View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Research Papers in Economics A New Index of Belgian Shares1 Ronald Anderson Davy Reinard Olivier Scaillet IRES Université catholique de Louvain Place Montesquieu, 3 B-1348 Louvain-la-Neuve July 1997 Abstract A factor analysis of returns of shares traded on the Brussels Stock Exchange reveals that the first dominant factor is highly correlated with the popular Bel-20 index and that a distinctive alternative trend is represented by the markets second factor. We propose a new stock index consisting of 22 Belgian industrial and commercial shares which are particularly sensitive to this second market factor. The resulting index offers opportunities for diversification of a portfolio consisting of Bel-20 shares and could form the basis of derivative products which would be particular sensitive to Belgian industrial performance. A fundamental analysis shows that shares within the new index are less sensitive to BEF/$ exchange rate and the price of oil than are Bel-20 shares. We have benefited from the financial and technical support from the Brussels Stock Exchange. Responsibility for errors and all views expressed is our own. 1. Introduction: Does Brussels Need a New Stock Index? In this study we explore the possibility of defining a new stock index for the Brussels Stock Exchange. Since it was introduced in the early 1990s the Belgian 20-Index has become the widely quoted benchmark for the Brussels Stock Exchange much in the same way that the Dow Jones Industrial Average operates for the New York Stock Exchange. Furthermore, it has served as the pricing basis for a number of Belgian equity derivative products such as the futures and options traded on the BELFOX. In light of this success, one may wonder why it might be interesting to introduce a new Belgian index? We believe that a number of factors suggest that the future demand for equity products in Belgium may be strong. Belgian finance has been traditionally oriented toward interest rate products; however, the long-term bull equity market internationally has finally started to lead some Belgian savers to explore investment alternatives to bank deposits and bond mutual funds. In particular, in recent years there has been a strong growth in mutual funds giving investors a guaranteed rate of return plus a return enhancement based on the performance of the BEL20 index. While not sold as such, these funds implicitly give the investor a mix of Belgian government bonds plus call options on the BEL20. It seems quite likely that hedging of these funds has been at least part of the reason for the strong volumes recorded in recent years on the Brussels Stock Exchange. Given the strong returns registered by the BEL20, investors in these products have improved on the returns they would have obtained in an all-interest rate portfolio. This experience should encourage a continuation of the migration of the Belgian investor into equity products. While the stocks included in the BEL20 certainly account for a large fraction of the volume on the Brussels Stock Exchange, there are reasons to believe that they represent a narrow basis for building the complex of equity products. In particular, the BEL20 has become increasingly weighted in financial companies, and this trend is likely to continue in the future. Furthermore, given the holdings of the Société Générale de Belgique in BEL20 shares, the degree of concentration on a small number of shares is even greater than it first appears. Thus the BEL20 is not a broad representation of Belgian industrial activity as a whole. Furthermore, given that the BEL20 is not widely diversified, it is possible that a period poor performance of a handful of companies could serve to depress the whole complex of Belgian equity products. In light of this we have considered whether it is possible to use an alternative group of Belgian shares to define a new stock index which would be markedly different from the BEL20. If so, this index could be used to define a new line of equity products and, in combination with the BEL20, would allow for a greater diversification for Belgian investors. It is clear that in going beyond the BEL20 shares, volumes tend to drop off rather sharply. In order to permit index arbitrage and hedging of index linked products, it is important that the shares to be considered for the new index be at least somewhat liquid. As a consequence, we have confined our attention to 1 shares treated on the Brussels forward market. However, we have not restricted our attention only to shares that are currently quite liquid. The reason is that we must recognize that inclusion in an index is often one of the factors that tends to make a share liquid. It is reasonable to expect that liquidity of some shares would increase should they included in a new index which is launched successfully. Given the composition of the BEL20, our expectation from the beginning of the study was that the alternative index would have to be distinctly more industrial in character. However, we decided not to confine our attention to companies on the basis of industrial classifications (e.g., chemicals, energy, and so on). Given the diversification of many firms and the complex nature of their commercial relations, it is not easy to summarize the character of the firm under any single rubric. Furthermore, it seemed to us entirely possible that some Belgian holding companies could provide exposure to segments of Belgian industry currently little represented in the BEL20. As a consequence of these considerations, it was decided from the outset that we would employ a statistical analysis of returns and volumes to serve as the basis for identifying a group of firms to be included in a new Belgian index. It was recognized that this historical study of past behavior potentially could lead us to the list of firms to be included in a new index at the time of its launch. However, to be operational the new index would need to be constituted on the basis of criteria for including and excluding shares. In this way the composition of the index could be adjusted as Belgian industry and the Brussels Stock Exchange evolve. Our study stops short of providing the detailed criteria for a new index. Instead, we provide an analysis of the fundamental economic determinants of the Belgian shares. This allows us to identify more clearly the ways that shares proposed for inclusion differ from other shares. The remainder of the paper is organized as follows. In the next section we describe our data and methodology. In section 3 we study the liquidity of Belgian shares. In section 4 we study the main determinants of the returns of Belgian shares using the method of Factor Analysis. Using these results, in section 5 we propose a new stock index and discuss the relation of the new index and the current BEL20 index. In section 6 we study explore which economic variables account for the different performance of the new index. In section 7 we conclude. 2. Methodologyand Data We carry out three distinct statistical studies: (1) an analysis of share liquidity based on historical volumes, (2) a factor analysis of the determinants of Belgian share returns, and (3) a regression analysis of the economic determinants of Belgian share returns. The first two studies were carried out using daily data from January 1992 through December 1996 provided to us by the Brussels Stock Exchange. These include volumes and closing prices for shares traded on the 2 forward market and quoted initially on CATS and more recently on NTS. These were augmented by dividend and split information obtained from CRESUS! in order to calculate returns. Since economic activity variables (e.g. industrial production) are reported monthly, the third study has been carried out using monthly data since 1991. Economic variables came from the IRES Data Bank. Microstructure studies of financial markets have taught us that market liquidity is a multi-dimensional concept. Ideally, in characterizing the liquidity of Belgian shares we would like to measure the tightness, depth, and resiliency of their markets. Something of this sort was done by Anderson and Tychon (1993) in their study of the hourly CATS quotes for the largest Belgian companies over a period of one month. Unfortunately, at this stage a machine-readable data set of NTS quotes is not available from the Brussels Stock Exchange, so we have not been able to carry out an analysis of this sort in the current study. Instead, we have been restricted to the more traditional measure of trading volume. We calculate a number of volume-based indicators of share liquidity detailed in section 3. Factor analysis is a technique increasingly used in the study of stock returns data since it allows the identification of multiple sources of risk instead of the single factor (the market) employed in the Capital Asset Pricing model. By postulating unobservable factors, the analyst is not constrained to find the determinant of returns on the basis of reported data thus avoiding problems of measurement error or infrequent observations. The technique proceeds by a decomposition of the variance/covariance matrix of stock returns in order to infer the sensitivities (the beta) of the shares to the various sources of risk. Given the betas plus observations of prices, it is possible to infer estimates of the underlying factors. In this way we create time series of factors that have determined the evolution of the Belgian stock market. We can then see the degree to which movements of a given share or stock index are explained by factor 1, factor 2 and so on.