Index Rex

September 09, 2003

II. Adjust Weightings for Cross-Holdings/Float

For the purposes of determining a company's size and capitalization category, it is necessary to take into account all of a company's outstanding shares, because the stock's performance is influenced by the economic size of the company. However, in determining the stock's weight in an index a different standard should be used.

The investment universe available to active investors should be the starting point for all indexes. Many companies have shares that are closely held by individual investors, or cross-held by other corporations or governments. To the extent that these positions represent strategic long-term holdings that do not 'float' on the market, they should not be used to calculate the stock's weight in the index, and thus its contribution to the index's return. They are not a part of active investors' opportunity set.Including these shares in a benchmark distorts its return relative to the universe of active investors because, in aggregate, the managers cannot own all of the shares outstanding. In truth, there is probably no index-related issue less debatable than this. In fact, two major global indexes, the MSCI and FTSE indexes, have recently been reconstituted to adjust for shares that don't float. Although these changes resulted in hundreds of billions of dollars' worth of transactions for index and active funds, causing large transaction costs, those short-term costs will improve the long-term integrity of the indexes.


III. Define Market Capitalization as a Band, Not a Line in the Sand

Indexes based on market capitalization must be periodically reconstituted to ensure that they reflect the performance of the market segment they purport to measure. Both objectively and subjectively determined indexes currently capture this concept, to varying degrees. In each case, the rebalancing usually results in significant market impact on the stocks affected and unnecessary turnover and transaction costs. This marketplace turmoil is not prima facie evidence of poor index construction. However, rebalancing as it is now practiced doesn't reflect how active managers adjust their portfolios, and, therefore, leads to the creation of an inappropriate benchmark.

Active managers do not unanimously agree on the boundaries between two capitalization ranges. One manager might classify a $4 billion company as large-cap, while another might consider it mid-cap. To capture this ambiguity, an index's demarcation between capitalization ranges should be a band, not a line in the sand. If a stock's relative market capitalization changes so that it enters the band, the stock remains a constituent in the index to which it was previously assigned. It migrates to the other index only if it exits the opposite side of the band. A small-capitalization stock will remain in the small-cap index even if its market cap grows into the range that may have demarcated 'large-cap' when the index was first established. It will become a large-cap stock only if its market capitalization moves past the upper edge of the band.

The advantages of these bands would be twofold: First, they would reduce turnover during periodic index rebalancings, as stocks would not vacillate between one index and another based on minor changes in their market capitalizations. Second, and more important, these bands would more accurately reflect the way active managers think of their investment universe. Managers do not summarily throw a stock overboard because it crosses an imaginary line. They frequently continue to hold it even though a manager with a different investment style might consider it to be in a different index classification.

Find your next ETF

Reset All