There
is a clear link between cross-holdings and free float but adjusting indices for the latter
is more contentious. Free float is the share capital of a company which is freely
available for trading in the market.
Identifying and defining the
proportion of a company's share capital which is freely available is a subjective issue.
Authoritative data are not available. This leads to many practical
difficulties in trying to apply free float weightings to all stocks. For the purpose
of calculating the indices, we define restricted shareholdings, which are excluded when
calculating free float, as trade (i.e. a holding by a connected commercial company),
rather than portfolio investments. Companies are currently included in the FTSE
indices at their full market capitalisation if they have a minimum of 25 per cent free
float. The rationale is that each company's full economic value should be included
in the index. As a result, large, medium and small companies are treated according
to their total size rather than on the basis of the proportion of their share capital
which is freely traded.
However, limited free floats
often cause liquidity problems with investors and derivative traders finding there are
insufficient shares available to meet their needs. In extreme cases, this can cause
price distortions. Many fund managers argue that including such companies at their
full capitalisation can make an index an unrealistic benchmark for performance measurement
purposes.
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FTSE
have accordingly begun to address these problems in their international indices. The
world and European indices are adjusted to allow for privatisation companies with a
limited free float. Where that free float is less than 50 per cent, their index
weighting is restricted to the free float level.
However, adjusting for free float
does have drawbacks. It can lead to an increase in the number of weighting changes
with a corresponding rise in costs for index users. It can also lead to some large
and medium-cap stocks being given very small weightings relative to their economic size.
One option, which FTSE favours,
is to extend the use of the current rule on free float for privatisation stocks to all
stocks in our indices. This would replace the existing rule requiring a minimum of
25 per cent free float and has the benefit of overcoming liquidity problems in individual
stocks while avoiding the negative aspects of completely free float-based indices.
In the longer term, FTSE will assess whether there is demand to move to a free float
weighting system and would welcome views on this approach.
If you have any views and
comments on any of these issues, we would be pleased to receive them by email and relay them to FTSE International.
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