CSE sheds light on proposed revision of ASPI calculation methodology

The Colombo Stock Exchange (CSE) is planning to revise the calculation methodology of All Share Price Index (ASPI) by changing the constituent weighting method from full Market Capitalization to free float-adjusted Market Capitalization. The following interview with Head of Research and Strategy Nishantha Hewavithana intends providing some essential information in this regard.

What is a stock market index and the purpose of it?
A stock market index is a statistical measure which shows changes taking place in the stock market. 
Hence, an index reflects overall market sentiment and direction of price movements of the stock market. These indices can be calculated for the whole market (broad market index), a select segment(sector indices) or based on any other theme (eg; Dividend Index, ESG Index etc). Indices are mainly useful in determining the return of the market segment, understanding the overall market direction.

What are the different types of calculation methodologies?
There are various types of calculation methodologies based on different aspects. One such aspect is the weighting of index constituents. 
Two major weighting schemers are weighting index constituents on full market capitalization of each constituent and weighting index constituents on float adjusted market capitalization of each constituent.

What is float adjusted market capitalization?
Simply, this means total market capitalization multiplied by the public holding percentage. Public holding is the portion of the issued quantity of shares readily available for investors to trade and expressed as a percentage. 
This is calculated by companies and disclosed in interim financial statements. The definition of public holding can be found in ‘Contents Definitions and Introduction’ under Listing Rules that can be accessed at https://cdn.cse.lk/pdf/cse-rules/listing-rules/Contents-Updated-as-at-22-06-2021.pdf
For example, in a given company the public holding percentage is 19 percent means that only 19 percent of the issued quantity of shares are readily available to go hand in hand among investors in general. The balance 81 percent is held by strategic investors which we cannot expect to be traded in the market in general. 
Accordingly, 19 percent of the market capitalization (known as float adjusted market capitalization) is ready to go hand in hand- on daily basis.

What is the ASPI methodology revision of 2022?
The ASPI has been calculated based on full market capitalization which means the index constituents are weighted based on the full market capitalization of each security. Alternatively, it could be weighed on float adjusted market capitalization. The revision is to change the weighting scheme from full market capitalization to float adjusted market capitalization.
Since companies disclose public holding quarterly in their interim financial statements the index weights would be revised quarterly (known as Index Rebalancing).

What is capping and why capped at 5 percent?
Capping is the technique use in index calculation to address the issue of over representation of one of few securities in an index. Index is capped at 5 percent level to address the issue of over representation of one of few securities in an index. 
Once capped the excess weight is distributed proportionately among the remaining securities in the index. The same procedure is repeated until no security is exceeding 5 percent cap rate.
We back calculate Float ASPI index and capped at different cap rates. Based on return per unit of risk, 5 percent capping level has been the best. 

What makes CSE to move for this kind of change?
Indices based on float adjusted market capitalization are better able to generate realistic market returns than those based on total market capitalization because they are based on tradable quantities. 
Since the introduction of this idea in early 2000, most of the markets have adopted this in their index calculation methodologies. All the index service providers such as S&P Dow Jones, FTSE are using this method and is considered as a best practice in index calculation methodologies.

What are the advantages and disadvantages of this move?
The main advantages of the revised index would be that it will generate more realistic returns and the index methodology would be in par with generally accepted best practices of index calculations. There are no disadvantages such.

Will the ASPI index value change suddenly due to the implementation this change itself?
No. On the effective date of the methodology revision the ASPI will start moving from the same value that it closed on the day immediately prior to the revision. 
When this methodology revision is implemented, the serial continuity of the index will be maintained and there will be no sudden shift of the index level solely due to the launch of the new index.

How will it affect the ASTRI index (All Share Total Return Index)?
All Share Total Return Index (ASTRI) measures the total return (Price Return + Dividend Return). The ASTRI reflects returns due to both price changes and dividend income. After the implementation of the methodology revision of  ASPI, the price return component will be based on float adjusted market capitalization. This means that ASTRI is also calculated based on float adjusted market capitalization

Is the index methodology of CSE publicly available?
Yes. It is available on CSE website.https://cdn.cse.lk/pdf/Index-Methodologies-of-Colombo-Stock-Exchanhge.pdf