Survivorship Bias - Is the Index indicative ?

It was with much interest that I read about the recent revamp of the Straits Times Index (FTSTI) in March 2009 and that the Index would be reviewed and revamped twice a year in March and September to ensure a fair and true representation of stocks listed on the Stock Exchange of Singapore. The latest revision removed 2 property companies - Yanlord Land and Keppel Land; while adding two transport operators - ComfortDelgro and SMRT. Interestingly enough, the reason given was that property was in a slump and that the market capitalization of Yanlord and Keppel Land was lower than that of the 2 transport companies, thus removing them from the index would ensure a better representation as transportation was seen as a more "resilient" industry.

This brings us to the very obvious conclusion that the Index seems to be "revamped" every other time such that the components are switched for other companies. The issue of survivorship bias will certainly be raised - this bias can be explained by the fact that the index continues to persist and climb higher over time not because shares on the whole keep rising, but because the components in the Index are substituted with stronger companies over time, while leaving out the laggard companies which do not perform. This is especially pervasive if you consider the fact that bellweather companies such as Creative used to make up the index until they were dropped due to declining sales and profits.

To cut a long story short, what I am trying to say is that if one uses an Index as a benchmark for stock market performance, one is likely to get results which are highly skewed due to this bias. When weak companies are dropped in favour of good ones, isn't it very obvious even to the layman that the index will continue to rise in future instead of stagnating or even falling behind over time ? Thus, the many articles written about stock markets always returning about 6-8% per annum may not be totally 100% true after all, if we account for this bias and the fact that the index is simply NOT representative from one period to another. For simplicity sake, I will confine my discussion to the Singapore Stock Market as some may point out that the Dow Jones Industrial Index (DJIA) had so many switches in its components since its inception that the Index is almost a totally different animal today than it once was 70 years ago.

This begs the question - how representative is an Index of the broad market and should investors rely on such indices to gauge market sentiment and relative price levels ? Some points to ponder on:-

1) The high weightage of the three local banks (DBS, UOB and OCBC) plus SingTel skews the Index towards these 4 companies. In fact, the rise and fall of just these 4 companies can have a drastic and sharp effect on the Index even though other index components ma not fluctuate much. My argument here is that the weightage is skewed too much towards financial stocks currently.

2) The usage of just 30 stocks to represent a universe of about 700+ companies seems to undermine the representative strength of the index. In the USA, though the DJIA is the bellweather Index which is still used by a broad array of investors, there are also two other important indices - the NASDAQ and the S&P 500. Of the 2, the S&P 500 is considered to be the most representative index because it includes 500 companies in it - this obviously makes it more representative than the DJIA which only includes 30 blue-chip companies (some of which are not so "blue-chip" any longer). My suggestion is for Singapore to have such an index incorporating about 40-50% of the companies on the 2 Boards, in order to show a more representative sample.

3) There are many other indices as mentioned by SGX in their press release some days ago, such as the FTSE ST Mid-Cap Index, Small-Cap Index, Fledgling Index and even an ST China Index. However, all these indices are not prominent enough and are usually not even mentioned by commentators or news reports (with the exception of the China Index since S-Shares seem to be taking a severe battering these couple of weeks). I was hoping SGX could come up with more useful indices which are better recognized rather than the existing ones which seem (to me) to be rather defunct.

4) How are dividends accounted for in terms of computing the returns on an Index ? Besides the fact that an index suffers from survivorship bias, another problem is also that of dividends which are declared and paid out by index constituents over the years. Are these accounted for by the Index ? I doubt so. There are researchers, however, who assume the dividends are reinvested into the Index and compute a median return for that. Suffice to say that such literature remains buried amongst the scholarly and those who study the stock market for a living, and has yet to be mentioned in a mainstream media article or given due attention.

All the above seek to highlight the problems with STI and indices in general. I would appreciate opinions on this issue as well as it is also quite a new area for me to blog on, and I will approach this subject again in the near future should I discover new insights.