SPECIALS
Understanding Indices - Free Float Changes

By Rob Davies
June 13, 2001

Every day we hear and read about the level of various stock market indices and people often make significant decisions on the back of this information, not least because of tracker funds. For that reason a little knowledge of how they are constructed might help us.

Indices are constructed in one of two ways: arithmetic (or "unweighted") and geometric ("weighted"). Under the arithmetic method the shares that constitute the index are added together and then averaged, so the index is solely a measure of the share prices of the constituents. No other factors, like the size of the company, are taken into account. This method is used for the Dow Jones and the Nikkei 225 indices. Unfortunately, that means that changes in the Caterpillar share price, currently $54, have a bigger effect on the index than changes in General Electric with its $48 shares. The fact that GE is 27 times bigger than Caterpillar is totally ignored.

To get round this problem other indices, like the FTSE 100 for example, use a geometric, or weighted, method. The determining factor under this system is the market capitalisation of the company -- that is, the figure produced by multiplying the share price by the number of shares in issue. As a company's share price changes so does the market capitalisation, and that affects the position of the company in the index.

Rebalancing the index

Because the FTSE 100 is an index of the largest 100 companies in the UK market measured by market capitalisation, it needs to be updated regularly. This happens every three months and has become a much-reported feature of the stock market calendar. Last year was particularly active as technology and dot com stocks came into favour, and then went out again almost as quickly.

Nevertheless, this method at least has the merit of consistency, and it makes it fairly easy for tracker funds to follow the changes in the index, or even anticipate them. However, even this method has its drawbacks.

For instance: for a whole variety of reasons, not all the shares that a company has are available to be traded. Governments, other companies or the directors may hold big blocks of shares that are not available to investors trading shares on the stock market. This can reduce the shares actually available in the market, known as the  free float, to a much lower level, and can seriously restrict the liquidity of the shares. In plain English that means it might be difficult to buy a large quantity of shares at the price indicated on the screen.

A classic example is BSkyB (LSE: BSY) where parent company News Corporation holds a 36% controlling stake, leaving far fewer shares for other investors to buy. Vivendi owns a further 22% stake in the company so that means that less than half the shares are available to ordinary investors. This can result in distortions for tracker funds as they are required to buy shares to reflect their weighting in the the index -- which reflects the total size of the company, even though most of the shares may not be available for trading.

To get round that the boffins at FTSE International are planning to change the rules from June 15th so that the weighting of a company in its indices reflects the proportion of its shares that are tradable. In fact some shares in its indices are already adjusted to allow for these factors, but the new rules will put everything onto a standardised basis.

Under the new guidelines the "restricted float" will include significant long-term holdings by founders, government holdings, foreign ownership limits and trade investments. Anything that is not part of one of those categories will constitute the free float and will be expressed as a percentage of the total shares issued.

FTSE has chosen to use bands, so that tracker funds do not continually have to keep adjusting their portfolios. The full explanation is available at the FTSE website, but we have reproduced the table here. The "free float band" is the percentage of a company's shares that will be used to calculate its weighting in the index.

Precise free float         Free float band

<5%                Not eligible for inclusion in indices
>5% to 15%                        Actual
15% to 20%                         20%
20% to 30%                         30%
30% to 40%                         40%
40% to 50%                         50%
50% to 75%                         75%
>75%                              100%

So what does this mean for the shares involved? There may be some volatility in their share prices as funds that track the index adjust. But these should be short-term movements and, as always, it will be difficult to distinguish from other factors affecting the share price. It's good news for trackers as it should reduce the price distortions that can arise when a share has a restricted free float.

More on the changes:  FTSE International 
How Do Trackers Track? 
More on International Indices (Fool.com)