FTSE Grapples With Its Reclassification

April 01, 1999

The FTSE International indexes have gone through some dramatic changes recently with the introduction of a new global classification system, and it looks like more index alterations are lurking around the corner.

As of July 1, 1999, FTSE reclassified the FT/S&P-Actuaries World Indices according to its new global industry classification system. The system was introduced in stages to the FTSE European and UK index series earlier this year.

The new system was instituted because of the evolving nature of the markets, said Steven Vale, a spokesperson for FTSE. "It's becoming harder to put companies into country boxes," Vale added. "[The global classification system] allows a sector-based approach to investing." He said, "The real driving force [behind the classification] is people wanting to be able to compare things on a cross-border basis and wanting one classification system for all our indices."

Sector-based investing is becoming increasingly popular in the aftermath of the euro. The new classification system involves a three-tier hierarchy that is constructed using a "bottom up" approach. Companies involved in the same lines of business are grouped into Sub-sectors. The Sub-sectors are in turn grouped into Sectors, which represent a broader mode of classification. The Sectors make up the Economic Groups that are the largest components in the index classification system. There are 10 Economic Groups, up from seven, including Resources, Basic Industries, General Industrials, Cyclical Consumer Goods, Non-Cyclical Consumer Goods, Cyclical Services, Non-Cyclical Services, Utilities, Financials and Information Technology.

In the midst of the introduction of its new classification system, FTSE started another controversy with its release of a consultation paper proposing another possible reorganization of its indexes. The issues addressed in the paper include free float, nationality and cross holdings.

Nationality is becoming increasingly complex as more and more companies extend their operations globally, the consultation paper said. Acompany may have tax residency in one country, have its primary listing on the exchange of another country and conduct the majority of its business in a third country.

Cross-holding refers to companies holding stakes in other companies, which can lead to what the paper describes as "double-counting." This means that Company Acould own 22% of Company B, yet both could be represented in the index at their full market capitalization. FTSE believes that in the case of "significant cross-holdings" of roughly 10% or more, the market capitalization of each of the companies that is represented by the cross-holding should be removed from the index. Amore complex question is how to adjust for cross holdings between two companies involved in different indexes.

Float, the number of a company's shares that are outstanding and available for trading by the public, is somewhat difficult because of the subjectivity involved in deciding what constitutes "free" float and a lack of sufficient data, FTSE said in the consultation paper. Currently, FTSE requires a minimum of 25% free float for a company to be admitted in its indexes; it excludes sharehold-ings by other commercial companies from its definition of free float. Liquidity problems and price inflation can be caused by limited free float, issues that affect index portfolio managers in particular.

 

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