of the Supervision of Markets Division 1 October 2 Summary During 1 June 23 1 June 2, a total