Free float adjustment's evolving role
From their early beginnings as barometers of investor sentiment in the late 19th century, indices have evolved to become a major influence in investment management. Some 14.5% of US equity mutual fund assets are estimated to track an equity index1. The percentage of institutional mandates that is passively managed is higher, and in the UK approximately 27% of total pension fund assets are estimated to be indexed2. The popularity of indices has further expanded with the growth of the markets for derivatives and exchange-traded funds (ETFs). In many jurisdictions, ETFs are required to follow an index and although the ETF universe has expanded to encompass asset classes other than equities and strategies other than capitalisation-weighting, traditional equity ETFs perhaps account for a significant US$1.25 trillion3 of the investment market.
Because of the size of assets tracking indices, decisions made by the index manager in relation to corporate events and the handling of index changes can have a significant impact on security prices. It follows that indices have moved beyond their initial role of holding a mirror to the market to one where their operation can have a real influence on its functioning. This is especially so in markets where one index has a dominant share, as is the case with the FTSE All-Share in the UK market, together with its subsets, the FTSE 100, 250 and 350 indices.
This article examines the way in which the FTSE UK index series has evolved to take account of its growing influence in the market, with particular emphasis on the role of free float. The article covers FTSE's initial introduction of banded free float to modify index constituent weights in 2001, the more recent decision to use free float as an index eligibility requirement, and the impending introduction of actual free float in the UK index series.
The early index pioneers did not envisage how their creations would eventually come to influence equity markets. The Dow Jones Railroad Average (1884) is widely regarded as the first equity index and it, and its long running successor, the Dow Jones Industrial Average (1896), were constructed as simple averages of stock prices. Discontinuities in the index developed when constituents changed or underwent corporate actions, and these were only addressed with the introduction of a divisor methodology in 1928.
Subsequent indices, starting with that developed by the Standard Statistics Company in 1923, tended towards capitalisation-weighting, although the FT30, which was created by the Financial Times in 1935 and used an unweighted geometric average methodology, was an unfortunate exception. Capitalisation–weighting, as the name suggests, sensibly gave more weight to the largest companies in the index, and not to those which simply had the highest nominal share price. This could therefore be considered a more accurate representation of market sentiment. However, the virtues of capitalisation-weighting only became apparent with the development of the Capital Asset Pricing Model (CAPM)4 and the early experiences of trying to run money against an index benchmark.
Although the CAPM gave theoretical justification for running a capitalisation-weighted portfolio, by showing that this portfolio should, ex-ante, have the highest expected reward–to-risk ratio, the first index-tracking mandate, run by Wells Fargo for the Samsonite pension fund from 1969, chose to follow an equally weighted index, consisting of all the stocks traded on the New York Stock Exchange. Such indices necessitate periodic rebalancing to maintain the equal weights and this proved an insurmountable challenge for the front and back office technologies of the time. In contrast, capitalisation-weighted indices are self-rebalancing in the absence of corporate activity. The Samsonite fund switched to the capitalisation-weighted S&P500 in 1976.
At around the same time both Batterymarch and Vanguard launched index-based strategies for institutional and retail clients. These launches were met with general scepticism and, from some, derision. Batterymarch was given a "Dubious Achievement Award" by Pensions and Investments in 1972. Attempts by Wells Fargo to market indexation in the UK in the early 1970s were met with hostility.
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 dot.com 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.
Deciding whether the holdings of a shareholder or category of shareholders should be considered restricted or part of a company's float is an imprecise science: detailed information is not always readily available.
Accordingly, FTSE's initial implementation of free float assigned companies to free float bands rather than attempt to calculate an accurate number for all companies. Recognising that price squeezes on index entrants would be most pronounced for companies with low floats, FTSE decided to use precise floats rounded up to the nearest 1% for companies with floats below 15%, floats rounded up to 10% bands between 20% and 50%; two additional bands at 75% and 100% were used for stocks less susceptible to price squeezes. To avoid unnecessary turnover in its indices, FTSE introduced buffer rules to minimise the sudden change in weighting that would otherwise occur as a company's actual float crossed a band boundary.
The current system of banded floats has served its purpose well in the dozen years since its introduction. However, the use of bands can have unfortunate consequences in the event of certain corporate actions.
For example, consider the merger between company A with an actual float of 21% (banded to 30%) and company B with an actual float of 55% (banded to 75%). Assume that companies A and B are of the same size and that shareholders of both companies receive one share in the new company for every share of companies A and B that they previously held. The resulting company will have an actual float of 38% which, under current rules, would band to 40%. Index managers will have received new shares in line with their holdings, which will be determined by the banded weights of the constituents, namely 52.5%. They will therefore need to sell down their holdings in the new entity to meet the new investability weight.
In this example, the banding structure is driving an unnecessary trade. Had the constituent companies been held at investability weights that reflected their actual float, no—or at least only very limited—reweighting of the components, or indeed other index constituents, would have been required following the exchange of shares.
The use of wide bands also has the potential to distort markets when a secondary offering or a sale of stock by a restricted holder takes the actual float from just under a band boundary to just over it. For example, a company whose actual float changes from 74% to 81% could potentially see its investability weight change from 75% (the band above 74%) to 100% (the band above 81%).
