Free float adjustment's evolving role
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.