Rethinking Float Adjustment

March 03, 2003

Standard & Poor's recently announced a switch to free float methodology for its U.S. indexes. S&P takes a critical look at the issue in a concept paper.

This paper was originally published in late October, when Standard and Poor's announced that it was reviewing the possibilitiy of switching its indexes to free float methodology.  It is a comprehensive review of the subject from David Blitzer, Chairman of the S&P 500 Index Committee, and Srikant Dash, who works closely with Blitzer.

·Standard & Poor's is considering float adjustment of its U.S. indices. This document is a concept paper. No index policy changes are being made now.

· The term 'float adjustment' has become a popular catchphrase as most major indices moved toward this concept in the last three years. Unfortunately, there has been very little critical analysis on how float adjustment fits into the conceptual design and purpose of indices.

· The basic argument for float adjustment is investability. However, the issue of investability is already captured by Standard & Poor's multivariate indexing process. Potential additions have to meet explicit criteria concerning liquidity and public float to be eligible for index admission.

· Float adjustment would not affect the structure of Standard & Poor's U.S. indices, nor would it amend their risk profiles or sector compositions. There would be no improvement in liquidity of the index portfolio. Overall, float adjustment causes little practical change in index properties.

· There are three types of float adjustments: adjustments for investment regulations, adjustments for cross-holdings, and adjustments for strategic holdings.

· Adjustments for investment regulations are not an issue for U.S. equities. Cross-holding adjustments prevent double counting and are conceptually justified. However, strategic-holding adjustments do not fit into the conceptual purpose of indices of being accurate measures of the market. They also introduce agency friction and distortions in asset allocation.

· Standard & Poor's is considering two refinements to its U.S. index methodology.

1) The public float requirement for additions to the S&P MidCap 400 and S&P SmallCap 600 would be raised to 50%. S&P 500 additions already require minimum public floats of 50%. Existing S&P U.S. index constituents that have a public float of less than 50% would not be affected by this change.

2) Shares of its U.S. index constituents having cross-holdings greater than 10% would be reduced, in bands of 10%.
· Based on September 2003 index composition, only four companies in the S&P 500 and nine companies in the S&P Composite 1500 would be affected by this proposal, resulting in small additional turnover of 0.6% and 0.7%, respectively. There would be no impact on the S&P MidCap 400 or S&P SmallCap 600.

Introduction

The term 'float adjustment' has become a popular catchphrase among those who deal with indices. Ever since the International Finance Corporation (IFC) started adjusting the market capitalization of stocks in its emerging market indices for cross-holdings, strategic holdings by governments and public sector undertakings, and investment restrictions imposed on foreign investors, virtually all index providers have adopted this in some form for their indices. In the last three years, almost all indices, including Standard & Poor's non-U.S. indices, have been adjusted to reflect for available float. Standard & Poor's maintains that it is important to consider any index policy, including float adjustment, from the perspective of how it fits into the conceptual design and purpose of indices.

In this report, we explain the three different kinds of float adjustment. We discuss how Standard & Poor's U.S. index criteria address the issue of float. We then review the practical and theoretical relevance of float adjustment. We explain the difference between U.S. and non-U.S. markets as it pertains to this issue. We also describe proposals for two enhancements to be made to Standard & Poor's U.S. index methodology, and discuss their rationales and impacts. Standard & Poor's will widely consult market participants on these proposals, and will give sufficient notice before announcing any changes in methodology.

Types of Float Adjustment

There are three types of float adjustment.

Float adjustment for investment regulations

In some countries, private investors are not allowed to hold more than a certain percent of stocks in some sectors. Ceilings might also exist for foreign investors. These restrictions do not exist in the U.S.

Float adjustment for strategic holdings

These adjustments involve reducing the market capitalization of a company by the amount held by investors deemed as strategic. These include holdings by officers and directors, founders, and employees, and controlling positions held by private individuals and trusts. In some countries, the government or a quasi-government entity might hold a significant portion of a company, though this is not the case with the U.S. public companies.

Float adjustment for cross-holdings

These adjustments involve reducing the market capitalization of a company by the amount held by other companies in the index. This prevents double counting of that portion of shares of an index constituent held by another index constituent.

In subsequent sections, we will examine the conceptual arguments for strategic-holding adjustments and cross-holding adjustments.

Standard & Poor's U.S. Index Criteria and the Issue of Float

Current addition criteria

  • U.S. companies
  • Adequate liquidity and reasonable price (the ratio of annual dollar value traded to market capitalization should be 0.3 or greater; very low stock prices can affect a stock's liquidity)
  • Market capitalization of $3 billion or more for the S&P 500, $900 million to $3 billion for the S&P MidCap 400, and $250 million to $900 million for the S&P SmallCap 600 (ranges are reviewed from time to time to assure consistency with market conditions)
  • Financial viability, usually measured as four consecutive quarters of positive as-reported earnings, which are GAAP net income excluding discontinued operations and extraordinary items
  • Public float of at least 50% of a company's total shares outstanding for the S&P 500, and at least 40% for the S&P MidCap 400 and S&P SmallCap 600
  • Maintenance of sector balance for each index as measured by a comparison of the GICS sectors in each index and in the market in the relevant market capitalization ranges
  • Operating companies and not closed-end funds, holding companies, partnerships, investment vehicles or royalty trusts; Real Estate Investment Trusts are eligible for inclusion in Standard & Poor's U.S. indices

Current deletion criteria

  • Companies involved in mergers, being acquired, or significantly restructured such that they no longer meet addition criteria
  • Companies that substantially violate one or more of the addition criteria

Index maintenance

Standard & Poor's believes that unnecessary and excessive turnover in any given index should be avoided. At times, a constituent may temporarily violate one or more of the addition criteria. However, these criteria qualify a company's viability with respect to gaining admission, not retention of admission once obtained. As a result, an index component that appears to violate the criteria for addition to that index will not be deleted unless ongoing conditions warrant an index change. When a company is removed from an index, Standard & Poor's will explain the basis for the removal.

The issue of float is captured in index criteria

The key rationale supporting float adjustments is investability of the index. This is already addressed by the multivariate criteria used for Standard & Poor's U.S. indices. Specifically, there is a 30% liquidity ratio and a minimum public float requirement for additions to an index. As part of ongoing index maintenance, companies have been removed from indices for reasons of low liquidity or public float.

Float Adjustment Has No Practical Impact on Properties of S&P U.S. Indices

In this section, we will consider the relevance of float-adjusting Standard & Poor's U.S. indices, specifically with respect to resultant changes in liquidity, index structure, sector distribution and risk profile.

 

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