The Hidden Dangers of ETF Index Construction: Lessons from Barito Renewables

The Barito Renewables Saga: A Case Study

PT Barito Renewables, Indonesia’s largest geothermal power company, was initially scheduled to be added to the FTSE Global All Cap Index on Sept. 23, 2024. However, just a day before its anticipated inclusion, FTSE Russell reversed its decision, citing the company’s high shareholder concentration — where four shareholders control 97% of total equity¹. Barito’s shares are majority-owned by Barito Pacific, which itself is controlled by billionaire Prajogo Pangestu, who owns 71% of Barito Pacific. Additional stakes are held by Green Era Energy (23.6%) and Jupiter Tiger Holdings and Prime Hill Fund, which each hold 4.4%. This extreme concentration of ownership raises liquidity concerns, making it difficult for investors to trade the stock.

The reversal triggered a 20% decline in Barito Renewables' stock price, and it also caused significant ripples throughout the Indonesian market. Other companies owned by Pangestu, including Petrindo Jaya Kreasi and Chandra Asri Pacific, also experienced sharp drops, contributing to a 2% decline in the Indonesian Stock Exchange Composite Index. This illustrates the broader market impact of index inclusion decisions and highlights the liquidity risks associated with emerging market stocks.

The fact that such an extreme lack of free float wasn’t identified until the day before the stock’s entry into the index raises significant red flags for both the index provider and investors. It calls for more rigorous oversight in index construction to avoid exposing investors to sudden, avoidable risks.

Potential for a Short Squeeze

Whether intentional or not, having such a small free float sets up the perfect scenario for a short squeeze, where short-sellers struggle to find shares to cover their positions, potentially driving the stock price up. This is especially problematic in stocks like Barito, where liquidity is already constrained. It would be interesting to analyze whether the free float was this limited prior to the announcement of its inclusion or whether it was strategically reduced after the announcement. Understanding this timing could shed light on whether the stock was intentionally primed for such volatility.

The Role of Index Desks and Trading on Rebalances

In addition to the concerns about the oversight of index inclusion, this reversal likely had a profound impact on traders who specialize in index rebalances. Many firms have dedicated "index desks" that make a living betting on the outcomes of index rebalances, and I can speak to this from personal experience, having been part of such a desk in the early 2000s in Ireland. These desks monitor potential inclusions and exclusions very closely and often build positions in anticipation of the rebalance.

In the case of Barito, it's highly likely that several desks were aware of the company’s planned inclusion and had positions going into the rebalance. The last-minute reversal must have caused significant gains or losses for those involved, amplifying the financial impact of the decision beyond just the stock’s price movement. This example underscores how much is at stake for both institutional investors and index traders when such unpredictable events occur.

Pitfalls in Emerging Market Index Construction

Emerging markets are known for their potential for high growth, but they come with added complexities that investors should not ignore:

1. Concentration Risk
   The Barito case exemplifies concentration risk. With such a high proportion of shares held by only a few investors, the lack of liquidity and free float increases volatility. Index providers like FTSE Russell must carefully consider these factors when constructing emerging market indices, as concentration risk can lead to price distortions and hinder an investor’s ability to exit a position.
2. Liquidity Challenges
   Emerging markets are prone to liquidity risks due to low trading volumes and limited access to capital. In Barito’s case, the liquidity risk was magnified by the fact that most shares were in the hands of a small group of investors. This creates a scenario where, despite the company's large market cap, trading can become highly volatile, making it difficult for investors to enter or exit positions without significantly impacting the stock price.
3. Regulatory and Market Instability
   Regulatory risks are common in emerging markets, where abrupt changes can affect market dynamics. Indonesia, for example, has experienced several instances of regulatory shifts that led to dramatic stock movements. The Barito saga serves as a reminder of how quickly regulatory decisions or corporate actions can disrupt market stability.
4. Index Methodology and Timing Risks
   Index construction methodologies are often transparent, but they can also be rigid, leaving little room for adapting to real-time market shifts. In Barito's case, the timing of the exclusion — just after its anticipated entry into the FTSE index — resulted in a sudden sell-off. This scenario highlights the importance of understanding how and when indices review and adjust their components, particularly in volatile markets.

The Role of ETF Providers and Investors

ETF issuers and investors need to be mindful of the risks involved in index construction, especially in emerging markets. While index providers such as FTSE Russell and MSCI play a crucial role in maintaining the integrity of indices, ETF capital markets experts also need to closely monitor these events to manage potential risks in portfolio construction. Working closely with market participants, ETF providers can ensure better liquidity management and minimize the impact of unexpected index exclusions.

Conclusion: Caution in Volatile Markets

The exclusion of PT Barito Renewables from the FTSE Global All Cap Index serves as a cautionary tale for investors and ETF issuers. Emerging markets offer immense opportunities, but they are fraught with risks related to liquidity, concentration, and regulatory changes. As ETF investors increasingly look toward emerging markets for diversification, it is essential to understand the complexities of index construction and the potential pitfalls involved.

By learning from cases like Barito, ETF issuers and investors can make more informed decisions, ensuring that they are prepared for the challenges of navigating emerging markets.

About the Author

Nicholas Phillips | President of ETF Capital Markets Advisors LLC
With over 25 years of experience in ETF market making and capital markets, Nicholas Phillips is recognized as a subject matter expert in the ETF industry. He started his career spending the first ten years as a lead market maker for SIG and Goldman Sachs. At the helm of MCAP LLC's ETF Desk, Nicholas built and scaled the division, enhancing its operations through innovative pricing and risk models, and robust relationships with market makers and issuers. His tenure at Van Eck Associates as Director of ETF Capital Markets further solidified his expertise, managing critical facets of operations and deepening connections within the trading community. Beyond market making, Nicholas is an avid content creator, sharing insights that demystify complex market dynamics. He is keen on exploring board member roles that benefit from his extensive background and forward-thinking approach to ETF strategies. His dual US/Ireland citizenship complements his global perspective, enriching his professional endeavors in diverse markets.

¹ "PT Barito Renewables Energy Excluded from FTSE Global All Cap Index Due to Shareholder Concentration Issues," Bloomberg, September 2024.

² "Indonesia's Barito Renewables Faces Last-Minute Exclusion from FTSE Index," Reuters, September 2024.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.