It is primarily for these reasons that FTSE has announced it will move to use actual float (rounded up to the nearest 1%) in the UK index series with effect from the June 2012 review.
As we have seen, the concept of free float was introduced to overcome the liquidity problems experienced as index-oriented investors sought to obtain more shares than were freely traded in the secondary markets. With some refinements in definitions and banding structure, the concept has worked well and most popular indices now include free float as a factor when calculating the investability weight of a stock in an index.
However, free float took on a new importance in 2010 when FTSE reviewed the rules concerning the eligibility of companies which had incorporated outside the UK for inclusion in the FTSE UK index series. In earlier incarnations, FTSE All-Share membership required companies to be incorporated, listed and tax-resident in the UK. Over time, the strict requirements for UK tax residency and incorporation were dropped from the eligibility rules to allow companies such as Shire and WPP, which had changed their incorporations to the Channel Islands, to remain in the index. In their current incarnation, only the listing requirement (more specifically a premium listing from the UK Listing Authority and admission to trading on the London Stock Exchange) remains a necessary condition for UK series eligibility.
After the relaxation of the eligibility rules, companies such as PartyGaming (Gibraltar), Colt Telecom (Luxembourg), and Petrofac (Jersey) sought index entry on the basis of non-UK incorporations. Following consultation with users, FTSE set up a Nationality working party in 2006 to determine whether additional requirements should be imposed on companies that were not incorporated in the UK, and so not subject to UK company law or the automatic jurisdiction of the takeover panel. The working party proposed the following:
- adherence to the principles of pre-emption rights;
- compliance (or an explanation for non-compliance) with the UK Combined Code (now the Governance Code);
- submission to the jurisdiction of the Takeover Panel in so far as practical;
- no controlling shareholder or group thereof.
This last point represented the first time that corporate governance concerns had become embodied in a criterion for index entry. The rationale for this step was that a controlling shareholder could override the wishes of minority shareholders when appointing board members, and be generally unresponsive to requests to meet minority shareholders in convenient locations.
In practice, deciding who or what constituted a controlling shareholder or group thereof proved to be a subjective matter that required debate by the Nationality working party and its successor, the FTSE Nationality committee. As a matter of principle, FTSE seeks to avoid subjective inputs to the construction of its index series and, following the UK Listing Authority's introduction of premium listings in 2010, which subsumed much of FTSE's additional index eligibility criteria, the controlling shareholder criterion for non-UK incorporated companies was replaced with the more objective requirement that such a company should have a minimum free float of 50%. In this way free float became one of the eligibility requirements for index inclusion.
The minimum free float requirement for overseas incorporations has now operated successfully for almost a year. However, towards the end of 2011 FTSE was approached by a group of users requesting consideration of the possible imposition of a similar free float requirement on companies with UK incorporations. The impetus for the request was the observation that several companies with predominantly overseas businesses were seeking index entry by taking UK incorporation. Although some users were concerned that these companies had little overt connection with the UK economy, more were exercised that such companies could avoid the free float requirement imposed on overseas incorporations to the potential detriment of corporate governance standards.
In response to the concerns raised by these users, FTSE undertook a further client consultation in the second half of 2011 which showed overwhelming support for the introduction of a 25% minimum free float requirement for index entrants with UK incorporations.
Although the 25% minimum float requirement had widespread support, many respondents argued that it did not go far enough and that a higher minimum float requirement should be applied universally. Such a float would make it easier for dissenting minorities to block special resolutions put by a dominant shareholder: although theoretically 25% of the votes would be required to block such a resolution, corralling all minority votes would be difficult in practice.
Other respondents argued that a higher float requirement would limit London's attraction as a primary market and the future investment opportunities available to UK investors. Further, it was not clear that any of the governance grievances attached to existing constituents would have been headed off with a higher float requirement.
In the light of these opposing viewpoints, FTSE is undertaking further consultation with index users and industry bodies to investigate the merits of a higher free float requirement versus the imposition of additional governance requirements on companies. The announcement of the UK Listing Authority's own consultation on changes to the listing regime is particularly timely in this regard.
Irrespective of any future changes to entry requirements, the use of free float as an eligibility requirement for a company as distinct from a tool to weight specific securities has highlighted the need to further tighten the definition used in this regard. Accordingly, proposals regarding the consideration of voting rights, including those attached to non-ordinary shares and those associated with total return swaps entered into by restricted shareholders, will be presented for discussion at FTSE's practitioner committees.
Indices have developed immensely from being mere mirrors to the market to become tools that guide, with varying degrees of precision, the investment strategies used in the management of vast quantities of assets. Providers must remain alert to any potential market consequences arising from changes to their rules.
If the use of divisors or, for some indices, price adjustment factors, were the major original innovations in the construction of capitalisation-weighted indices, the use of free float both as a liquidity management tool and an eligibility tool surely ranks second. The role of free float adjustment will continue to evolve as indices develop, but to date it has greatly helped in improving the usability of indices.
- 2011 Investment Company Fact Book, 51st Edition, Chapter 2, Investment Company Institute, Washington DC
- WM UK Pension Fund Annual Review 2010
- Blackrock ETF Landscape, January 2012
- Sharpe, William F. 1964. "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk." Journal of Finance, V. 19: September, pp 425-442
- Ferri, Richard A. 2007. "All About Index Funds", published by McGraw-Hill