Why Class Matters More Than Ever

May 22, 2012

Equity indices are based on common shares. But there's little equitable about the way an increasing number of companies treat shareholders.

[This blog originally appeared on our sister site, IndexUniverse.eu.]


It’s probably too early to call Facebook’s initial public offering (IPO) a debacle, even if on their second day of trading the company’s newly listed “A” shares fell up to 13 percent below the IPO price of US$38.

And Facebook’s share price isn’t yet having an effect on the main market indices, though it will do from August.

As a result of a recent easing in the exchange’s index eligibility rules, the stock may enter the Nasdaq and Nasdaq-100 indices in three months’ time, rather than after a year’s “seasoning”, as previously required.

There’s no immediate prospect of Facebook entering the broader S&P 500 index, though, at least until the company’s existing shareholders decide to part with more stock. David Blitzer, chairman of the Standard and Poor’s index committee, reminded attendees at last week’s Inside ETFs Europe conference that S&P requires a minimum free float of 50 percent before it will consider US companies for index inclusion. Facebook, meanwhile, has so far sold only around 15 percent of its share capital to the public, according to Bloomberg.

But should Facebook’s newly listed “A” shares be eligible for index inclusion at all?

As a reminder, Facebook’s “A” shares carry only a 10th of the voting rights of the “B” shares typically held by founders and early investors. Mark Zuckerberg continues to exert control over nearly 56 percent of the company, even after the IPO.

“Dual-class share structures used to be rare and confined largely to family-run enterprises or media companies, such as The New York Times, where they could be justified as protecting the company’s public mission,” the New Yorker’s financial columnist, James Surowiecki, reminds us.

Now, however, says Surowiecki, they are par for the course at an increasing number of companies, especially tech firms. Google, with its recent issue of “C” shares, carrying no votes at all, took split structures a level further.

There’s no reason why we, as individual investors, might want to hold shares that confer no voting rights and typically no dividends either. But what if the index tracked by a fund we own includes them by default?

Some index firms won’t include shares that discriminate against certain classes of shareholder. FTSE, for example, includes only those shares that carry a “premium listing” in its UK index series, and since the UK regulator has said that full voting rights are a prerequisite for the premium listing category, from the end of May (after a two-year transitional period) you won’t find the non-voting shares of companies with split share structures in the FTSE UK indices. Daily Mail and General Trust “A” class shares, for example, will drop out shortly. But FTSE doesn’t extend the same policy to its overseas equity indices. Should it?

"Corporate governance is an area of potential vulnerability for index providers," one head of a European index firm told me at last week's conference.

There are signs that institutional investors are already putting pressure on their benchmark compilers to be more discriminating in this area. There's plenty of evidence that the rapidly increasing pool of capital invested in tracker vehicles might be leading to market distortions (see Jeffrey Wurgler's recent Journal of Indexes Europe article). There's also a clear incentive for those companies listing shares to do so in a way that guarantees index inclusion, particularly when the index is widely followed. FTSE’s consultation and subsequent decision to raise the minimum free float requirements for its UK index series members was a good illustration of some of the competing interests at play.

But there are currently few signs of consistency when it comes to split share classes. Indeed, most index firms, perhaps regarding their role primarily as chroniclers and measurers of the markets’ behaviour, have historically lumped all share classes together, voting rights or not.

MSCI, in a recent consultation, raised the possibility of reducing securities’ index weights in proportion to their voting rights. A share of Volvo B has 10 times less voting power than Volvo A, MSCI reminds us, BMW Vorzug has no voting power compared to BMW Stamm, and Porsche’s listed shares don’t have any voting power, but all these share categories currently make it into MSCI’s indices.

In the meantime, however, split structures and large issues of stock with limited or no voting rights are becoming increasingly common. Until there's a more consistent approach to handling distinct share classes in index construction, investors in passive funds need to pay particular attention to what they are buying.



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