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.