The Role Of Free Float In Indices

April 26, 2012

The Introduction of Free Float

In these early days, the share of index-based mandates was small and the actions of index managers had an insignificant effect on the market. However, as the share of index mandates increased in the subsequent two decades, it became apparent that the desire of index fund managers for the performance of their portfolios to match closely the performance of the underlying index was causing stock prices to become distorted in certain instances.

This was most apparent during the boom in the late 1990s. Many companies took advantage of investor appetite for exposure to the new economy by launching initial public offerings (IPOs) on the world's exchanges. IPOs typically provide for only a small fraction of the company's share capital to be made available to the public. This is partly because a company should only raise the capital it requires for its immediate needs, and partly because public investors want reassurance that the founders of the business have retained a significant fraction of the shares and continue to have "skin in the game".

In the US, many companies will choose to "float" only a small percentage of their shares at IPO. In the UK the requirements are more stringent. The UK Listing Authority requires newly listed public companies to place a minimum of 25% of shares in "public hands", although there are derogations for larger companies if the UKLA believes the float will be adequate for a proper market in their shares to develop. For example Glencore, the mining company that floated in May 2011, initially placed only 12% of its shares in public hands.

Consistent with the CAPM, indices initially included such companies at their full capitalisation weight. From a theoretical perspective there is little reason to weight a company in an index differently according to the number or size of its shareholders. However, from a practical perspective it soon became apparent that the demand for the shares of new entrants from index-tracking fund mandates was starting to exceed the number of shares floated. To minimise tracking error, index managers usually seek to acquire stocks at the same price at which they enter the index; in the case of the FTSE All-Share this is the market closing price on the day before the "effective date". This led to squeezes in the share prices of new entrants which, in turn, offered significant opportunities for hedge funds and trading desks to anticipate the run-up in price ahead of index entry and so profit at the expense of those invested in index-tracking mandates.

The response by index providers was to reduce the weight of stocks in their indices to take account of the shares that weren't available to purchase in the secondary market. FTSE was the first major index company to adopt the concept of free float-weighting for newly listed companies in 1999 and, following the provision of nine months' notice, extended the principle to encompass all index constituents in June 2001. MSCI made its free float announcement in December 2000, with the implementation spread over the next two years in two phases. S&P followed in 2004, implementing a free float methodology in 2005.

FTSE's free float approach was to categorise shareholders from the information available in annual reports or regulatory news announcements, and then to determine whether the holdings of each class of shareholder should be considered as constituting part of a company's free float. For example, holdings of founders, directors and shareholders subject to "lock-in" agreements post IPO would be considered as restricted from selling, whereas portfolio holdings of investment managers and insurance companies would not.

This approach is still followed today. For example, Glencore entered the UK Index Series at an "investability weight" of 12% which reflected the fact that only 12% of the company's share capital was floated at the offering, with the remaining 88% being retained by directors and employees of the company, all of whom were subject to "lock-in" agreements of 12 months or more to prevent them from selling holdings before the share price had stabilised.


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